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“I don’t belong here”

Radiohead, Creep

Last week, we discussed the importance of turning points in relation to the current financial market dynamic - and by extension the US inflation print and the multiple underlying factors that make the inflation dynamic very complex at the current juncture. At the core of the problem is the fact that there are concurrently two supply shocks (pandemic supply chain and commodity price shock) and one demand shock (inflation). This is a backdrop that enables multiple equilibria and thus facilitates uncertainty.

This uncertainty in financial markets has driven a significant drawdown in risk assets of late, as the market contemplates the impact of global monetary tightening in response to inflation. Indeed, last week, the market price action was very ugly, as the emphasis shifted away from the Fed reaction function to the threat of inflation (pricing the pace and extent of the interest rate response) and towards the impact of tightening monetary conditions (the Fed reaction itself) on future growth.

We have some sympathy with the evolving view that market pricing of the Federal Reserve System (Fed) cycle is now near complete. Slightly softer wage pressures in the US over recent months are more conducive to a more predictable Fed reaction function. Furthermore, it is likely that the current level of market pricing (a terminal rate in the 3.00 - 3.25% range) and the wider level of tightening of financial conditions through the equity and credit channels are sufficient to bring demand and supply back to balance (as the Fed so target), especially if we consider the impact of fiscal contraction as broadly equal to the positive impact of Covid reopening and pent up household demand (and or savings).

In other words, it can be argued that the market has priced a reaction function of the Fed - a tightening of financial conditions - sufficient to rein in inflation. Real yields have remained relatively stable in modestly positive territory, and this stability is likely testimony to this thesis: that the Fed will act to curtail inflation (at whatever level). Ultimately, this has shifted the uncertainty to growth. In fact, it could also be argued that switching the uncertainty away from inflation and towards growth has driven the focal point of market positioning and the uncertainty away from treasuries and towards equities.

The important question now is whether or not markets have priced too much uncertainty, too much forward-looking negativity into equities and risk assets.

In Europe, there has been much more emphasis on a range of potential economic outcomes - albeit driven largely by the dominant factor in Europe - the Ukraine war (as opposed to the dominant factors of inflation and Covid in the US and China, respectively). These outcomes or scenarios have been noted in the shifting European Central Bank (ECB) reaction function. Finnish ECB Governing Council member stated this week that they see the ECB’s June forecasts “near the adverse scenario from March”, as the ECB narrative now gravitates towards an end to APP purchases in June and a rate hike in July.

In the US, perhaps due to the singular (inflation) focus of the Fed (as opposed to the economic emphasis of Europe due to the more direct implications of the Ukraine situation), the market emphasis has been much more binary: hard landing or soft landing. Indeed, this narrative has been fuelled by the Fed. In the press conference following the 4th May Fed 50bp rate hike, Chair of the Federal Reserve said “We have a good chance to have a soft, softish landing”. Furthermore, this week the President of the Federal Reserve Bank of Philadelphia said that the Fed can make a safe landing, if not a soft landing”.

The problem with this language is that it is very poorly defined and in many respects fuels the uncertainty of the market. Above, we note the shifting medium for market uncertainty - from inflation to growth and from treasuries to equities. It is likely that much of this is a function of the concern that the Fed will not be able to hit the narrow landing strip (as some commentators have described it) of a soft landing. If the Fed can’t manage a soft landing, then it must be a ‘hard landing’ - a poorly defined and likely overly negative descriptive narrative. So much so I expect it will be replaced fairly soon in the Fed lexicon.

What does a ‘hard landing’ mean? If a soft landing is broadly defined as a smooth process by which demand can be damped to ‘catch down’ to supply such that it does not cause a recession, such that the unemployment rate does not rise sharply; such that the unemployment rate does not rise above the equilibrium level (which is likely significantly above the current level)? Mass layoffs?

Indeed, it is possible that in the US, following a negative initial reading for Q1 GDP, that we also get a negative, or flat reading for Q2, before base effects likely see a sharper pickup in growth through the second half of the year. Thus, we could be in a situation over coming months, where the US has had a technical recession and full year growth above potential (as individually disclosed estimates and the most recent ‘dots’ continue to expect). This would be a recession as a function of the tightening of financial conditions from Fed guidance and market expectations. If this is a hard landing, is it (a modest technical recession confined to H1) a scenario that warrants a near 25% decline in equity market valuation?

Furthermore, the current two-fold supply shock is ultimately transitory: global supply chains will ultimately be resolved. Thus, it could well be argued that the current global shock to real incomes will reverse over coming years, as supply chains and commodity prices adjust back lower. Thus, if growth prospects are being curtailed in the near term by the negative real income shock, this too is transitory, as the future holds a positive real income shock. On a forward-looking basis, this does not sound like a scenario consistent with a dramatic repricing lower of risk assets - albeit the timing and magnitude of the decline are unclear.

Moreover, when we look at the US labour market, if one thing really stands out it is the decline in participation since the Covid crisis. There have been some modest signs of late that there is some un-retiring (or re-entry of the previously retired back into the workforce). If this becomes more of a theme across the labour market spectrum, then the resultant increase in the workforce could be the helping hand the Fed is looking for to reduce pressure in the labour market (and raise the unemployment rate back towards equilibrium) without layoffs - a widening of that landing strip for a soft landing! Indeed, this could see the unemployment rate higher (perhaps sharply, depending on the pace of re-entry) without the need for a single layoff. Again, not really a catastrophe for risk assets

Lastly, in the currency space, there are broader implications of the attainment of markets fully pricing the likely Fed reaction function. That is to say that there is likely a subsequent rate repricing of DM markets relative to the US - thus narrowing the rate differential advantage of the USD in FX markets. Indeed, in recent sessions we are also seeing a reduced correlation between the USD and what would traditionally be described as ‘risk-off’. From our perspective, the best value USD shorts are likely (selectively) in the EM space as yields, valuation, participation, commodities and geographic location all favour outperformance over coming months. However, as we have noted on many occasions recently, we are increasingly biased towards a weaker USD in DM.

Both in the USD and global risk markets, after what are now very significant moves, it is likely that the key questions going forward are centred on what a hard landing looks like. And more pertinently, if we are to get a hard landing, is it likely to be as bad as what markets have already priced into risk assets. There is clearly a risk that the supply driven aspects of inflation become more pernicious and that central bankers feel they have to hit demand harder as a consequence. But for us, this remains a risk, not a core theme. It is therefore legitimate to question if risk assets “belong here”

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