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.