Nearing the mid-year mark, disinflation is a strong contender for WOTY. But if I’m being objective my top pick right now would probably be “resilient,” or some variation thereof. I’ve used it as an adjective—e.g.,
resilient growth, consumer, or labor market—countless times, to the point that I’m now scanning the thesaurus for alternatives. I'm not alone—the use of resilience has become ubiquitous in any characterization of economic activity.
Much of market performance this year reflects "disinflation" and "resilient" being top WOTY contenders. Disinflation is usually a positive for asset prices because it leads to lower interest rates. Pairing that with accelerating growth is the Goldilocks outcome for risk assets. While resilient growth is not the same as accelerating, it has held up far better than expected, so on a relative basis, it’s been a tailwind for risk assets.
How markets perform from here will surely depend on the pace of disinflation and the resiliency of growth. We already noted in " Across the market-verse" that the distribution of macro outcomes has become “fat and flat” and that rapid disinflation, if it occurs, may be a stronger near-term market tailwind than decelerating growth would be a headwind. The argument assumed that disinflation further shifts a soft-landing from the upside scenario to the base case for many investors, while slowing growth would already be in line with expectations. The first test of this conjecture comes Tuesday when May CPI is released. A result below consensus expectations should add fuel to the recent market rally. Beyond disinflation and growth resiliency, a few other factors are relevant for the near-term outlook.
First, investors seem to be simultaneously expecting a recession, albeit delayed, while also becoming bullish on the possibility of a soft landing for equities. The latter is evident in cross-asset returns since 31 May, when the debt ceiling risk was effectively eliminated. The S&P 500 is up 2.2% since then, but small-cap stocks are up 6.7%, their entire total return for the year. Overall, cyclical and value stocks have outperformed after significantly lagging growth stocks all year. Last week, the VIX index also fell to its lowest level since January 2020, while the AAII Bulls-Bears sentiment gauge reached its highest level since November 2021, months before the first Fed rate hike. Perhaps investors really do believe that a soft landing is the most likely outcome, or maybe they have to chase the rally because their pain trade is a continued grind higher. Either way, market pricing leaves little margin for error on the macro outcome.
Second, the Fed has an opportunity at the FOMC meeting on Wednesday to clarify its policy intentions. It won’t be easy. The market is pricing about a 30% chance of a rate hike, with an 85% cumulative probability of a hike by July. Investors have taken their lead from Fed Chair Powell and Vice-Chair Jefferson, who’ve indicated a preference for skipping June to give them more time to assess how the economy is responding to the tightening thus far. Their job will be a lot easier if May CPI is at or below expectations, justifying a skip. But if inflation comes in hot and the Fed doesn’t hike, the markets could again fear that the Fed has fallen behind the curve, requiring even more hikes down the road, not a good scenario for any asset class. The Fed has been discreetly supporting the risk rally this year by allowing financial conditions to ease. That tailwind could change quickly if the economy stays too hot.
Third, the omission to this discussion so far is the third WOTY contender: AI or artificial intelligence. The “ surging seven” mega-cap stocks have been the biggest beneficiaries of AI, and since they collectively account for over 90% of the S&P 500’s 12% return year-to-date, one can credibly argue that’s the real market story this year. AI certainly has fundamental implications, but quantifying its impact on earnings or the economy is in the early stages. Investor speculation and their fear of missing out about AI could keep the market momentum going for a while. Forecasting its end is speculation itself. In other words, AI will matter, but exactly how so is even more of a guessing game than disinflation and growth resiliency.
The bottom line: We said that 2023 would be a year of inflections. There’s certainly been an inflection in financial markets the past few weeks, as they’ve priced in a more optimistic outcome for the US economy. There’s some justification to this inflection after the debt ceiling tail risk was eliminated and bank stress has stayed contained. Combined with resilient growth, this has resulted in a less negatively-skewed distribution of possible macro outcomes. But with markets rallying on these developments, investors face the same underwhelming risk-return trade-off for equities versus high quality bonds. The events of the next week and month could change that. The only near certainty is that "disinflation" and "resilient" will be front and center as investors debate whether and how much.
Main contributor: Jason Draho
Content is a product of the Chief Investment Office (CIO).
Original report: Disinflation or resilient? , 12 June 2023.