That was fast
A week ago the market looked ripe for further melt-up if better-than-expected inflation fueled the Goldilocks narrative. Inflation did its part and the market responded accordingly—the S&P 500 was up 3.8% after the July CPI was released Wednesday morning. With investor FOMO rising, the question is what comes next for the markets. Here are a few thoughts to help answer that question.
? With inflation far too high and the labor market too tight, the Fed’s priority this year has been to tighten financial conditions in order to slow growth below trend and cool the economy. While inflation is likely to continue falling, core measures remain too high and the labor market has loosened only very modestly. Thus, the Fed may not be pleased with how much financial conditions have eased during the past two months, undoing 15% to 45% of the tightening in the preceding six months, based on various estimates. That sets the stage for the Fed to push back even more aggressively against current market pricing for fear that it negates the hard work put in during the first half the year. This wouldn’t be good for financial assets.
? The fundamental economic outlook has improved on the basis of the very strong July jobs report and with most inflation measures set to continue declining. At the margin, this shifts the probability from a recession to a soft landing outcome. It also trims the downside tail risk of a deep recession because it’s looking less likely that the Fed has to hike rates significantly to bring down inflation. This suggests that a recession, if one occurs, would be mild, concentrated in manufacturing and an inventory correction. But it’s also far too premature to assume that recession risk is now low. The Fed still wants growth to slow to ensure that inflation falls back near the 2% target, and once growth gets to around 1%, the economy is vulnerable to any risk—of which there are many—tipping it into a recession.
? Market-implied probabilities of a recession have undoubtedly come down, and a rough estimate is that they’re well below 50% in most cases. For perspective, the S&P 500 is now only down 10.8% from its all-time peak, and it’s up nearly 17% from its June low. The index is trading around the same level it was at in early May, and the same applies to US high-yield corporate bond spreads. That was when investor concerns started shifting from inflation being too high to growth slowing rapidly. But it was only in mid-June that a recession became the consensus investor view. Thus, the market moves since then suggest that risk assets are pricing for a soft landing, not a recession. The inverted yield curve suggests otherwise and while the curve may only be a coincident indicator, the disconnect between market pricing across asset classes implies that one of them isn’t right.
? Investor sentiment has gone from being very poor in June and July, with investor positioning also being light, to now talk of FOMO and a Goldilocks outcome. The rally over the past month in particular has had a technical tailwind, consisting of short-covering, systematic strategies adding risk, corporate buybacks, and positive retail fund flows. There’s scope for this tailwind to continue supporting risk markets, as it appears that investors have been either eliminating hedges or starting from low levels of risk more so than adding significant risk exposures. The sentiment reversal over the last two months is a reminder that extreme pessimism is often a good counter-indicator. Bullish sentiment is less predictive of subsequent returns, but investors becoming more optimistic in the current highly uncertain environment does make the markets more vulnerable to negative news.
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? There aren’t any obvious events in the next couple of weeks that could disrupt the market grind higher, though unexpected news is always possible. All eyes will be on the central bank gathering at Jackson Hole from 25–27 August. Fed Chair Jay Powell is set to give a speech, but he’s unlikely to say anything new about the bank's plans for the September FOMC meeting and beyond. Like investors, Fed members will be waiting for the August jobs and inflation data to firm up their plans. The absence of any significant news is likely to be good news for market momentum in the near term.
? On the data front, investor focus is increasingly being narrowed to inflation and labor market data, as that’s what matters most to the Fed. And among the inflation and labor data, the most critical is wage growth. If it starts to moderate while job growth remains solidly positive, then the key economic variables will be in place for investors to fully embrace the soft-landing scenario. If not, then investors may need to recalibrate their scenario probabilities again in a less optimistic way.
Taking all of these factors into account, the one thing that we can say with some confidence is that market volatility is likely to rise again as we move into late summer and the fall. The VIX volatility index is now below 20, a level it hasn’t been able to sustain for more than a few weeks since the Fed made a hawkish pivot late last year. Barring a clear dovish Fed pivot, which is likely more than a month away, bouts of volatility with market downside should be expected. It’s true that the economic outlook has marginally improved and there is now a credible upside scenario, but much of this is already reflected in market pricing. That pricing should also be taken with a grain of salt, as it’s occurring while trading volumes are low with many investors on summer vacation. For now, the markets can easily continue to grind higher and tighter, as investors wait for the release of August data and the Fed’s hiking intentions. The medium-term outlook should be a little clearer after that, whether it's good, bad, or somewhere in between.