There is no doubt that the markets have been operating in "soft landing" mode in recent months, which is basically a scenario that can be summarized as:

• Leading indicators stabilized before improving in the first half of the year.
• Concerns about a global recession are overly pessimistic, as labor markets remain strong. 
• Core inflation is moving toward central bank targets as energy and food prices decline and base effects reduce year-over-year comparisons. 
• China recovers as COVID restrictions are lifted, policy (monetary and fiscal) is tightened and real estate market challenges are put aside.

Recent data support an easing of near-term recession risks, visible, for example, through PMI surveys, with an improvement in orders complemented by rising employment and falling inflation.The recent data support a decline in near-term recession risks, which are visible, for example, through PMI surveys, with an improvement in orders complemented by an increase in employment and a fall in inflation, as well as economic data in the various regions have been generally surprisingly upward.

In this scenario, the policy response is characterized by central banks adopting a less aggressive tone and the market brings forward the expected peak in policy rates. (SEE MORE)

By the way, this is a positive scenario for risk assets:

• It is leading to a stock market rally, where emerging assets are performing particularly well and ex-US assets are outperforming US assets.
• Positioning is more cyclical and growth sectors outperform value sectors.
• Corporate spreads compress and HY debt outperforms IG.
• The dollar weakens and commodities appreciate.

And if you look at the performance of the various markets over the last 3 months and so far in 2023, that is just what we have gotten, with the notable exception of commodities, which have surprised to the downside.

Performance of different asset classes 3m; YTD

Source: Fynsa Estrategia; Bloomberg. Data as of February 08, 2023

So far it seems like a very good story to tell, but let me make some counterpoints:

• The good performance of the markets is supported almost exclusively (the rest is the reopening of China), in the expectation of a "substantial deceleration" of inflation going forward and therefore a more accommodative stance of interest rates, as well as that all this is achieved within a "soft landing" economic context. and therefore a more accommodative interest rate stance, as well as that all this is achieved within a "soft landing" economic context.
• The new buzzword in the markets is "disinflation", some even speak of "immaculate disinflation", after Chairman Jerome Powell's post-policy statement press conference this month suggested a slight shift in the Fed's reaction function, which seemed to become more optimistic about a solf landing and a painless decline in inflation in the labor market.
• These same statements were reaffirmed in an interview with Powell at the Economic Club of Washington this week, where he clearly stated that he believes the disinflation process has begun, but that it will be a long road ahead, that it will not be smooth or risk-free, and that further interest rate hikes are likely to be needed, also warning that the peak in the federal funds rate could be higher, particularly if the labor market remains strong.
• He also emphasized that the disinflationary process is only clear in goods prices, which are only 25% of the underlying CPI, while the process is not yet showing up in services inflation.. He said he continues to expect housing services inflation to slow "in the second half of this year" and that non-housing services inflation will cool as wage growth cools. In addition, he said that non-housing services inflation (just over 50% of core inflation) is his "biggest concern" regarding the inflation outlook.
• Indeed, while year-over-year inflation has been moderating, core inflation remains high and the strength of services inflation poses a greater challenge for the Fed. A tighter inflation trajectory in services in conjunction with the strength of the labor market will also make it difficult for the Fed to cut rates and thus avoid a recession.

Source: Fynsa Strategy; Bloomberg

In short, it seems that the markets "only listen to what is convenient for them" and have decided to "buy disinflation" without further questioning.

But let's agree that what the Fed intends to do is a very difficult job: Slowing down the economy through interest rate hikes and preventing us from falling into a recession, which it may succeed in doing. But our biggest question mark is that a soft landing scenario is already largely built into prices and we don't see much reason for risk assets to keep rising amid higher rates and still hawkish language from several FOMC members this week.

Indeed, stocks have continued to rally as interest rates on the short end of the curve have risen nearly 40 basis points over the past 7 days (the yield on the two-year note reached 4.5%) and nearly 30 basis points on the long end of the curveThis has accentuated the inversion of the curve at the widest level since the 1980s.

What's more, the terminal fed funds rate already steepens above 5% and options traders have been accumulating bets with a 6% target.

And break-even inflation expectations in the bond market are starting to recover again.

Source: Fynsa Strategy; Bloomberg

Finally, how long can the equity recovery be sustained, with further downward revisions in expected earnings and higher interest rates putting pressure on valuations that are not particularly attractive? 

Source: Fynsa Strategy; Bloomberg

*Immaculate Disinflation: Refers to the idea that inflation can somehow be reduced without a material impact on demand and thus on GDP growth. Or that price growth slows to normal, but without collateral damage to the labor market.

Humberto Mora

Assistant Investment Manager Finance and Business Finance and Business Brokerage Firm