Investors broadly agree on two things. First, major economies will fall into recession in 2023 (if they are not already there). Second, inflation rates have peaked and will decline sharply, maybe not back to inflation targets, but most of the way there. Sounds like transitory inflation after all.
Investors are confident that already-healing supply chains will return to full health as inflation’s pandemic-specific drivers unwind – China’s abandonment of its zero-covid policy, for example. This is the first justification for today’s consensus. The second is that any residual inflationary momentum from overheating labour and product markets will be addressed by actions that have already been taken. Short-term interest rates may need to rise a little further in early 2023, but such moves are already priced into yield curves.
Finally, there is a belief that the recession ahead of us will be short and shallow, as will be the hit to corporate earnings. And, beyond the current burst of inflation, there are no threatening economic or financial imbalances that will turn a run-of-the-mill downturn into something more destructive. Private sector balance sheets are relatively healthy, aided by fiscal giveaways during the pandemic and a decade of tight lending standards after the global financial crisis (GFC).
Investors also take comfort that the banking system has historically large buffers of capital and liquidity, heavily fortified after a decade of regulatory pressure. That no core asset class has broken, despite the rapid repricing of short-term interest rates, adds to the sense that the financial system is structurally well prepared.
“A decade of free central bank money has left in its wake the mother of all short-volatility trades – a crowded bet that inflation risk has been eliminated for good.”
A CYCLICAL BEAR MARKET?
The consensus forecast (of a cyclical bear market) is underpinned by the following narrative. Downside earnings risks are limited because the recession will be unremarkable. The inflationary dangers will prove transitory after all, so Powell and his colleagues can pivot quickly into an easing cycle. Ignore the Fed rhetoric of 2022. The Fed put is close to being in the money. And most of the market turmoil is already behind us.
But the path to a cyclical bear market is very narrow. It would require an unexpected sharp and persistent drop in US (core) inflation, and just the right amount of economic weakness: enough for the Fed to start cutting rates but not so much that the jobs market starts contracting, in which case any policy pivot won’t be in time to stop the self-reinforcing downward momentum characteristic of recessions. Bulls will have to hope that there are no more nasty surprises, eg from a chaotic reopening in China, a renewed spike in global energy prices or an unexpected twist in the Russia-Ukraine conflict. But, equally, too much good news – eg because Chinese activity rebounds strongly after a short-lived but manageable covid ‘exit wave’ – and there will be no Fed pivot at all. China’s reopening boom may, in fact, be so powerful that hopes of a Fed pivot are quickly replaced by fears of an even higher peak in US interest rates. Expectations of dramatic global goods disinflation would surely be squashed.
If Lady Luck is smiling on Powell, the cyclical bear market scenario is just about possible; but the odds look remote. As complex and dangerous as predicting the future is, there are fleeting moments in financial markets when the way ahead seems surprisingly clear. This is one.
The Fed can only slow the economy and curtail inflation by tightening financial conditions. Its policy cannot gain traction on the real economy unless we see lower equity prices, higher treasury yields, wider bond spreads and greater constraints on bank borrowing. The more financial conditions are buoyed by evolving data (the ‘bad news is good news’ dynamic) or miscommunication by the Fed, the harder Powell will have to slam on the brakes. Unfortunately, we cannot return to a world of low and stable inflation without a sizeable economic correction. That would mean the equity bear market has further to run.
AIR POCKET AHEAD
This hints at an underappreciated danger: financial conditions could tighten much further, beyond what the Fed is ultimately comfortable with. A decade of free central bank money has left in its wake the mother of all short-volatility trades – a crowded bet that inflation risk has been eliminated for good. 7
Policymakers are confident the financial system is far less fragile than it was a decade ago. In their view, the pernicious dynamics that lead to disorderly financial markets stem from excessive leverage and short-maturity funding in the banks and dealers at the core of the system. These weaknesses have been addressed since the GFC.
We remain sceptical. Post-GFC regulation has reduced systemic risk: the economy is better insulated from the financial system. But, within the financial system, risk has largely been transformed – (asset) illiquidity is the new (balance sheet) leverage – and pushed beyond the regulatory perimeter into non-bank financial institutions. The violent blow-up of the UK’s liability-driven investment (LDI) sector was a timely reminder that an unlevered asset manager-dominated system can be fragile, unstable and destructive. A reminder too that the central bank’s balance sheet is no less necessary as a guarantor of orderly market conditions.
7 Cole (2017), Volatility and the alchemy of risk: reflexivity in the shadows of Black Monday 1987