The year began with a soft-landing narrative taking hold in January, which in February turned into talk of fatter tails for the macro outlook due to resilient growth and sticky inflation. That segued to rising downside risk in March with the Federal Reserve potentially hiking rates to 6%, only for that scenario to be squashed in just a few days because of the banking crisis. After all that, how did 1Q end? The S&P 500 was up 7% in the quarter, the NASDAQ surged 16.8%, and 2- and 10-year Treasury yields both fell 40bps. And soft-landing chatter re-appeared in my inbox on Friday after better-than-expected inflation data and signs of deescalating bank stress.
It goes without saying that economic fundamentals don’t change every four weeks. What can change very quickly is investor perception of the fundamentals when there’s high uncertainty over what’s actually happening in the economy and Fed policy is contingent on volatile data. While investors want quick resolution of uncertainty and clarity on future outcomes, fundamental trends often become apparent only gradually, with the current environment being no exception. Thus, the evolution of growth, inflation, and policy rates this year are likely to be slow burns playing out over multiple quarters, rather than fast sharp turns.
Starting with growth, a Lehman-like moment that causes an immediate negative hit looks very unlikely in the near term. Instead, tighter credit because of the banking crisis will take at least a couple of quarters to be a significant drag, if at all. There’s little hard data yet on the crisis impacting credit availability, only anecdotes of lending terms from regional banks in a state of flux. Even if tighter credit becomes a major headwind for the economy, the latter does have good momentum, growing above trend the last three quarters assuming 1Q tracking estimates over 2% prove correct. Plus, loosening a tight labor market will likely take many months of rising jobless claims and falling job openings. Even if the pace is in doubt, investors can be fairly sure that growth will slow, because that's what the Fed wants in order to be confident that inflationary pressures are curtailed. If tighter credit doesn’t achieve that goal, more rate hikes will.
Turning to inflation, hopes of rapid disinflation early in the year have given way to the reality that core measures are proving to be sticky and will likely decline at a measured pace. Core CPI did fall from 6.6% in September to 5.5% in February, but the annualized paces over the last eight, six, and three months are all around 5.2%, meaning there’s been no real deceleration yet. Shelter inflation leading indicators do suggest it will start to fall later this year, and the University of Michigan 1-year inflation expectations index fell to 3.6% in March, continuing a steady decline from 5.4% one year ago. Improvement is in the pipeline. But even the Fed is projecting core PCE inflation to still be 3.6% by year-end, down from 4.6% in March.
Finally, market expectations for Fed rate hikes have been incredibly volatile the past few months, but the Fed’s policy guidance has been consistent. It wants to keep rates “higher for longer” in order to bring inflation down over the next two years, while tolerating some, but not severe, economic pain (i.e., the unemployment rate rising from 3.6% to 4.6%). This gradualist risk management approach is more reminiscent of the Greenspan Fed of the 1990s than the “shock-and-awe” Volcker Fed of the 1980s. The Fed following through with this higher-for-longer approach will hinge on growth not falling off a cliff. But it would likely gladly accept a slower decline in inflation if the trade-off was, at worst, a mild recession.
The slow-burn bottom line: When we downgraded equities to least preferred two weeks ago, upgraded bonds to most preferred, and recommended tilting portfolios away from US equities towards US investment grade corporate bonds, we didn’t expect a quick payoff. Instead, it was a calculation that high-quality bonds like IG credit offered a better risk-return trade-off than equities over the next six to nine months. In other words, it was a slow burn payoff race in which we favored the tortoise over the hare. Of course, sometimes the hare can temporarily pull ahead. Equities rallying to end 1Q despite greater downside risks to growth reflects relief that the banking stress has moderated, not gotten worse. But if equities were pricing in a relatively benign outlook two weeks ago, the S&P 500 forward P/E multiple now over 18.5 leaves little room for positive surprises, and a lot of scope for disappointment. At some point the equity hare is likely to hit the wall in this race, but a slow decline in growth means that may not happen in the near term.
Main contributors - Jason Draho
Content is a product of the Chief Investment Office (CIO).
Original report - Slow burn, 3 April 2023.