Soft or Hard Landing?

A soft inflation report last week halted the upward grind in government bond yields that were on the verge of setting new cycle highs. The global economic expansion, while slowing, certainly continues, probably making bond yield easing limited/temporary. Such market action is working at cross-purposes to central banks’ desire to slow growth and engineer some labor market slack. which is critical to both sustaining disinflations, and ensuring that inflation does not quickly revive after the next growth phase takes hold.

In the near-run, any relief in bond yields is welcomed by equity bulls, who celebrate whenever the probability of monetary policy overkill is perceived to have declined. Calm bond markets are critical for equity markets because all of the gains since the October low were due to a re-rating of stocks. For now, bond yields have backed off, although the short end of government yield curves are still close to new cycle highs in the U.S. and euro area. While year-on-year inflation has continued to steadily retreat as expected, we foresee core inflation measures levelling at levels that will be well above those recorded pre-pandemic. In other words, underlying inflation will be too high for central banks to start cutting policy rates any time soon.

The implication is that there may be more policy rate hikes ahead and higher bond yields, assuming the Fed is serious about bringing down inflation to the 2% area and maintaining a low inflation backdrop. There is a strong belief among central banks and bond bulls that the rise in inflation in the past two years was solely due to a series of one-off shocks caused mostly by the pandemic. With the war in Ukraine contributing as well. We continue to disagree with this “transitory” view. The unprecedented fiscal and monetary stimulus in 2020-2022, combined with these one-off pandemic-related effects, caused a huge rise in inflation and generated extremely tight labor markets. The revival in long dormant wage demands (and now increased strike action) and the boost to longer-term inflation expectations underscore that returning to a 2% inflation world will entail a “cleansing” downturn, i.e., a recession. In other words, economic slack must be created and then persist for some time.

The outlook for equities remains tricky, with near-run forces being supportive, but the cyclical outlook troublesome given valuation levels and earnings risk. Despite some recent broadening, the thin nature of the global advance in equities this year dominated by massive gains in a handful of U.S. mega-cap tech and related stocks, remains a concern. We caution against chasing richly-priced assets, while remaining tactical flexibility with an overweight in cash.

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