Executive Summary

  • Economic data still strong, the unemployment rate is still falling.
  • Inflation expectations high and but falling due to expected recession (or falling oil prices).
  • Fed now expected to hike even more aggressively in 2022 and 2023.
  • Recession probability still rising – 10y-2y inverted for the first time.
  • Financial markets are positioned defensively with only energy and utilities positive YTD, stronger USD, supply-side spike in commodities.
  • Key events and expectations:
    • Data to start reflecting slower growth with elevated inflation (stagflation).
    • Fed to actually hike aggressively by 50bpt at the next meeting.
  • Stock market outlook: bear market to continue
    • Counter trend risk: failed 100dma technical breakout. Credit risk keeps falling.  

Current Data

GDP = 5.5% (Q4 01)Strong post-pandemic growth boosted with extraordinary monetary and fiscal stimulus.  
Unem.rate = 3.6%Full employment – still falling
CPI: 7.9%Well above the 2% target – triggered the Fed’s price stability mandate.

Inflation drivers: expected to keep rising demand still strong – supply sill tight

Demand shock:Supply shock:
Extraordinary pandemic-related monetary stimulus causing higher credit consumption.  Extraordinary pandemic-related fiscal stimulus (direct cash, benefits).Investment gains: stock market, housing, cryptocurrencies.Pandemic-related labor shortage causing rising wages (5.6%).Pandemic related labor shortage (low participation rate 62.4%)Pandemic related supply chain bottlenecks  (China 0-covid policy)Pandemic related material shortages (chips)Commodity shortages: Russia sanctions, geopolitics (long-term problem?)Longer term: de-globalization

Expected long term inflation: Falling, and real rates rising (end of QE beginning of QT expected).

5-Year BE = 3.34% (3.70%) 10-Year BE= 2.82% (2.99%) 30-Year BE =  2.45% (2.56%)Long inflation expectations seem to be de-anchoring – but fell last week. 5-Year Breakevens are still above the key 3% level, and 10Y Breakevens are above the key 2.75% level. De-globalization is likely to contribute to rising inflation long term.
2.38% = -0.44%+2.82% (2.49%=-50%+2.99%)Long term rates decreased, real rates increased, and inf exp decreased. Economic slowdown pricing, due to Fed hiking and QT? Lower oil due to SPR release?
US10-Ger10=2.01% (1.91%)Still widening, USD positive. Germany more affected by Russia sanctions.

Expected monetary policy (the Fed) Hike faster in 2022, and 2023 – Fed more behind, first cut still Dec 24.

Inflation-mandate: monetary tightening. QE ended in March and QT to be announced in May.  Possible easing starts in January 2025 – recession?

CurrentJan 2023Sep 2023Dec 2024(Dec 2024)Jan 2027 terminal
0.34% 2.48% (2.41%)3.21% (2.95%)2.75% (2.65%)2.95%

Note: Out of 13 interest rate hikes since 1945, a recession occurred 10 times. Exceptions: 1994-95, 1983-84, 1965-66

Recession probability: very high – still rising – caused by the Fed

10Y-2Y-0.08% (0.20%)First inversion – recession forhtcoming
10Y-5Y-0.18% (-0.08%)Deeper inversion – recession forthcoming
2Y-3mo1.95% (1.75%)No immediate recession expected – Fed more behind

Increase in Federal Funds rate leads to inverted yield curve, which precedes a recession. 10y-2y is the best indicator: did not invert in 1995 and 1984 (no data for 1966).

Credit risk: risingstill falling- intervention?  No expectations of an imminent credit crunch or a recession.

10Y-BBB1.93% (2.01%)Decreased from 2.38% on March 10 – as S&P bounced (1.77% on Jan 19th)

Spikes in a recession as defaults increase.

Expected data: slowing growth with high inflation – stagflation (eventually recession)

Slowing growth (slowing demand – the Fed)Higher interest rates (Fed) – less credit consumption – lower sales (discretionary sector) Higher mortgage rates (10y) – lower housing prices (wealth effect – housing stocks) Lower stock market and cryptocurrencies – wealth effect (less consumption) *Russia sanctions and higher oil – lower consumption (as long as sanctions last) (energy) Longer-term: de-globalization leads to slower growth (less exports and imports)
Uptick in UnemploymentSlower growth will lead to uptick in unemployment rate (lower demand)
High Inflation to persist*Higher oil (Russia) will keep inflation high (oil as well as other commodities) Longer-term de-globalization is inflationary. *Pandemic related supply-chain bottlenecks still inflationary (China lockdowns).  Supply issues unresolved – demand still not affected by the Fed and Oil

Financial markets scan: Market pricing is consistent with the recessionary expectations in the US, caused by higher inflation and the Fed. The only sectors going up are energy and other utilities, which is consistent with higher inflation and late cycle. Last week, XLF turned negative – inverted yield curve?

 YTD (last w)Last moveLeadersLaggards*Next move
SPY-4.64% (-4.68%)Bounce from 13% drawdown to 100dma Bear market rally?XLE: 39% (41%) XLU: 5.5% (1.7%) out XLF: -2.1%(1.2%)XLC: -10.8% (-10.9) XLY: -9.4%(-10.3%) XLK: -8.9(-9%) XLRE: -5%(-9%)Consistent with inflationary recession – slow growth high inf.

*Needs lower interest to boost laggards – unlikely to happen.

 YTD (last week)Last movePricing
EEM6.04% (-7.68%)Bounce from sell-offChina regulation. Reacts neg. as Fed rises interest rates.
EAFE-5.58(-6.89%)Bounce from sell-offGlobal recession. Bounce as oil corrected.
GSCI18.5% (25%)Deeper CorrectionInflation – sanctions on Russia, supply chains, demand (oil released from SPR)
USD3.22% (3.85%)Uptrend pauseSlower global growth, Fed more aggressive, Euro (Russia) Commodity currencies up
Gold4.9% (6%)CorrectionRising real rates-? Geopolitics FTS+? Strong USD-?

Market outlook

S&P500DownUS recession expected – no global or domestic counter positive drivers.
EEMDownUS recession, protectionism, de-globalization
STOXXDownNegatively affected by the Russian sanctions and the war
EuroDownThe Fed more aggressive, EU growth relatively weaker
AUDNeutralHigher commodity prices positive – weak global growth (de-globalization) negative
CommUpRussia sanctions play: oil, palladium, platinum, wheat Risk: an imminent recession and demand destruction Broadly: Up leading to a recession – down with an imminent recession
GoldNeutralRising real rates and stronger USD are negative vs flight to safety (geopolitics and recession) and de-dollarization are positive
10Y futNeutralFlight to safety (geopolitics and recession) vs rising inflation exp and rising real rates

Risk variables: what could change? (decrease in inflation expectations and widening of the yield curve)

  • Quick end of Ukraine war and removal of Russian sanctions – oil goes down and the Fed is less aggressive. Unlikely – long conflict expected.
  • China embraces US against Russia, and China tariffs are reduced – rebirth of globalization. Unlikely – China is under US tariffs and constant threat, plus the issue of Taiwan.
  • End of covid and increase in global demand – global reopening, with easing supply chains. End of covid likely, but global reopening will be overshadowed by the de-globalization (inflation).

Turning point trades: At which point do you start pricing an imminent recession (interest rate cut, lower commodities, weaker USD?

Chart of the week: S&P 500 still at the 100dma resistance after the bear market rally and brief 100dma breakout to top of the downtrend channel.