Macroeconomic & Geopolitical

Eliminating the Improbable

February 2023 – 3 min read

With a fresh surge of inflation increasingly unlikely, the market outlook is far better than it was a year ago.

‘When you have eliminated all which is impossible’, as Sherlock Holmes liked to say, ‘then all that remains, however improbable, must be the truth’.

After a global pandemic, a major European war and a Saudi Arabian defeat of Argentina in the 2022 World Cup, nothing seems ‘impossible’ these days. But investors can still eliminate the ‘improbable’ and then search hard for truth amid the jumble of what is left. This exercise suggests a difficult economy this year, but markets may just offer positive returns as they begin looking to 2024.

Will inflation rise from here?

On the list of ‘improbables’, rising global inflation ranks high. Yes, China’s reopening could drive oil and gas prices higher. Escalating violence in Ukraine might disrupt Russian exports and roil global commodities markets. A new strain of COVID-19 would surely trigger fresh turmoil in supply chains.

Still, it’s hard to imagine the U.S. Consumer Price Index ending the year higher than the 6.4% it printed on February 14, following the sharpest set of Fed hikes in decades. Manufacturing indices from purchasing managers in Europe, the U.S. and Japan all show slowing economies. Meanwhile, supplies of everything from semiconductors to shipping containers to workers are returning mostly to normal. It’s hard to paint a picture of prices running wild anytime soon. 

Are we on the verge of a sharp recession?

Given the global headwinds and the depressing political headlines, recession hardly seems out of the question. But it looks either more distant or less severe every day with every new data release. In the U.S., a strong jobs market continues to support healthy consumer spending, with January’s retail sales blazing in 3% higher than the previous month.

Elsewhere, Europe’s winter never came, helping cushion the loss of Russian supplies while governments offered subsidies that kept households spending. China’s sudden decision to lift most COVID restrictions may boost its growth this year a full percent above current forecasts, enhancing global demand and making a sharp recession this year almost as unlikely today as runaway inflation.

Will the Fed soon declare victory over inflation?

Markets have been looking for the Fed’s ‘pivot’ ever since inflation readings peaked last summer and investors have been redefining the term ever since. Now even the shift from a 50-basis point hike to 25-basis points gets an enthusiastic reaction from investors.

But with a January U.S. jobs report that soared above even the highest market expectations, how could the Fed even begin to contemplate more dovish policy? And with the ghost of Paul Volker haunting every member of the Federal Open Markets Committee, who among them wants to urge a premature cut only to have inflation then tick higher the next month?  

Will higher rates finally trigger an accident?

Interest rates that have marched inexorably lower for four decades created possibilities for all kinds of new business models. But those days are gone, and investors are rightly bracing for the accidents that come with every tightening cycle. So far, the surprises have either been well-contained, as with the U.K. pension turmoil, or not entirely surprising, as with the land of crypto currencies.

More disruptions will surely come. Just because derivatives are traded on transparent exchanges since the Lehman Crisis doesn’t mean we understand all the exposures of non-bank finance. But most banks report solid balance sheets, making a financial detonation that morphs into a systemic crisis hard to imagine.

Will markets end the year below current levels?

Nervous investors and battle-scarred strategists have found enthusiasm amid slowing growth and persistent inflation easy to dismiss as excessive. Bond markets seemed to price in recession at first, but have been more resilient in recent weeks. Major stock indices are up anywhere from 5-15% since New Year’s Day.

It’s easy to say we won’t repeat the dismal performance of last year’s returns for stocks and bonds, but the dissipation of uncertainty around inflation, growth and monetary policy should reduce market risk and raise the range for reasonable valuations. Another market slide from here doesn’t seem likely to last.

And so, having excluded most of what is improbable, we are left with the possible, or even the likely.

Last year’s ‘stagflation shock’ has evolved into something more like a ‘stagflation haze’. U.S. growth will be lower than last year’s 2.1%, but next year’s should be better than whatever we get this year. Europe’s will definitely fall from 3.4% but may yet avoid recession. If inflation continues to fall—slowly but more or less steadily—then the economic outlook and risk markets look far more attractive this February than they did last.

That is, as long as we avoid a shock on par with a pandemic, an invasion, or an epic World Cup upset.


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