LaLa Land Economics: Market Dismisses Potential Recession and Inflation Risks

Unfazed by Economic Indicators

Despite the economy pointing towards a volatile, possibly recessionary period, markets appear to be turning a blind eye. The twin tail risks of a potential downturn or a resurgence in inflation are being overlooked. Instead, the market is leaning towards the highly unlikely scenario of "immaculate acceleration," characterized by robust growth and mild price appreciation.

Disparity Between Market and Economy

This isn't the first instance of a disconnect between the markets and the economy, but it's certainly one of the most glaring. As the economic climate grows increasingly gloomy and signs of sustained price pressures persist, the market has effectively ruled out the tail risks of a recession or an inflationary shock.

Estimating Probabilities

By examining SOFR options, we can estimate the likelihood of the Federal Reserve's rate dropping below 3% or rising above 6%. Despite the decreasing time to expiry, the message remains consistent: tail-risk pricing is disappearing.

Immaculate Acceleration: A Market Dream

The market's expectation of non-recessionary growth and immaculate disinflation has shifted towards an immaculate acceleration: accelerating growth and slowing inflation. This scenario, however, seems as unlikely as accomplishing two impossible tasks before breakfast. Yet, this is precisely what the market is preparing for: a surge in nominal rate volatility, indicative of a predicted positive growth shock, and a decline in real rate volatility, suggesting an anticipated drop in inflation.

Market Complacency

In the absence of outright panic, the market quickly swings from fear to greed and complacency. Even if you don't believe a recession or unruly inflation are likely, it's hard to deny that the market's assigned probabilities are irresponsibly low.

Stock Market Vulnerability

This complacency leaves the stock market in a precarious position. The market has been rallying in this cycle, confident that the Fed would aggressively cut rates if a recession seemed imminent. However, stocks are now surging ahead, despite the fact that this tail risk is no longer priced into the rates market, displaying a level of nonchalance not previously seen.

Growth Expectations

The two impossible scenarios can be seen again in growth expectations. Economists' forecast for 2024 real annual GDP has increased from 0.6% in August to 2.4% now, while the Atlanta Fed’s GDPNow estimate for the current quarter is almost 4%. However, the market still predicts a steady fall in headline CPI back to 2.5% within the next year.

Ignoring Clear Signals

The market appears to be intentionally disregarding clear signals from the economy. While the risk of a recession has been dormant for over six months, that is changing. Although the near-term risk of a downturn remains low, we are at a point where it wouldn't take much to significantly increase the risk of a recession in the next few months.

Early Indications of a Recession

We've seen weak ISM services and manufacturing data, and the unemployment level by US state is deteriorating. This can be an early sign of a recession, indicating a widespread weakening of labor markets across the country — a classic precursor to a national downturn. This typically signals higher market volatility, as companies cling to their workforce despite slowing demand.

Ignoring Inflation Backdrop

Bond volatility is also disregarding the inflation backdrop. Bond volatility is a price on uncertainty, and there is no greater uncertainty for bond holders than inflation. Inflation volatility is high and rising again in the US and Europe, yet bond volatility is near two-year lows. A repricing to match inflation volatility would result in a decline in global sovereign-bond liquidity and, consequently, much higher bond volatility.

Commodity Market Behavior

Commodities are beginning to behave less predictably. Copper, cocoa, and natural gas have risen 30-50% over the last few months, and more commodity-future curves are going into backwardation. Volatility has increased in several commodities, but overall it remains subdued.

Portfolio Hedging Costs

The silver lining is that the widespread level of complacency in markets, coupled with subdued implied-volatility, means portfolio hedging costs are cheap. This seems like a prudent strategy considering the twin tail risks of inflation and recession have all but been erased from the market’s outlook.

Overlooked Possibilities

Also being overlooked is the possibility of entering a recession with high inflation. Very few portfolios are likely prepared for this double tail-risk, or either one individually. Furthermore, little thought is given to the potential inflation-boosting impact of the rate cuts that the market has priced in.

Immaculate Acceleration: A Risky Bet

Immaculate acceleration is akin to trying to thread a needle while shaking from an adrenaline rush. In other words, it's unlikely to go according to plan.

Final Thoughts

This article presents an intriguing perspective on the current state of the economy and the market's response to it. It appears that the market is choosing to ignore clear signs of potential economic turbulence, opting instead for a highly unlikely scenario of immaculate acceleration. What are your thoughts on this? Do you think the market is being overly optimistic, or is there merit in its current trajectory? Share this article with your friends and let's get the conversation started. Don't forget to sign up for the Daily Briefing, which is delivered every day at 6pm.