Benjamin M. Lavine, CFA, CAIA, RICP
Chief Investment Officer, 3D, a Freedom Advisors company
My how quickly a consensus-driven prevailing market narrative can shift over a couple of economic releases. Picture an incoming plane expected to make a bumpy landing but doesn’t land and instead pulls up the landing gear and accelerates upward. This essentially captures the switch from Soft Landing to No Landing scenario being priced into financial markets.
In the span of less than two months, the conventional consensus conviction for a Hard Landing in 2023 entailing 1) an economic recession, 2) collapsing inflation, and 3) pivoting central bank policies has yielded to the new narrative of No Landing or the Big Flip entailing 1) resilient economic growth (despite the sharp rise in nominal interest rates) and 2) elevated and persistent inflation that is not slowing down fast enough for central banks to ease up on tightening policies. Other aspects of the Big Flip include a persistently tight labor market where labor costs start to entrench themselves into higher overall costs of goods and services leaving central banks further behind the inflation curve.
There are differing opinions over who first coined the No Landing scenario, but we credit Neil Dutta from Renaissance Macro, who posts frequently on LinkedIn. Neil Dutta has been one of the few economists to not call for a U.S. recession despite the prevailing consensus among his peers. In a Wall Street Journal interview, Neil now believes that growth acceleration would require higher interest rates to tame inflationary pressures.
But outside of a handful of economists and market observers, Big Flip was hardly on anyone’s radar at the beginning of the year. At the end of 2022 through the FOMC meeting at the beginning of February, the institutional consensus of a hard landing had been expressed through an overweight of “defensive” assets to “risk-on” assets (Figure 1). Fund managers were expecting a slowdown that would benefit “duration” while seeing little need for inflation protection (via TIPS exposure).
Figure 1 – Fund Managers Overweight Bonds versus Equities Heading into 2023 Implying Hard Landing Outcome
Few fund managers expressed concerns that higher or elevated inflation would remain a prominent risk in 2023 (Figure 2).
Figure 2 – Few Fund Managers Expected Elevated Inflation as a Prominent Risk in 2023
This risk-off conviction was first challenged by a sharp YTD rally in high beta speculative growth stocks (see our January 2023 Market Commentary) that suffered in 2022 followed by Fed officials signaling increased confidence in a disinflationary slowdown that would see the eventual end of rate hikes (even though Fed officials kept pushing back the time table for rate cuts versus what was implied by Fed Funds futures prices). However, the Treasury curve continued to invert (long-term rates lower than short-term rates) which saw the 2-Year Treasury yield dropping to 4.1% and the 10-Year Treasury yield to 3.4% earlier this year (even though Fed officials were still projecting a 5% terminal Fed Funds rate) with the bond market convinced that central banks would need to cut rates later this year in reaction to an abrupt slowdown despite the rally in risk assets (high beta stocks and speculative-grade credit).
But then in less than the span of a month, dreams of a disinflationary soft landing characterized by slowing nominal growth and higher inflation-adjusted growth slammed into the Big Flip wall of reality captured by this month’s economic releases such as a robust January payrolls report, elevated CPI and PPI releases (inflation is slowing but perhaps not fast enough), and consumer spending (retail sales, credit card surveys). According to Atlanta Fed GDPNow (Figure 3), 1Q2023 annualized gross domestic product growth is now projected at 2.5%, higher than initial estimates of 0.7% at the beginning of the month, led by higher than expected personal consumption (PCE) and capital investments.
Figure 3 – So Far, U.S. Economic Growth Proving to Be Quite Resilient per Atlanta Fed GDPNow Estimates for 1Q2023 GDP
Source: Atlanta Fed GDPNow via @wabuffo
One way to track the Big Flip narrative is the change in inflation expectations priced into the breakeven spread between U.S. TIPS and nominal Treasuries. As the narrative has shifted to the Big Flip, 1-year term inflation expectations priced into breakeven rates between TIPS and nominal Treasuries have spiked from a low of 1.6% earlier in the year to nearly 3% today (Figure 4). Two- and 5-year breakeven rates have also risen although longer-term breakeven rates have not moved much from 2% (Figure 5).
Figure 4 – Implied Short-Term Inflation Expectations (Breakeven Rates Between U.S. TIPS vs Nominal Treasuries) Have Spiked Over the Past Month Reflecting the Narrative Shift from Hard Landing to Big Flip
Figure 5 – Even Though Long-Term Inflation Expectations (as Expressed Through 5Y/5Y Forward Breakeven Rate Between TIPS and Nominals) Remain Well-Anchored Around 2-ish%.
Higher short-term breakeven rates but well-anchored long-term breakeven rates suggest that the market expects higher inflation over the short term but for inflation to eventually settle down towards the Fed’s long-term average target of 2%. Comments from Fed officials (especially voting members who lean dovish such as Patrick Harker, Philadelphia Reserve Governor), seem to indicate a preference for the Fed to move incrementally while remaining confident in the disinflationary (slowing inflation) trends – or a willingness to tolerate elevated inflation in the near term so as not to risk overtightening that would send the economy into recession.
The risk is that the Fed overestimates disinflationary trends forcing them to backpedal their dovish comments and get more aggressive on tightening (former voting member Steve Bullard remarked that he pushed for a 0.50% rate hike at the 2/1 FOMC meeting instead of 0.25% and hasn’t ruled out a 0.50% hike at the upcoming March meeting). Invariably, the Arthur Burns versus Paul Volker inflation debate of the 1970s comparison could resurface as Fed Chair Jerome Powell faces prospects of renewed tightening in the face of the Big Flip. Even strategists who now subscribe to the Big Flip, such as Michael Harnett from Bank of America, believe that recession is just delayed until 2024 and risks being even more severe due to an anticipated overtightening response by the Fed.
What does the Big Flip mean for equities? While corporate profitability can hold up in a No Landing scenario (as it did in the 1990s), so far S&P 500 company earnings are being revised lower during the 4th quarter reporting season. According to Factset Earnings Insight 2/10/2023, analysts are projecting just 2.5% earnings growth for CY2023 on 2.4% revenue growth, with the first half expected to see contraction followed by a 2nd half recovery (10% growth in the 4th quarter). Profit margins will likely come under pressure from rising costs, but this is being offset through higher price pass-throughs even if unit volumes shrink (hence slowing revenue).
The Big Flip doomsters largely believe that a reflationary No Landing scenario poses risk for all financial (stocks, bonds) and hard assets (gold, commodities), but year-over-year inflation trends are still expected to trend down due to a combination of base effects (i.e. comparisons from last year), lower shelter costs (as indicated by real-time surveys of newly signed leases), and easing of supply chain bottlenecks (as expressed by lower shipping and freight costs). The key will be the degree of moderation in recent “hot” releases into something resembling a soft landing characterized by slower disinflationary growth and weaker labor markets but not so weak as to push the economy into recession.
Although we are less sanguine on equities due to higher valuations stemming from this year’s rally, 3D holds to a strategic asset allocation mindset that aligns time horizons with underlying investment risks. We continue to be defensively positioned in fixed income with respect to duration, inflation-protection, and credit risks although we will revisit some of this positioning in light of recent interest rate movements. In equities, we continue to emphasize diversification across risk-based themes (value, high quality, dividend-focused) and across regions. We are not flipping out over the Big Flip but remain mindful of the quickening shifts in narratives based on the latest economic releases.
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