That’s certainly been the case so far, with signs of rapid disinflation, a better-than-expected global growth outlook, and central banks nearing the end of their rate-hiking cycles fueling an “everything rally” across financial markets to start the year. Then the outlook started inflecting at 8:30am on 3 February when the January US payrolls report far exceeded even the most optimistic forecast. Subsequent data on US services, credit card spending, and improving sentiment suggest that the US economy may actually be re-accelerating. Better growth isn’t a bad thing, unless accompanied by stickier inflation and upward revisions in expected Federal Reserve rate hikes, both distinct possibilities.
Putting aside these inflections, investors have learned over the past month that the distribution of macro outcomes for 2023 likely has fatter tails—higher probabilities of upside and downside outcomes and thus a flatter overall distribution—than what most were assuming coming into the year. The broad consensus was that 1H23 would be challenging for risk assets as they dealt with slowing growth and downward revisions to earnings. But that would give way to a better 2H23 as growth started recovering and central banks pivoted to rate cuts. This thinking led to a narrowing of perceived paths for the economy, and thus financial markets.
Instead, the data this year suggests that a Goldilocks soft-landing for the US economy is still very much on the table, as long as the labor market holds up while inflation continues to fall. But the most recent data are also sending signals that perhaps a hard-landing recession, induced by more than two additional Fed rate hikes, will be necessary to bring inflation back to 2%. Both tail scenarios remain very plausible because there are elements of the data trajectory over the past six months that can be used to credibly argue in favor of either outcome. In effect, the economy hasn’t reached the fork in the road where after it goes down a path in which only one of the two outcomes is inevitable. Or it has, but it’s just not clear yet.
Turning to the markets, cross-asset performance this year looks like the consequence of investors trying to properly price in, and position for, the higher and evolving probabilities of these tail scenarios. While soft and hard landings are the upside and downside tail outcomes, a mild recession was the base case for a majority of investors, including CIO. This explains the initial cautious 1H23 outlook and generally light risk positioning for many investors. The good macro news to start the year that lifted soft-landing expectations also lifted asset class returns, reversing the relative performance of 2022. That was the case until the 3 February inflection point. Asset prices have fallen in the six trading days since the January payrolls report was released, with return patterns strikingly similar to those for 2022.
While it’s too simple to explain all market pricing as the consequence of investors updating tail scenario probabilities, it's fair to say that investors were overpricing the probability of a soft-landing and underpricing the hard-landing risk during the first month of the year. Last week was a modest course correction.
It’s also noteworthy that market performance over the past 13.5 months has adhered to a simple binary condition: whether the Fed was trying to tighten financial conditions in order to cool inflation and the labor market, or if it was willing to tolerate some easing of these conditions. The former was the case for all of 2022, but the latter was applicable this year up through the FOMC meeting on 1 February when Chair Jay Powell didn’t push back against the recent easing of conditions. Nor did he really walk that back last week when given a chance during an interview. Not that it was necessary. The market reverted preemptively to tightening financial conditions in response to the potential growth re-acceleration on the anticipation of more Fed rate hikes than were currently priced. Hence, why return patterns last week look a lot like those of 2022.
Investors may be dealing with the binary market performance regime for a while, as long as investors are toggling probability between soft and hard-landing scenarios, and the Fed is either aiming to tighten financial conditions or tolerating their easing. But after being unprepared for a possible soft-landing outcome, the data suggests that investor positioning has become more balanced. This should dampen the influence of technicals as market drivers for the time being. But their impact will return if a particular path for the economy becomes more definitive, and investors move quickly to avoid being incorrectly positioned for this next inflection.
The bottom line: The macro tail outcomes have been in the spotlight this year, but investors should still position their portfolios for the central scenario, while being prepared for upside and downside outcomes with selective positions. This warrants cautious overall risk positioning, especially after large rallies in equities and credit, favoring defensive sectors in equities and staying up-in-quality within fixed income. Select cyclical positions are attractive where there’s higher probability of fundamental improvement, in our view, including commodities and EM equities both benefiting from China’s re-opening. But the binary market performance pattern so far in 2023 is a reminder that the market swings of the last year are likely not yet a thing of the past.
Main contributor: Jason Draho, Head of Asset Allocation
See the original report - Fatter & flatter, 13 February, 2023.
This content is a product of the UBS Chief Investment Office.
