The Big Picture – April 27th, 2023

Published Apr 27, 2023

Asset markets are behaving as if it’s a foregone conclusion that inflation is falling, the economy will slow, and the Fed will reverse course sometime this Fall. Based on current indicators, that’s a reasonable call. But there’s something troubling about markets all looking the same way; when they get blindsided, they get hurt, badly. Think, Joe Theisman meets Lawrence Taylor.  

Pick whatever economic indicator you wish – Conference Board leading indicators, Philly Fed, freight rates, diesel prices, the yield curve, etc. – all are signaling slowdown. Core inflation has come down but remains buoyed by the price of services and a tight labor market. Bank lending standards have tightened for everything from auto loans to small business loans. But the Fed has indicated it isn’t stopping, we should expect at least one more rate hike and we shouldn’t expect a reversal any time soon. Yet futures markets indicate the Fed will pivot in Sep, equities have rallied 16% from the 2023 lows, the VIX index (which measures expected stock volatility) remains deep in sanguine territory, gold is rallying, the MOVE index (which measures expected volatility in bond prices) is signaling big moves ahead, and even bitcoin is rallying. The markets are all betting big that the recession will be mild enough to sustain corporate earnings but bad enough to cause the Fed to reverse; in short, everyone is expecting the Goldilocks scenario, and soon.

In fact, the only debate these days seems to be how soon the Fed Funds target will come down with the 2023 forecasters pointing to historically reliable leading indicators and the ‘not-so-fast’ camp pointing to the resilient labor market. Both camps make good arguments. Apart from tech and finance, the labor market shows no signs of cracking as ‘employee hoarding’ continues to be the order of the day for service providers who struggled to find staff over the past few years. The delayed-pivot camp points to our aging population and lack of coherent immigration policies as catalysts for continuing wage pressure. They make a good point about macro trends; the Fed won’t pivot because corporate earnings disappoint, they will pivot if employment drops, and employment (on average) remains strong.

In the meantime, stocks are priced for perfection and the yield curve is so inverted that it’s hard to see how the 10Y rallies much even if the Fed does cut short rates (although shorter rates would come down to normalize the curve). So, what if something in the data changes meaningfully, or there is some exogenous shock? I don’t recall a time in which so many people have convinced themselves of the inevitability of a particular outcome and if they are disappointed, there will be panic as everyone heads for the exits. So, here are a few of the “known unknowns” to keep your eye on:

  • Banks – The deposit run has abated, but watch for commercial real estate losses, deposit flight, and lower NIM to hurt more regionals.
  • Debt – The debt accumulated by households, businesses and the government has nearly doubled since 2008 and shows no sign of slowing. The government’s debt limit is becoming a political battleground and according to the CBO, the cost of servicing government debt is expected to stay well-above tax revenues which will necessitate even more borrowing. Moreover, at least one of our biggest creditors (China) isn’t so friendly and might not be as stable as we think.
  • Geopolitics – The world is a dangerous place as countries with aircraft carriers, not just rifles and rhetoric, vie to challenge U.S. hegemony.

There are certainly more risks, but you get the idea. We knew about pandemics, but COVID took markets by surprise. We knew about Russian intentions, but Ukraine took markets by surprise. We knew that banks take stupid risks (and we have a huge regulatory apparatus so prevent them), but SVB took markets by surprise. Nobody wants to believe the ‘Fall pivot’ story more than me but having done this for a while, there’s something unsettling about such a strong consensus market view. I still truly believe that home sales and buying activity will rebound sharply, but how we get there might not fit the current narrative. Don’t be surprised or discouraged if markets get blindsided along the way.


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