Over the past month, fears of an imminent recession have fallen along with banking systemic risk, steady disinflation is making inflation look like last year’s problem, and the Fed appears to be only one hike away from being done. Except for the banking crisis part, the preceding sentence describes how the market narrative unfolded in January. Just compare cross-asset performance from 1 January until 2 February, when the S&P 500 reached its 2023 peak, with returns since 13 March, when the S&P hit its year-to-date low. Return patterns are very similar, with almost all assets rallying in both periods. There are some differences; small-cap stocks have not done as well the past month and bond returns would be about three percentage points higher if measured from 8 March, while positive commodity returns since mid-March partly reverse their poor start to the year. But overall, markets were pricing for relatively benign macroeconomic outcomes both times.
Market performance after the “everything rally” in January is a good reminder that a benign outcome is the bull-case scenario, not the base case, especially with hard-to-quantify banking and credit risks. The 1Q rally was cut short by surprisingly resilient if not accelerating growth—January payrolls and retail sales far exceeded expectations—and core inflation that wasn’t disinflating. Instead of the Fed being nearly done, the market began pricing four more hikes and a greater probability of a hard landing. Then came the banking crisis to compound the headwinds for risk assets.
History rhymes, it doesn’t repeat, so the same combination of resilient growth, sticky inflation, and an 80bps upward revision in the terminal federal funds rate that occurred in February to early March is unlikely to be why risk assets roll over again. But the markets collectively look complacent on disinflation, fear a recession yet are pricing for growth to hold up, and are underestimating the risk that the Fed hikes more than once and holds longer than expected based on the roughly 60bps of rate cuts priced in by year-end. Three observations support this conjecture.
First, equity volatility isn’t signaling any impending growth problems. The VIX volatility index at just over 17 is the lowest it’s been since early January 2022, two months before the Fed started hiking rates. S&P 500 20-day realized volatility is even lower at 12.6%, a level last reached in late November 2021. This could suggest investor complacency, but it more definitively suggests a narrower range of outcomes for the economy than just two months ago. Back then, accelerating growth and sticky inflation implied that the distribution of macroeconomic outcomes had fat tails. It’s hard to think that a banking crisis and tighter credit conditions have diminished those tails, especially the downside one.
Second, while there’s been improvement on inflation, investors are treating it as a largely solved problem. One indication of that is the 30-day correlation between S&P 500 and Treasury returns, which is once again deeply negative at -0.6. This stems from Treasuries rallying as a safe-haven on days when equities are lower. In contrast, the correlation was positive most of last year when high inflation and Fed hikes drove both asset class prices lower. This optimism on inflation may eventually be proven right, but core inflation is still far above 2% and disinflation over the past year hasn’t been a straight line.
Third, a growth slowdown is on track, but it’s more likely to be a slow burn than suddenly falling off a cliff. Credit tightening was well underway prior to the banking crisis, and that’s continued since it began. But there isn’t yet concrete evidence that aggregate lending has declined by a notable amount. It also may not hamper economic activity that much in the next couple of quarters. In the March National Federation of Independent Business (NFIB) survey of small businesses, only 2% of respondents said that their borrowing needs were not satisfied. A gradual growth slowdown would allow the Fed to keep rates high for longer, and the longer it does, the greater the risk of something in the economy really breaking.
The bottom line: If history did repeat, then the message from 1Q would be to sell in May. Since history only rhymes, it’s safer to say that at some point over the medium term the current market pricing for a benign macroeconomic outcome is likely to lead to investor disappointment. Slowing growth is the most probable culprit, but complacency on inflation and optimism on a Fed pivot mean that there are multiple reasons why markets will pull back from pricing for a near perfect macro outcome. That’s why we continue to prefer high-quality bonds over equities.
Main contributor: Jason Draho, Head of Asset Allocation
Content is a product of the Chief Investment Office (CIO).
Original report - Rhyme time , 17 April, 2023.
