It has been a few weeks since we have published as your humble student of the markets has been on the road meeting investors. From our perch, there has been a notable shift in the prevailing bias over the period which our astute Italian friend has phrased “the big flip” – in essence the consensus trades that worked since late last year; peak inflation, rates, dollar weakness and EM out performance have “flipped” again since the start of February. The related consensus belief or fear of a hard landing in late 2022 has been undermined by resilient macro conditions, especially in the labour market, retail spending and some underlying components of inflation. The debate has pivoted from hard to soft or no landing at all.
Of course, an implication of the big flip, which has been reflected in short term interest rate markets is the re-pricing of July Fed fund futures by around 30 basis points since late January. Clearly there has also been a rise in terminal rate expectations and a higher-for-longer path for short term rates.
Put another way, the longer that significant portions of the US economy remain resilient, the higher interest rates need to rise to be restrictive. Despite 400+ basis points of tightening last year, policy is still not restrictive enough (typically rates must peak above the rate of inflation). Nevertheless, our sense is that the magnitude and speed of the current tightening cycle will eventually contribute to a hard landing in growth and profits. It is important to remember that policy lags by 12-18 months and will take time to impact the real economy and corporate earnings. For example, in previous cycles jobless claims (unemployment) after the peak in policy rates. Indeed, once the labour market starts to deteriorate more rapidly, the Fed is typically cutting the policy rate (chart 1).
Another key aspect of the big flip has been the correlated reversal in dollar weakness over the past few weeks. The belief that inflation and short-term rates had peaked late last year, also contributed to a correction in the US dollar (which is itself a key component of broad financial and liquidity conditions). US dollar weakness also coincided with a recovery in emerging market assets (inverted on the time series below – chart 2). To be fair, the rally in EM was also driven by the rapid policy pivot and reopening from China. Although we would argue that both trends are reflexive with price and beliefs influencing risk perceptions in a feedback loop.
Tactically, the near-term risk for emerging markets (Asia) is that short term rate expectations in the United States, might warrant a larger rally in the US dollar back toward the October peak last year. While we are careful not to overstate the importance of naïve overlay relationships, higher short-term rates in the US, especially relative to other regions, might support a renewed phase of dollar strength (chart 3). It will probably lead to policy and financial conditions that are restrictive… eventually.
To be fair, it is always important to ask: what is your quarrel with price? For now, the global risk proxy (the S&P500) has been resilient with macro conditions. However, our fear is that will lead to more policy tightening and rates that are eventually restrictive for risk assets. We trimmed net equity risk following the FOMC earlier this month in Asia Tech and growth equity. We suggest clients avoid speculative or profitless “growth equity”.