The market got a reprieve for at least one day, as discussed in Back from the bear market brink. To provide some perspective on the investment outlook from here, it's helpful to consider a number of macro, policy, and market developments.
First, the overall market set-up remains the same: as long as inflation is well above target and the labor market is hot, the Fed will aim to tighten financial conditions and slow growth below trend to cool both. That’s not a favorable environment for risk assets. It also means that resilient growth and rising equity markets can be self-defeating if they simply bias the Fed towards more tightening. In effect, equities have to suffer as long as inflation is far above target. This dynamic is unlikely to change until either the inflation data improves and/or the Fed begins clearly signaling a less hawkish policy stance.
Second, the recent macro data has been mixed at best, while the outlook for growth has gotten worse, more so than for inflation. April CPI/PPI details were slightly worse/better than expected, but combined they suggest PCE inflation declined again in April. Consequently, we should be past peak inflation, with favorable base effects the next two months further helping. But investors won’t have a good sense of how much inflation can decline based on current Fed hiking plans until late summer. Meanwhile, US growth data suggests current spending and production is holding up well. But the sharp slowdown in China due to COVID lockdowns, European growth at risk due to the Ukraine war, high commodity prices, and the lagged effect of Fed tightening all point to slower growth in 2H22 and into 2023.
Third, the Fed’s policy course is set for the next few months, but it's more uncertain from there. A number of Fed governors have reiterated the same message the last two weeks, which is that the Fed is focused on bringing inflation down. It will do so with 50bps rate hikes at the June and July meetings, although a 75bps hike, while unlikely, is not completely off the table. The first hard decision will come in September, which is whether to hike 25 or 50bps. By then the Fed will have more data to assess the potential inflation moderation and growth slowdown. Financial conditions have already tightened enough to suggest US GDP growth could be below 2% by year-end. That may be sufficient to cool inflation, and that possibility is likely enough for the Fed to err on the side of caution when considering more aggressive rate hikes than is already expected.
Fourth, pricing across markets suggests that investors are starting to worry more about slowing growth than high inflation. A simple rule of thumb is that when investors are more focused on inflation than growth, the correlation between stock and bond returns is positive, and when growth is the main worry the correlation is negative. For most of this year the correlation has been positive as stocks and bonds sold off together. But in the past few weeks, bonds have often been rallied when equities were selling off, and vice versa. This is consistent with investors believing that the Fed will do enough to bring inflation down, but at the risk of “some pain” to growth and the labor market.
Fifth, sentiment remains very bearish and there are indications that investors are starting to capitulate. Looking across a range of sentiment and positioning indicators the one thing that stood out until recently is that fund flows into equities and fixed income were still positive. That’s changed over the past month, a sign that asset allocators, not just hedge funds and systematic strategies, are now actively selling. With a fair amount of negative news already priced in across markets, we believe there is a set-up for a tactical rally or short squeeze in the very near term on any good news.
The bottom line: The global economy is being challenged with a number of downside risks, while the consequences of tightening financial conditions for inflation and growth won’t become clearer until later in 2H22. Until then, financial market volatility is likely to remain high. But the risk of a recession starting in 2022 appear overstated amongst investors, while the prospects of a soft-ish landing over the next year are heavily discounted. Given current investor sentiment and positioning, good news on growth and inflation could provide a market tailwind that’s more than just a short-term tactical bounce.
Content is a product of the Chief Investment Office (CIO).
Main contributor: Jason Draho, Head of Asset Allocation
Original blog - Talking points, 16 May, 2022.
