In a soft landing we trust – right?

In the latest instalment of Simply put, where we make macro calls with a multi-asset perspective, we explore the scenarios underlying different markets, as well as their one commonality: the anticipation of a soft landing. What are the implications for portfolios?

 

Need to know Different asset classes seem to expect different economic scenarios right now Equities see a rapid slowdown before a recovery, bonds anticipate a slow but steady decline in growth, and commodities expect a period of stable but lower growth All three markets do agree on one thing: the anticipation of a soft landing. The risk to our portfolios, therefore, is that this scenario may not play out

 

An unusual period for markets

We are currently going through a unique period where markets focus more on nominal phenomena than on real ones. The rise in equities since the start of the year is the main symptom. Yes, rates are higher and the (manufacturing) economy is slowing, but corporate profits remain strong, and the overall (nominal) economy remains resilient. Nominal US growth in the first quarter probably offers the best summary of this: almost +7% year-on-year and +5% quarter-on-quarter. Sales of S&P 500 companies rose 5.9% in the first quarter – strikingly consistent with the growth figures.

The main question for any investor today is: what is the underlying scenario in the market? Only in answering this can we start to consider tactical over/underweighting. This week's Simply put offers an analysis of this implicit scenario: is the market pricing in a slowdown in the nominal economy today? It is time for linear regression and expectation reading.

 

Waiting for nominal growth

Several data sources can help to measure market expectations. We focus here on three key markets: bonds, equities and commodities. To simplify things, we will concentrate on US 10-year rates, the S&P 500 and oil (WTI). For each, we have the following ingredients:

• 10-year rates: forward rates in 3, 6, 9 and 12 months, which will be useful for calculating the expected variations in spot rates

• S&P 500: the expected variations in corporate profits for the next four quarters, according to analyst consensus estimates

• WTI: the term structure of the price per barrel for the next four quarters, obtained from the futures market

With these few elements, we can build a series of variations in 10-year rates, in profits and in the price of oil, which we can then correlate with fluctuations in nominal growth. Based on this correlation work, a simple linear regression can then be estimated between these series to convert the expectations of rates, profits and oil prices into expected nominal GDP growth. The result of this process is shown in figure 1.

 

Figure 1: Expected nominal US growth by market (year-on-year)

Source : Bloomberg, LOIM

 

The key points in this chart are as follows:

• The 24-month change in 10-year rates correlates remarkably well with historical nominal growth. By incorporating 10-year forward rates up to Q1 2024 as a forecast for 10-year spot rates, we see a gradual decline in the rates over the 24 months. Thus, this offers an indication that the bond market is expecting a slow decline in nominal growth, with the drop intensifying in the first part of 2024
• Analysts see profits for S&P 500 companies contracting in Q2 and to a lesser extent in Q3: a darker short-term scenario than the one for bonds, but with a recovery expected at the end. As a result, the nominal growth scenario that emerges from this is one of a rapid decline (although remaining in positive territory), followed by stabilisation and a recovery in the first part of 2024. The divergence between equities and bonds is clear here
• Finally, with the term structure of the oil price having flattened considerably since last year, we get a third scenario: lower but steady growth in the quarters ahead for oil

Thus, from the three markets studied, three different scenarios seem to emerge: a rapid decline followed by a recovery for equities, a slow decline with no recovery for bonds, and relative stability at a lower level of growth for commodities.

 

Here comes a soft landing

How do these scenarios compare with the last three recessions sparked by central bank rate hikes? These occurred in 1990, 2001 and 2008. Figure 2 presents the estimated nominal growth scenario implied in each of the three markets, with the measured nominal growth for the recessions. What 1990 and 2001 have in common is a similarity to a soft landing: growth declines and unemployment rises, but only to a limited extent (2.3%). The 2008 scenario is more akin to a hard landing.

The analysis in figure 2 shows that while the three asset classes differ in the form of the slowdown, they agree on one thing: each expects a soft landing, and this is where the risk of any allocation lies. The overall market is committed to the soft-landing cause (who said the Federal Reserve was not credible?). The obvious blind spot here is a hard landing rather than a stagflation scenario where the nominal economy would continue to benefit.

 

Figure 2. US nominal growth scenario implied by each asset class

Source: Bloomberg, LOIM

 

Simply put, there is a divergence of expectations among asset classes as to the shape of the slowdown, but not as to its nature. The market broadly expects a soft landing, with a clear cross-asset consensus.

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Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises and global monetary policy surprises designed to track the recent progression of macroeconomic factors driving the markets. 

Our nowcasting indicators currently show:

• Our growth indicator lost a little altitude again, as the US indicator continued to fall
• Our US inflation nowcaster has remained stable. The US inflation report showed stabilisation – consistent with our nowcaster’s diffusion index, which increased from 40% to 46%
• Our monetary policy indicator remains unchanged: despite inflation being only slightly down, our indicator still expects central banks to be very moderate

 

World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)

World monetary policy nowcaster: long-term (left) and recent evolution (right)

Reading note: LOIM's nowcasting indicators gather economic indicators in a point-in-time fashion to measure the probability of a given macroeconomic risk - growth, inflation and monetary policy surprises. The Nowcaster ranges from 0% (low growth, low inflation and dovish monetary policy) to 100% (high growth, high inflation and hawkish monetary policy).

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