In US professional sports, teams often “tank” in order to finish at the bottom of the standings, with the hope of drafting a player who can transform their prospects. Being aware of teams’ tanking incentives is critical for those who bet on games or participate in fantasy sports. Investors are evaluating a different “race to the bottom” between inflation and economic growth, with even more important consequences. High inflation and rising interest rates have driven cross-asset performance this year on the assumption that GDP growth would fall faster than inflation rolls over.
That thinking has started to change in recent weeks, which is evident in market pricing. The winning macro trades this year have been to short equities and Treasuries and buy the USD, the result of the Federal Reserve tightening financial conditions in order to bring down inflation. But in the past month equities have rallied, led by cyclicals, value, SMID, and ex-US markets, the 10-year Treasury yield is 40bps below its peak due primarily to lower inflation expectations, and the DXY dollar index is down 5.5%. This market reversal is due partly to extreme investor positioning in these trades being flipped by the fear of missing out a year-end rally.
But the reversal of these macro trades has been fueled by recent US data. October CPI and PPI data declined more than expected, import prices and the ISM prices paid index have returned to pre-pandemic levels, and housing prices and new rents indicate shelter inflation should slow materially later in 2023. Meanwhile, solid October retail sales indicate consumer resiliency, and with new unemployment claims still very low and inflation declining, real spending power should improve going forward. That said, leading indicators point to a slowing economy, manufacturing activity is near contraction territory, lending conditions are tightening, and housing activity is arguably already in a recession. How one views all this data is in the eye of the beholder, but a soft-landing outcome that looked very unlikely a month ago is now a slightly more plausible scenario and recent market pricing reflects that shift in probabilities.
The question is whether the reversal of the 2022 winning trades is temporary or the start of a new market regime. There was already some reversal of the reversal trade by the end of last week, with the equity rally stalling, and rates and the USD marginally higher. A pause is typical after such large moves, though two other factors came into play. First, Fed officials pushed back against hopes for a pause in rate hikes anytime soon in an attempt to prevent financial conditions from easing too much. Chair Jay Powell doing this in the next two weeks would be an even stronger headwind for the reversal trades to continue. Second, the market tailwind from hedge fund and systematic investor re-risking over the past month is fading now that positioning is less extreme.
The bottom line: The medium-term market outlook ultimately hinges on how much and how quickly inflation and economic growth fall, and how Fed policy reacts to the evolving macroeconomic landscape. To put it another way, we expect 2023 to be A Year of Inflections, and how soon and at what levels these macro variables reach their inflection points will determine market performance. For now, we can be pretty confident that the Fed will continue to hike rates into 1Q and growth will continue to slow, a combination that’s not good for risk assets. Thus, it’s unlikely that the reversal trade is the start of a new market regime. But if inflation can credibly race growth to the bottom, a better regime could start earlier in 2023 than is currently expected.
Main contributor: Jason Draho
Read the original blog Race to the bottom 21 November 2022.
This content is a product of the UBS Chief Investment Office.