There’s no shortage of developments to consider, and the following touches on some of them. But rather than be linked by a common narrative thread that dictates cross-market performance in the near term, the markets are instead likely to jump from one narrative to another as they lack clear direction in a data-dependent environment.
First, banking stress has eased, reducing near-term systemic risk, but there are indications of further tightening of credit conditions that will weigh on medium-term growth. The good news is that deposit outflows continue to slow though remain large in absolute terms; reliance on Fed liquidity has declined; and funding market stress indicators remain contained. The bad news is the decline in commercial and industrial (C&I) loans and real estate lending, and loan volumes fell and credit standards continued to tighten in the Dallas Fed Banking Conditions Survey conducted 21–27 March. Changes in credit conditions are a good leading economic indicator, so these developments don’t bode well for growth later this year.
Second, data released last week showed the labor market is cooling, but whether that’s a negative or positive development depends on your point of view. Lower JOLTs job openings, revised jobless claims revealing an upward trend over the last two months, and continued moderation in job growth, hours worked, and average hourly earnings in the March payrolls report all indicate a loosening labor market from very tight conditions. Pessimists view this as the first cracks that will be followed by much greater deterioration in the coming months. The optimistic interpretation is that the labor market is returning to balance relatively painlessly. In fact, over the past year, the seemingly improbable combination has occurred: positive job growth, a lower unemployment rate, moderating wage growth, and a decline in job openings. Painless rebalancing may not continue, but so far the labor market cooling but staying resilient is consistent with a soft landing.
Third, inflation has fallen behind growth as a market concern, despite core CPI inflation remaining stubbornly high at 5.5%. Shelter inflation expected to fall later this year due to the lagged effect of lower rent growth, average hourly earnings over the past three months annualizing to 3.25%, a level consistent with 2% inflation, and the belief that slower growth will bring down inflation are driving inflation to a secondary concern. Even if core inflation stays elevated for a while, headline CPI is expected to fall rapidly over the next few months. Consensus is forecasting March CPI of 5.1%, down from 6% in February, and favorable base effects could result in CPI close to 3% by the summer. The Fed cares more about core inflation, and thus so do the markets, but the optics of 3% CPI inflation will validate the view that growth rather than inflation will be driving Fed decisions and market performance.
Fourth, the VIX volatility index fell below 19 last week, a level typically associated with a benign economic outlook, even though there are numerous downside risks and a majority of economists expect a recession. A moderate VIX level in the face of these uncertainties is an implicit indication that the Fed has flipped from being a source of market volatility when it was hiking aggressively to now potentially taking volatility out of the market. While it’s not directly intending to do that, the Fed’s fast policy response to maintain
financial stability during the banking crisis has that effect. Furthermore, expectations that the Fed will pivot to rate cuts later this year has a similar volatility-suppressing impact because the purpose of those cuts will be to ease financial conditions in order to avoid a hard-landing recession. Such Fed behavior is why some hedge funds with relatively light risk positioning have been “vol sellers” whenever volatility surges, while other investors are selling high volatility (i.e., writing put and call options) to harvest the income. Either way, this technical selling also suppresses volatility.
2022 was difficult for investors, but the narrative was simple: Inflation was too high and the Fed aggressively tightened financial conditions in response. The result was pain for stocks and bonds, and a tailwind for the USD. So far, 2023 has been a much better year for asset class returns, but the prospect of the macro narrative frequently flipping won’t make it easy to navigate from here. Why could the narrative flip? Growth and inflation are both very likely to fall during the rest of this year, but as the declines occur it’s hard to know in real time whether they’re falling toward a soft landing, a mild recession, or a hard-landing recession. In data-dependent markets, the overarching narrative could continue to flip month-to-month.
The bottom line: Navigating market narrative flip-flops isn’t easy, but it helps that rates are pricing in a more pessimistic view, while equities at the index level lean toward an optimistic outlook. This differentiation is a key factor for our preference for high-quality bonds over equities. One could argue that bonds and equities are actually pricing in similar views on a Fed pivot and the dampening impact on risk asset volatility. But equities aren’t pricing in the hit to earnings growth that would likely correspond with a Fed pivot later this year. The markets might continue to jump from one narrative to another for the rest of the year, but what they can’t continually do is price in different narratives across asset classes.
Main contributor: Jason Draho, Head of Asset Allocation
Content is a product of the Chief Investment Office (CIO).
Original report - Narrative jumping , 10 April, 2023.