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The Twisted Logic of Bad Equals Good

One of the key characteristics of 2023 has been swings in the prevailing bias on major macro trends that have caught consensus positioning and beliefs offside. At the start of 2023, most investors were positioned for recession in the first half only to be hit by underlying macro resilience. The prevailing bias then positioned for “higher-for-longer” only to be taken out to the woodshed by the US regional banking crisis. Then the consensus positioned for a credit collapse led recession and got caught offside with liquidity, fiscal support, and resilient growth again. From our perch, investors are positioned for “higher-for-longer” again just at the point where the lagged impact from prior policy tightening is starting to impact macro conditions. For the tactically minded, it has paid to fade the prevailing bias.

Just as the investors positioned for “higher-for longer” the recent macro news flow has started to confirm the impact of the tightening cycle that started in 2022. Ironically, the first batch of bad macro news has contributed to a relief rally in rates (decline in yields). In turn that has reduced market anxiety on the narrow equity and credit risk premium. Of course, the deterioration in the macro news flow is only positive if the economy “soft lands” – that is the prevailing bias among fund managers according to the Bank of America survey. It is also reflected in consensus earnings revisions which have trended higher again recently. However, historically the odds of a soft landing are 2 in 12. The big picture risk is that the macro news flow continues to deteriorate leading to a growth scare, recession anxiety and a deeper correction in equities.

An excellent example of bad macro news flow contributing to relief on rates and the equity risk premium is the JOLTS job opening data. The time series commenced in 2000. However, the JOLTs have been a reliable leading indicator of total US employment in the last three macro cycles (chart 1). The decline in job openings and underlying data such as the quit rates is consistent with a material slowdown in the US labour market. The good news is that this might reduce inflation and rate pressure. Of course, a large rise in unemployment would also lead to or coincide with a sharp correction in final domestic demand, corporate profits, and a credit default cycle. Put another way, the relief on rates is only bullish if the economy “soft lands.” Note the JOLTs is a leading indicator of the labour market so we would not be surprised if it is not yet reflected in August payrolls on Friday.

It is too early to tell whether a soft landing is the higher probability outcome. It is possible. A plausible reason for that outcome might be the US fiscal thrust and the necessity of more assertive policy support by China in this region. However, historically a soft landing has been the lowest probability outcome. Moreover, even if that is your bias, risk compensation is not very attractive. The earnings yield – bond yield differential is the lowest in 30 years. Investors can also earn a higher yield in duration free money market than in equities and credit. The positive in emerging markets and Asia is that risk compensation is considerably more attractive or priced for a more pessimistic outcome. For the tactically minded, it has also paid to fade consensus positioning and beliefs in 2023. Of course, that always feels uncomfortable.


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