Equities were expected to follow a similar down-then-up path. Investors positioned accordingly, de-risking their portfolios and waiting for a market pullback to buy. Just one problem: A recession hasn’t started, and instead of a significant pullback creating a buying opportunity, the S&P 500 was up 16% in 1H.
The situation is quite different now with the second half of 2023 underway, and that consensus has splintered into a wider range of views. To frame the situation, think of the economy and the markets as coming to a fork in the road, with one path headed toward a soft landing and its corresponding positive market implications, and the opposite for the other path ending in a recession. That there are two plausible and distinct paths for the economy makes for a different investing environment versus the start of the year when a soft landing seemed improbable.
While multiple outcomes have always been possible, what’s different now is that we should get more clarity during the summer on which path the economy follows. Hence, a fork in the road is nearing. A soft landing has gained momentum as the data has consistently surprised to the upside the past two months, which was reinforced by the first batch of June data released last week. Ironically, one data point that didn’t positively surprise was June payroll growth—209,000 versus 230,000 consensus—the first time in 15 months that payrolls didn’t beat expectations.
Doubts about a soft landing hinge on two related points. First, while there’s been rapid disinflation in headline CPI, core inflation has been stickier. The risk is that this will persist, especially if growth stays relatively strong, forcing the Fed to hike rates more than the 1.5 times currently priced in the markets. Yet beneath the headlines, the details for core inflation are more encouraging. The trend for 3-month annualized measures of core CPI ex-shelter have steadily declined over the past year.
That makes the release of June CPI on 12 July a critical fork-in-the-road data point. Both headline and core are expected to fall quite a bit on a year-over-year basis, and these 3m annualized core measures could be down to 2%. That’s not enough evidence to think that inflation is “solved,” but two more months of that trend might be enough to think it's well under control.
This leads to the second point of doubt about a soft landing, which is that it will be hard to avoid a recession with the Fed continuing to hike rates and keeping them higher-for-longer. That’s a risk, but if inflation falls as expected, the Fed may be able to stop soon to avoid unnecessary damage, a positive development for almost all assets.
That’s the macro perspective of the fork-in-the-road framework, what about the markets? Asset class performance this year reflects rising hopes for a soft landing. But that’s created a dilemma for investors who started the year underweight equities because of recession expectations. They can stay cautiously positioned, but it can be painful to be underweight absent a recession, as the first half demonstrated. The alternative is to increase equity allocations, but at the risk of getting whipsawed, especially if you think that a recession has only been delayed not averted.
Positioning data suggests that discretionary investors have erred on the side of caution rather than re-allocation. But what many have done is buy call options to capture some upside if markets continue to rally, while not being exposed to the downside. This is evident by the rise in total call option volume starting around mid-May, when positive economic surprises took off. Note that the volume has tailed off the past two weeks as investors became more cautious again after the strong run-up.
Another way to think about this fork-in-the-road moment is that one path entails a continuation of range-bound markets, as they have been for the past year, while the other path is a sustainable bull market. Markets will likely stay rangebound if the data remains inconclusive and a soft landing looks more like the bull rather than the base case. This path could also end up in a bear market if a recession does materialize, but given the current economic momentum, that looks like a late 2023 risk at the earliest. On the other hand, investors could shift to a soft-landing base case before end of summer, leading to a clear breakout from the top of the range, where the S&P 500 is right now.
The bottom line: Using call options is not a long-term substitute for owning equities outright and at some point, investors have to decide whether they want to buy or stay on the sidelines. This is tantamount to deciding whether you expect a recession or a soft landing, or at least no recession until well into 2024. With the economy’s fork-in-the-road moment near, investors will have to make that decision soon. Being cautious in range-bound markets is understandable—it’s not in a bull market. If economic data keeps tilting toward a soft landing, the markets are increasingly likely to price in that outcome, with investors reallocating to risk assets. June CPI data in-line with expectations is another step in that direction.
Main contributor: Jason Draho, Head of Asset Allocation, CIO Americas
Content is a product of the Chief Investment Office (CIO).
Original report: Fork in the road , 10 July, 2023.