Over the next few months, there's a solid case for inflation falling more quickly than growth. (UBS)

Even before the House and Senate passed the legislation, investors had turned the page. The question is what’s the next chapter in the 2023 market story that has already experienced multiple narrative twists and turns?

The elimination of the debt ceiling tail risk, combined with unexpectedly resilient growth and sticky inflation pushing up Fed rate hikes expectations, means that the distribution of potential US macro outcomes has once again gotten “ fat and flat.” That is, soft and hard landings are both still very viable outcomes and the distribution is less negatively skewed than at the peak of the banking crisis in mid-March. The May jobs report reinforced this conjecture because of its mixed messages. Nonfarm payrolls increased 339k, far exceeding the 195k consensus expectation, but there was a net 313k employment decline in the household survey. The unemployment rate rose to 3.7% from 3.4%, but this reflected the 440k increase in people seeking work, which is good news from the Fed’s perspective. Overall, there was something in the report for every investor view on the macro outlook.

There are two implications of this macro distribution for the market outlook. One is that the dominant market narrative—e.g., soft landing, hard landing, no landing—will continue to jump around frequently in response to incoming data. This means each chapter of the 2023 market story is relatively short. That’s a challenge for portfolio positioning because the optimal allocation for each narrative is different. The second, related implication is that there are multiple plausible paths for the markets the rest of this year and the “market universe” that becomes reality hinges on a variety of factors. They include growth and inflation dynamics, which combination of hike/pause/ skip/cut characterizes Fed policy, and whether AI propelling equities higher is in the early or late innings. These are big topics that require more space to properly address, so we’ll only make a few comments on how the evolution of the macro factors could drive market performance.

Rapid disinflation, if it occurs, may be a stronger near-term market tailwind than decelerating growth would be a headwind because of differing impacts on investor expectations for a soft versus hard landing. Inflation falling while growth stays resilient supports a soft landing, while the reverse macro dynamics increase the odds of a hard landing because the Fed may keep hiking even with the economy on the edge of a recession.

Over the next few months there's a solid case for inflation falling more quickly than growth. Headline CPI is expected to fall sharply through July—Bloomberg consensus for May is 4.1%, down from 4.9% in April, and it could be below 3.5% in June. May flash inflation for the Eurozone has already fallen more than expected. In contrast, a rapid growth deceleration is unlikely, given the still-tight labor market, strong aggregate household balance sheet, and positive real income growth. More time and additional rate hikes are probably necessary before growth really cracks.

If core inflation and average hourly earnings surprise to the downside during this time, while the labor market and consumer hold up, soft-landing expectations may go from possible to probable by mid-summer. Investors are already cautious and positioning still reflects that view, so disappointing growth data need not weigh much on risk assets, while data favorable for a soft landing could fuel a market melt-up. The May jobs report is at least directionally consistent with this scenario because it entailed growth resiliency through the strong beat on job creation, while average hourly earnings continued their gradual decline. Viewed this way, the S&P 500 finishing up 1.5% on the day is not surprising, or that cyclicals and small-caps led the way, with tech and communication services being the laggards.

The bottom line: Downside tail risks have moderated with the debt ceiling resolved and bank stress staying contained. The same isn’t true for US growth and inflation, which are both running hotter than the Fed wants. The good news is that a soft landing is still very possible. The bad news is that the longer the economy stays too hot, the greater the risk that the Fed can only cool it with a hard landing. That leaves us with a fat and flat distribution for potential macro outcomes the rest of the year, and multiple possible paths for the markets. With the S&P 500 definitely pricing in a good path, its risk-reward for the rest of the year is not particularly attractive relative to high-quality bonds. But the outlook for the next couple of months might boil down to this: The more that inflation cools while the labor market holds up, the more equities heat up.

Main contributor: Jason Draho, Head of Asset Allocation, CIO Americas

Content is a product of the Chief Investment Office (CIO).

Original report - Across the market-verse , 2 June, 2023.