In this week’s blog we’ll cover insights on the current state of market risks from financial analysis firm Variant Perception. Their viewpoint might come as a surprise to many who perceive the current period as fraught with increased risks. The distinction between market risks and global political risks is crucial in this context.
Historical Context and Current Perception
Over the past 18 months, starting from early 2023, there has been a significant debate about whether the economy has experienced a recession or merely delayed it. Despite various leading indicators showing troubling signs, the headline data does not reflect a traditional recession. Labor market data and consumer metrics have remained stable, despite credible analysts suggesting heightened recession risks.
Variant Perception’s analysis reveals that while areas typically hit hard by recessions, such as micro businesses and consumer credit, have shown signs of stress, broader economic indicators have remained resilient. Non-financial, non-corporate operating margins hit all-time lows, and consumer credit card debt showed high delinquency rates. However, these stresses did not lead to a widespread economic downturn, thanks in part to large fiscal deficits and government-driven job creation, which have mitigated negative feedback loops usually seen in recessions.
Inflation Dynamics
The discussion on inflation highlights a nuanced view. The lead indicators suggest an upward bias for inflation, but market prices have largely discounted this. Variant predicts an annualized inflation rate of around 3.5% over the next six months, which, while high, does not seem alarming enough to prompt immediate action from the Federal Reserve. The good news is that leading data for inflation, such as price plans from NFIB and ITSM, have peaked and started to decline.
Long-term, there is an expectation of upward pressure on inflation due to structural factors like scarce credit, labor, and commodities. However, in the short to medium term, inflation seems to be stabilizing, allowing central banks to consider more cautious monetary policies, such as the “hawkish cut” seen recently.
Market Expectations and Federal Reserve Policy
There’s a broad range of predictions about where inflation and interest rates are headed. Some believe deeply negative interest rates are possible, while others see inflation only increasing. Variant’s view is that disagreements often stem from different time horizons. Structurally, inflation risks are to the upside due to long-term factors. Cyclically, inflation appears to be peaking, while tactically, the market may have overreacted to short-term inflation fears.
The Federal Reserve’s potential rate cuts have been a hot topic. Despite skepticism about the need for cuts, there’s enough justification for at least one cut, primarily to manage market expectations and maintain economic stability. This aligns with market pricing, which anticipates several cuts by mid-next year.
Yield Curve and Fixed Income Strategy
The prolonged inversion of the yield curve has raised questions about its implications. Variant suggests looking at forward rates rather than just the spot rates to understand market expectations. For instance, the 2s10s forward curves have already started to uninvert, indicating that the market is pricing in future economic recovery. This approach helps in timing trades better, avoiding the pitfalls of the infamous “Widowmaker trade” of putting on a steepener too early.
Manufacturing Recovery
The research firm also highlights the recovery in manufacturing, driven by the normalization of supply chain disruptions and inventory cycles. The COVID-19 pandemic caused significant distortions, leading to an exaggerated and delayed bullwhip effect. As inventories normalize, there’s scope for a more standard inventory rebuild cycle, suggesting that manufacturing may have bottomed out.
Credit Market Insights
One key insight is the unique resilience of the U.S. mortgage market. Despite high new mortgage rates, the effective mortgage rate on existing stock remains low, thanks to many homeowners locking in lower rates. This has kept household debt service ratios manageable, preventing a typical deleveraging cycle. This situation contrasts with countries like Canada, where floating mortgage rates have led to higher household debt service ratios and more pronounced economic slowdowns.
Conclusion
In summary, while there are undeniable stresses in certain economic areas, broader indicators suggest a more resilient economy than many expected. The interplay between fiscal policy, consumer behavior, and market expectations has created a unique economic environment where traditional recession signals have not led to a full-blown downturn. Inflation remains a concern but appears to be stabilizing, allowing for cautious optimism in market outlooks.
The analysis underscores the importance of differentiating between market risks and broader economic or political risks. By understanding these nuances, investors can better navigate the current economic landscape, balancing caution with strategic opportunities in a recovering market.
