Cruising for a Bruising — Alpha Sources.CV

I am almost done with the fifth chapter for my book on demographics, but given that I’ve spent the best part of 18 months writing and researching it, I think I will let it marinate a bit further before giving it a final look and read, and present it to the world. In the meantime, however, there is plenty to chew on in markets and the wider economy.

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Financial market pundits are a bit like dogs chasing cars; they wouldn’t know what to do if they caught one. And so it is that after trying to figure out whether the economy and markets would achieve a soft landing in the wake of the post-Covid tightening cycle, no one quite knows what to think now that the soft landing appears to have arrived.

Let’s list the key requirements for a soft landing.

On the right side of a kinked Philips Curve - This is the idea that while interest rates have increased they have not done so to such an extent as to provoke a downturn in the economy. In other words, a sharp rise in unemployment and a fall in economic output have not, and will not, be needed to bring inflation back to something resembling target. I discuss some of the economic theory, and practice, behind this idea here and here.
Calm and collected financial markets - A soft landing is conditional on relative stability in financial markets. This is true for the the obvious reason that if something breaks in in markets, it could spill over into the real economy, increasing the risk of a hard landing.
Falling interest rates as inflation comes down - Strictly speaking, a decline in interest rates is not needed for a soft landing if the two previous conditions are met. But a key component of the soft landing remains the idea that rates comes down from restrictive levels as inflation eases. In other other words, a condition for a soft landing is that inflation comes down sufficiently from the peak to allow central banks to call some form of victory. If that doesn’t happen, it, by definition, increases the risk that the trade-off between economic output, the labour market and inflation isn’t as benign as we thought.

As I type it is fair to say that all three of these requirements are currently being met, either by the data or market expectations, but how resilient are they? Let’s take a look.

The global economy is improving

We still see significant divergence between the major economies. The US economy was in rude health at the end of 2023, while Europe was flirting with recession. Specifically, the UK slipped into a technical recession in H2-23, and the Eurozone was flirting with one. In both cases, however, falling inflation is now lifting real incomes, and labour markets remain resilient. This points to somewhat better times ahead ahead, perhaps with the exception of Germany, where the near-term outlook remains pretty grim. In China, meanwhile, we’re also still waiting for a meaningful pick-up in growth. But by and large, leading indicators suggest that global economic activity is firming at the start of the year, which will reduce the risk of a sudden leap unemployment.

This is partly due to the fading shock from rising interest rates. The first chart below shows that my diffusion index of global central bank rates—capturing the number of CBs raising rates vs no change and cutting vs hiking—extended its improvement at the end of 2023. By this measure, global economic activity—proxied by the composite PMI—should perk up further in the first quarter. The second chart plots my diffusion index of OECD leading indicators, which too seems to have settled on a positive trend. In summary, it does not appear as if the sharp increase in interest rates have sown the seeds of a broad-based downturn in global economic growth, at least not immediately at the start of 2024.

Markets are partying

In markets, investors and strategists remain enthralled by the flight of the magnificent seven. This has understandably elicited a vigorous debate about the perils of market concentration, thin market leadership, bubbles and the like. Europe has even joined the party via the GRANOLAS. I am not sure this acronym will have the staying power Goldman Sachs is hoping, but it is a sign of the time, all the same. I don’t have much value of add to this debate. We have been here before. We know that momentum and quality are strong factors in equity markets, and we know that a correction will arrive at some point. What is surprising to your humble econ blogger, however, is that this is happening with interest rates where they are. Granted, the opportunity cost of sitting on the sidelines as big tech marches higher is substantial, especially for professional investors and fund managers who can’t just sit around and watch their relative returns evaporate. But it is mitigated substantially when you can get nearly 5% on the risk free rate. There must be an awful lot of cash sloshing around!

More generally, we are now seeing more than a few warnings from market sentiment indicators that the air is getting a bit thin. But timing interim tops in a momentum driven market is dangerous business. The siren song of the long vol position is at its most dangerous when volatility is pinned to the floor and it can’t possibly go lower. It doesn’t have to for your put options to melt away over time. It merely has to stay down. In this sense, one interesting observation at the moment, from the first chart below, is that low equity volatility now seems to be pulling fixed income volatility lower. I would have expected the opposite, but there you are. The second chart shows that the total return of the broad global stock index is still below its previous peak, pointing to somewhat less exuberance compared to the message from the rise of big tech, obesity drug makers and the like. Could it be that sector rotation will continue to propel the broader market higher if and when the high fliers temporarily fall to the ground? One can only hope. The second chart also overlays the total stock market return with a binary signal from leading indicators, to mark-to-market to improved macro story described above. It isn’t a perfect overlay, and there have been some pretty spectacular false flags in the whippy post-Covid world. But when leading indicators make a transition from low-and-falling—their weakest point—to something better, it tends to occur in the context of broadly rising markets.

