THE HALFTIME AIR WAS SWEET PERFUME
We’re at the halftime mark in the first wave of the inflation volatility story. We’ve had the up; next comes the down.
It started with sweeter smelling November 2022 CPI data than expected. Equities and bonds rallied sharply on this news. The historical justification for the rally is synthesised in Figure 5. Typically, after inflation peaks, markets rally. But the chart also shows that, if a recession follows the peak in inflation, markets continue to suffer – except during the 1970s.
If the recession is mild in nominal GDP terms because inflation (though falling) is still elevated, that supports markets, because earnings are driven by nominal GDP. Obviously, the hope is for a similar result in 2023: inflation will fall convincingly, so the Fed will not have to drive the economy into a recession. Earnings declines will be softened by nominal growth, which slows but is not deeply recessionary, and equity multiples will find support through falls in bond yields, credit spreads and the dollar. In short: a goldilocks soft landing for the economy and risk assets.
NO VERDICT WAS RETURNED
While the market appears to be pricing this goldilocks narrative, market commentators remain bearish. The yield curve is inverted, and leading economic indicators are turning down, confirming economists’ consensus of an oncoming recession. Logically, therefore, earnings estimates remain way too high.
So why did markets rally from their October 2022 lows? The rally was probably driven by portfolio repositioning by the systematic investing community.3 These buying flows would have been triggered by the first signs of cooling US inflation and labour markets, reducing uncertainty about how high US rates will rise. With less uncertainty on rates, volatility can fall, and falling volatility drives flows into risky assets. Once these flows raise asset prices and change price trends, trend following investors start buying mechanically, blind to the recession’s impact on earnings.
Source: Datastream, Goldman Sachs Global Investment Research
3 These quantitatively driven funds tend to adjust their portfolios according to volatility and trend signals
So what should investors pay attention to? This question gets to the heart of the hyper-financialised system. Investment flows, driven by statistics like volatility and moving averages, appear more fundamental than actual fundamentals, such as earnings outlooks. After many years of stimulus and cheap money, the prospects for cheap money and investment flows now outweigh the prospects for profits.
So, to invest in today’s markets, an investor needs to understand and anticipate changes in flows. And this requires judgements on the size and composition of balance sheets in the financial sector, particularly commercial and central banks.