After a Terrible Year for Markets, What's Not Priced In?

Sometimes markets reflect the collective wisdom of careful investors around the world as they navigate difficult tradeoffs between risk and return. Sometimes they look much more like a soccer game played by six-year-olds, with everyone swarming around the ball.

You will learn more about the state of the world watching the nuanced signals from major asset classes, but you will make more money when you can spot where the herd has left its goal wide open.

For all the talk of uncertainty, the actual state of the global economy is not hard to describe. Growth is slowing, but not yet collapsing. Inflation has reached historic highs, but seems to be moderating (at least in the United States). The latest IMF forecasts show the global economy set to grow 3.2% this year and 2.7% in 2023. Global inflation, in this view, will slow from a searing 8.8% to a still uncomfortable 6.5%.

In spite of a brutal collapse in risk markets this year, investors hardly seem gripped with fear. Spreads on investment grade corporate bonds are near 160 basis points, which is not far from historic averages. The price-to-earnings multiple on the S&P 500 is hardly expensive, near 18 times through a season of nervous but decent earnings reports. Amid reports of spotty liquidity in the Treasury market and fears of financial accidents like the recent U.K. pension crisis, it may be surprising that the CBOE Volatility Index is off its recent highs.

Fed Chair Jerome Powell’s press conference last week certainly delivered a fresh dose of hawkishness, but the current betting seems to be that rates will come down next year even if they top out higher than expected. Markets have adopted the most generous possible definition of “pivot” when it comes to Fed policy. Even the hint at a slower pace of tightening seems to bring waves of cash from the sidelines.

But as in any soccer game, it’s often less important to know where the ball actually is than to anticipate where it might go next.

So, as a thought experiment, squint hard at the horizon and consider what news might just deliver surprise optimism to the current nervous picture:

• The U.S. jobs market cools rapidly as openings disappear without a significant surge in unemployment. By Christmas, the Fed signals an end to rate hikes.
• Amid rising domestic discontent, Russian President Vladimir Putin negotiates a ceasefire in Ukraine. Sanctions remain, but global food and energy prices ease.
• Now enshrined for a third term, Chinese President Xi Jinping announces more flexibility on COVID restrictions and new credit lines for the ailing property market.
• European officials agree on plans to meet their energy needs with more nuclear energy, more LNG imports, and more money to speed the climate transition.
• Peaceful democratic revolution in Iran opens the prospect for an end to sanctions, a reduction in Middle East tensions, and fresh supply to global energy markets.

Of course, as dreary as recent news has been, it’s always possible for events to turn worse. As the saying goes, just when you think you have hit bottom, someone may always get out a shovel and start digging. Consider:

• Wages continue to rise, gas prices surge, and rents edge higher, keeping headline Consumer Price Inflation well above 5% next year.
• Amid loose talk of “dirty bombs,” further military escalation in Ukraine could be disastrous. Worse economically would be an escalation of sanctions on China for expanding economic relations with Russia.
• A new COVID surge leads to renewed lockdown measures in China that further disrupt the domestic recovery and global supply chains.
• European winter comes in much colder than forecasts predict, putting enormous pressure on energy reserves and prices. The ECB hikes much more.
• S. government decides to sanction Saudi Arabia for its continued relations with Russia and triggers a further cut in OPEC supplies.

Lists of hypotheticals can be longer and more fanciful, but even the short version serves as a reminder of just how uncertain the outlook remains. Markets can price in improvement and deterioration very quickly if any one of these becomes more or less likely.

It’s also a reminder of how few credible policy levers remain in government hands to boost growth or cool inflation anytime soon. The global economy is sick and the only medicine available will make things worse before they get better. If the illness must run its course, then the best investors can hope for is to anticipate when that course may turn for the better—or for the worse.

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