Low vol begets low vol; buy at your peril

Sticky inflation

Everything was looking easy at the end of 2023. Inflation was falling rapidly, central banks were emitting dovish vibes and expectations for a series of soothing rate cuts from major central banks were firming. Roll on the January CPIs and suddenly the near-term outlook is a bit less forgiven. To be clear, inflation is still declining based on standard measures of trend analysis, and market-pricing remains consistent with monetary easing this year. But the January inflation numbers convincingly snuffed out hopes of rate cuts in March, at least in the US and in the Eurozone, and still-low unemployment continue to lurk as upside risks for wage growth. The first chart below shows that core inflation in the developed world—here US, the UK and the Eurozone—was still falling gently at the start of the year, but also that it remained high, at just under 4%. Headline inflation, by contrast, seems to be stabilising a touch over 3%. I believe both will fall further in the next three-to-six months, but it is also clear that either of these numbers are too high for DM central banks, as a collective, to contemplate rate cuts. In other words, for expectations of rate cuts in Q2 to be fulfilled, the inflation data for February and March need to play ball, and preferably serve up some downside surprises. If they don’t, the playbook for 2024 will need to be re-written.

Falling quick enough for rate cuts in Q2?

It wasn’t just the hard inflation numbers that threw a curve ball at the start of 2024. The price surveys did too. The chart below shows that global selling price expectations are now rising in both manufacturing and goods. To be clear, both are consistent with a continued fall in inflation, but the leap in the services index is nasty. Inflation in services prices was always going to be the stickiest, and evidence that the it is now already snapping back isn’t what central banks, or bond markets, wanted to see.

As I argued before Christmas in my conversation with Andreas Steno on his Macro Sunday podcast, I’ve always thought that inflation would rebound at some point this year. Specifically, I’ve argued that the difference between a soft and a hard landing is whether central banks will be able to live with the level at which inflation stabilises, even if it is plausibly a touch higher than the mythical 2% target. I’ve further speculated that 2-to-2.5% would probably be ok, while something closer to 3% would be a challenge, and anything above 3% would be a big problem for the global economy as policy would have to tighten further, significantly increasing the risk of a hard landing. What I didn’t expect, however, was for inflation to rebound as early as the first half of 2024. As I said above, I am hoping the February and March inflation numbers play ball.

Larry Summers, a US economist and former Treasury Secretary, has been predictably quick to troll all of us. Speaking on the January inflation numbers he said;

"It's always a mistake to over-interpret one month's number — and that's especially true in January, where calculating seasonality is difficult," he said. "But I think we have to recognize the possibility of a mini-paradigm shift."
(…)
"There's a meaningful chance, maybe it's 15%, that the next move is going to be upwards in rates, not downwards,"

Writing the in the FT, David Zervos, a US market strategist, is a bit more optimistic, though also non-committal. He emphasises the power of what the Fed can do, rather than what they will do.

“Here is my version of the outlook for monetary policy in 2024: The Fed can cut quickly and the Fed can expand the balance sheet aggressively, if things get messy.”

Mr. Zervos goes on to argue that the Fed’s ability to ease policy aggressively, if things get ugly, is now implicitly underwriting benign conditions in markets. In effect, he argues that the Fed Put is back. This, by extension, means that he thinks inflation is coming down quickly enough for the Fed to focus on downside risks to the economy, should they emerge, rather than upside risks to inflation. Let’s hope he is right.

More generally, Mr. Zervos’ reluctance to take a view on what the Fed will do, emphasising instead what it can do, is a bit of a cop-out. Forecasting is difficult, but it comes with the requirement to take a view, all the same. When it comes to interest rates, point forecasts can’t hide behind probabilities and hypothetical reaction functions. They’ll either hold, cut or hike. Perhaps what Mr. Zervos is really saying is that he doesn’t believe it is that important whether interest rates stay at their current level or fall slightly.

Dario Perkins, a UK market strategist, disagrees. In a widely lauded blogpost on the post-Covid cycle and soft landing he says;

“To secure the soft landing, central banks might need to cut interest rates soon to head off these problems. The good news is that, with inflation back to acceptable levels, they have the option of reducing interest rates: they could cut rates 100-200bps and still have policy that is “restrictive” by the standards of the pre-COVID economy. What are they waiting for?”

Again, we’re back to that idea of an “acceptable” pace of inflation. No one really knows what that is, which is why it remains difficult to exactly define the conditions under which a soft landing is truly durable. My own reading is as follows. We’re currently living the soft landing and it is very pleasant indeed. But inflation numbers at the start of the year have put us on notice. Like the high-flying magnificent seven, GRANOLAs and other market-power wielding large caps, hopes of a sustained soft landing in the economy are now cruising for a bruising.