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Gradually, then suddenly

Human beings are not particularly good at non-linear thinking. While many participants would like to believe that economics and markets are normally distributed, empirical evidence suggests that they are not. Rather they are complex and convex. Ernest Hemingway was asked how he went bankrupt? “two ways. Gradually, then suddenly.” As we have noted recently, the consensus belief in a “soft landing” is probably too optimistic. Either policy tightening that has occurred over the past 18 months contributes to a meaningful deterioration in growth or macro conditions remain firm leading to a reacceleration in consumer price inflation that in turn leads to further policy tightening to a level that is restrictive. Historical experience also suggests the odds of a soft landing are low. Only 2 out of 12 episodes since 1957 were moderate and none of the hard landings were anticipated by central banks.

The yield curve is always an important variable and generates a lot of attention. The time to fear the signal from the curve is not when it becomes inverted, but after it re-steepens following an inversion (chart 1). As Cam Crise has noted, the curve is primarily a function of monetary policy (how tight/easy policy is) and the economic cycle. Historically, each major cyclical episode or growth shock followed a re-steepening of the curve. The current episode has been complicated by the unusually large fiscal deficit for where we are in the economic cycle (at full employment) and has contributed to the consensus belief in higher-for-longer rates and bear steepening of the yield curve.

However, as we have noted recently, key leading indicators of the labour market suggest that the Fed will be forced to contemplate cutting policy rates over the coming months (chart 2). That is (ironically) counter to the prevailing bias in “higher for longer” and consensus belief in a “soft landing.” Nothing is certain in the economics or markets, but our sense is that investors ought to be contemplating downside risks to growth, rather than soft-landing or reacceleration.

Our other major quarrel with the prevailing bias is the compensation for risk. Put another way, even if you accept a “soft landing” or reacceleration in growth as the highest probability outcome, the earnings yield on US equities is inferior to money market, extremely low versus long-end yields and the lowest since at least 2005 (prior to the Great Recession – chart 3). Similarly, the credit risk premium is also unusually narrow relative to high grade bonds and leading indicators of the default cycle such as the senior loan officer survey.

To be fair, there is decent risk compensation available outside the S&P500 and the NASDAQ. Nonetheless, we still fear a renewed drawdown phase in the global risk proxy and the impact that will have on broader risk appetite. Implied equity volatility also remains (unusually) low comparted to the tightening in broad financial conditions which considers rates, swap spreads and US dollar strength (chart 4). We have remained “light and tight” in terms of positioning since July. Over that period the S&P500 is down about 9% from peak. On the positive side, the current correction is likely an opportunity to scale into non-US equity risk.


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