A peak in US inflation is not a green light to go on offense. The reality is that the path to a soft landing is narrow and a hard landing is a clear risk. In the spirit of the World Cup, those playing for an extension of the recent bounce in risk assets may find themselves caught offside.
We wrote last week that a peak in US inflation and slow exit from zero COVID in China does not necessarily mean the start of a new risk on regime, and that “it is hard to get structurally bullish risk assets unless you have a high degree of confidence in a soft landing or a China reopening that is not met with even more policy tightening in DM”.
Last week's price action repriced higher the probability of the hard landing scenario , and lower the probability of a China reopening. Notably, northeast Asian and commodity exporting currencies underperformed, with the Korean Won, Chilean Peso and Chinese Yuan all having 1.5 - 2 weekly stdev moves lower. We also saw demand side inflation proxies moving lower, with oil falling by 1.4 weekly stdevs and 2y US inflation swaps falling by 1.2 weekly stdevs. In contrast, US interest rates moved higher again, both on a nominal basis, and vs the rest of the world with AUD - US 5y rate spread widening by 22bps.
In our view, this retracement was warranted.
Put simply, the path to a soft landing is narrow. The full effects of policy tightening from developed markets have yet to be felt and indeed, have yet to be delivered. Secondly, while the direction of China's COVID policy is relaxing, China is experiencing one of its most severe COVID outbreaks of the pandemic, which is being met with severe restrictions. While the outlook for Chinese demand is more promising for 2023, as policy evolves away from zero COVID, in the near term, the chances of a Chinese white knight for global growth are slim. A reopening in China may be a more notable boon for Chinese domestic services demand than for the broader global economy, as long-term headwinds for property investment in China may mute the demand spillovers to the rest of the world that have been associated with Chinese investment-led demand expansions.
In contrast, there is growing evidence of hard landings ahead in Canada, Australia and Scandinavia - driven by the property market and in the UK, due to stagflationary conditions with no capacity to provide countercyclical fiscal support.
Focusing on the UK. last week's data makes for grim reading when assessing the possible depth and duration of the contraction ahead. CPI prices surprised to the upside, rising by 2%mom, bringing inflation to 11.1% y/y, the government announced a £55bn fiscal consolidation package, split almost evenly between spending restraint, notably less energy support and tax increases and next year, the Office for Budget Responsibility expects fiscal tightening to be ~1% of GDP. The UK labor market, however, remains strong, with near historical lows in unemployment and wage increases well above trend. Together, this means it is likely that the BOE will need to bring rates well into restrictive territory and will be hiking for quite a bit longer.
The dynamic in the UK displays the exact point we have made previously; DM labor markets remain strong and any deterioration in growth so far has happened in spite of, not because of, a rise in unemployment. This creates significant asymmetry, if labor markets also begin to weaken, the harshness of the landing could be much more severe than currently priced.
Therefore, our prevailing outlook remains intact. A recession is likely, but the nature and depth of that recession are the key questions. The data over the coming months will shape the outlook for next year, and this level of uncertainty will likely mean navigating some choppy markets ahead.
The market wants to believe in a soft landing, but that probability should not be overpriced. It will likely take some time before the conditions are in place for a more structurally positive risk outlook. On the other side of the fence, risks of a hard landing are meaningful, but much more so in countries with a clearer link to weakening property markets (Canada, Australia) or suboptimal policy mixes (UK). In contrast, the US remains relatively resilient, allowing or requiring the Fed to maintain tighter policy for longer. In this environment rates divergence will continue to be a key theme, and the USD can outperform again especially if the hard landing scenario actualizes.