While neither the Federal Open Market Committee (FOMC) statement nor Fed Chair Powell explicitly said that the Fed is pausing rate hikes, the strong indication is that policy is on hold, unless growth, inflation, and credit conditions are far stronger than expected over the next few months. With the Fed on pause, Q1 earnings season about 80% done, and the first batch of April economic data already out, there aren’t many market catalyst events in the next few weeks (we think the debt ceiling isn't likely to stress risk assets until shortly before the X-date).
A slowdown in major newsflow is a good time to level set the investment outlook. We've had the view that the economy is likely to evolve as a slow burn over multiple quarters, rather than experience imminent and rapid declines in growth and inflation. Yet the market outlook also hinges on a race to the bottom between growth and inflation, with the odds of a soft landing rising if inflation falls faster, and vice-versa for the hard landing probability. This race ultimately depends on which of the labor market, core inflation, the Fed’s pause, and regional banks break first. The fact that a soft and hard landing are both still very much in play is consistent with a fatter and flatter distribution of potential macro outcomes. All this leads to the market narrative jumping around, resulting in cross-asset performance that lacks consistent direction and keeps index levels and yields range-bound.
Where are we in this overarching view based on the latest data and policy developments?
First, growth still looks like it’s on a slow moderating trend. The labor market is emblematic of this gradualism. Monthly job growth since last November has been (in thousands) 290, 239, 472, 248, 165, and 253 in April. A slow growth moderation is evident elsewhere: the ISM manufacturing index has leveled off at 46–48 this year; housing starts and new home sales have stabilized and ticked higher the past few months; and real domestic final sales grew at 3.2% in Q1. The lagged effect of high rates and credit tightening should weigh on growth, but a big drop could be at least two quarters away.
Second, inflation is declining rapidly by some measures (headline CPI, PPI, import prices) and very gradually in others (wage growth, core CPI). In the race to the bottom with growth, we think what really matters is what the latter categories do. While wage growth has fallen only modestly, there are reasons why that could pick up pace. In the lead-lag dynamic between prices and wages, the former tends to lead the latter rather than the other way around, so rapidly-falling CPI bodes well for easing wage growth, in our view. Lower job openings also tends to lead wage growth lower. But the proof is in the pudding. Inflation dynamics are not well understood and hard to predict, and resilient growth can also temper inflation’s decline. Hence, inflation moderation is also likely a slow burn.
Third, the known unknown in this analysis is the hard-to-quantify downside risk that credit conditions deteriorate very rapidly, quickly bringing down growth followed by inflation. The continued weakness in regional bank stocks risks creating a negative feedback loop with deposits, at least until there’s clarity on how these banks’ problems will be resolved. How much this eventually weighs on credit availability depends on how quickly confidence can be restored. The longer the crisis lingers, the greater the risk.
Fourth, the Fed may be done hiking rates, but its policy tightening to date and communication from here will be highly impactful on the markets. Hiking twice since the banking crisis began may prove to be a mistake if the Fed can’t maintain financial stability while fighting inflation; that is, in trying to break inflation, the Fed may have broken credit transmission first. The Fed already has a tough communication challenge in convincing the markets that it will keep rates high for long enough to break inflation, even as bank stress lingers. Fed Chair Powell didn’t do himself any favors by downplaying that stress in his press conference, only to be followed hours later by media reports that one of the stressed regional banks was considering strategic options. Yet for all that, indications of a pivot to rate cuts should help catalyze the start of a sustainable new bull market.
Financial markets have their own take on this overarching view, collectively leaning towards inflation as the current leader in the race to the bottom, though it depends on the asset class. The rates market is pricing for a recession to begin in Q3, with rate cuts starting in the summer, and for inflation to fall alongside growth. On the other hand, equities are more sanguine on growth, while also expecting inflation to decline; i.e. they’re pricing in a soft-landing. How else do you explain the S&P 500 being up 7% since the banking crisis began, while realized and implied volatility are lower? Looking across all asset class performance this year, the consistent theme is disinflation (lower commodity prices have helped), with the decline in yields benefiting longer duration assets, such as mega-cap tech stocks, gold, and bitcoin, while economically-sensitive assets (e.g., small-caps, energy and financial stocks) have lagged the most. And while the outlook may entail fat upside and downside tail risks, the S&P 500 and the 10-year Treasury yield have stayed within well-defined and relatively narrow ranges, waiting for something bigger to break.
The bottom line: Neither the Fed pausing nor the banking crisis change the fact that the market outlook remains primarily a function of how growth and inflation will evolve over the next few quarters, and what’s already priced in. While growth and inflation are both on downward paths, we think they’ll continue to see uneven journeys, yet equities are still pricing for it to be fairly smooth without major speed bumps. The recent data suggests that's possible, the banking crisis suggests that's unlikely. For that reason, we continue to favor high-quality bonds over equities, though the final outcome should depend on which macro factor breaks first. Until then, expect the dominant market narrative to continue to flip-flop over the near term.
Main contributor: Jason Draho, Head of Asset Allocation, CIO Americas
Content is a product of the Chief Investment Office (CIO).
Original report - Level set , 8 May, 2023.