No, it's not all priced in.
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Please read the Disclaimer before reading this article.
In this article, I would like to discuss two topics:
1) The concept of a hard vs. soft landing.
2) Is everything priced in?
But first, let’s have a quick look at the market action and perceptions over the last 3-4 months.
After a difficult 2022, markets bottomed in the middle of October.
The S&P500 rose almost 17% until early February.
S&P Midcap Value stocks rose more than 35% and reached new all-time highs. (something you wouldn’t expect if the bear market was still intact)
KWEB (China Internet ETF) almost rose 100% in 3 months time.
This rally in risk assets was caused by a sharp decline in the US dollar (-12%) and a decline in interest rates (US 10 year yield declined from 4,2% to 3,37%).
Another element supporting this strong rally was the perception of investors. In Q4 last year, pessimism was high and there was a large consensus among economists that a recession was coming (see chart below). Surely, if everyone agrees and knows a recession is coming, it’s probably all priced in. (I disagree with this statement as I’ll explain in this article.) The China reopening and the sharp rise in its credit impulse propelled the hopes of a soft landing and the risk rally took off.
Since I became structurally bearish in January 2022 on risk asset (see here) and since you haven’t seen me write a bullish article since, you probably think I disagree with the above ideas. This is correct. In this article I’ll explain why. (Please note that this article lays out my strategic views. I’ve switched from bearish to bullish from a trading perspective a few times since the start of 2022.)
The concept of a hard vs. soft landing.
We’ve heard a lot of discussion last year about soft and hard landings. Recently, commentators started to debate a third possibility called ‘no landing’. A soft landing means that the Fed hikes interest rates and the economy and inflation slows without the Fed causing a recession. A hard landing means the Fed overdoes it and causes a recession. The ‘no landing’ seems to mean that the Fed hikes interest rates but the economy stays strong and there is no real softening in the economic data. Some recent strong economic figures caused the appearance of the ‘no landing’ idea.
I disagree with this ‘no landing’ idea. In fact, I think that a lot of commentators don’t even fully comprehend the hard vs. soft landing debate. In this article, I’ll show you a simple framework between the economy and markets that works very well. There seems to be this idea that markets front run the economy and even if the economy gets worse, given the fact that the stock market already declined significantly, it’s probably all priced in. Markets bottom before the economy and earnings, right?
This idea is right from a very high level view but in my opinion it’s too simplistic to use as an active investor.
There is actually a very interesting historical relationship between monetary policy, the economy and asset markets. The sequencing between different moves in these 3 factors is crucial and has repeated itself throughout history. And the hard vs soft landing debate is crucial in understanding how it works.
Once you see the interactions at work between these three elements, you’ll never have to wonder again where we are in the market cycle and whether or not it’s time to take risk or not. The sequencing of events also helps to show what’s being priced in by the market and what’s not.
I perform this historical analysis with the purpose of knowing where we stand today in the market cycle.
Let’s first look at the theory, afterwards I’ll prove it with data.
So, what is a soft landing and what is a hard landing?
Let’s look at the first two factors: monetary policy and the economy.
The chart below shows a graphical overview of the types of landings.
A hard landing occurs when the Fed is hiking rates and at the same time we see one (or multiple) of the following elements: an inflation shock, a rising unemployment rate, tightening lending standards. (Shoutout to Michael Kantrowitz from Piper Sandler who has been explaining this publicly for a long time.)
Please note that the unemployment rate doesn’t necessarily need to be rising during the rate hiking cycle. It’s however important whether or not it starts to rise afterwards. By using some leading indicators (more on this later) we can have an informed view about this.
A soft landing occurs when the Fed is hiking rates but none of the above happens.
Let’s now introduce the third factor: the behavior of asset markets around these landings.
The chart below gives an overview of the market behavior around the two types of landings. I also added all historical bear market bottoms of the last 60 years to show you how all of them fit into this framework. (The dates itself mark when the Fed stopped raising interest during the cycle in question.)
Stock market behavior around soft landing: The stock market bottoms as soon as the Fed stops raising interest rates (I call this a Fed pivot I, Fed pivot II is when the Fed starts cutting).
Stock market behavior around hard landing: Here there is a distinction to make. If the economy is in or very close to a recession, the stock market will keep declining even when the Fed stops raising rates and even when it’s cutting rates.
If a recession is still some time away, the stock market will rise when the Fed stops raising rates but will eventually decline again sharply.
So, this is the theory, let me now show you that this is actually how it historically played out.
We’ll discuss the four elements (from the ‘defining elements’ column above) below. After the historical analysis, I’ll explain what it means for the current cycle we are in.
1) Fed rate hiking cycle and market behavior
We start with the market behavior around a Fed pivot I. So we are looking at the market forecasting part in the chart overview above. First I need to prove that when there is a soft landing, a Fed pivot I is indeed sufficient to create a new bull market in stocks.
The following charts show the S&P500 on top. The orange areas indicate a recession. The bottom panel show the Fed funds rate. The vertical green lines indicate a Fed pivot I after which the stock market enters a new bull market. The vertical red lines indicate a Fed pivot I after which the stock market continues to decline (or will eventually decline significantly when a recession is not imminent).
As you can see, all the green lines, when a Fed pivot I is bullish for stocks, were not followed by a recession (no orange area follows the green lines). So when there is no recession and we have thus a soft landing, a Fed pivot is the trigger to get bullish on the stock market.
We can also clearly see that all the red lines are followed by a recession and that a Fed pivot I was not bullish for the stock market. When a recession is not imminent (1989 and 2006) we see a rally (of around 20%) in the market which eventually turns into a bear market as soon as recession hits. In the following part I’ll explain how to spot the difference between a recession being close or not.
2) Rising unemployment rate
So we now know that there is a big difference in market action around a soft and hard landing. In a soft landing a Fed pivot I is bullish, in a hard landing not.
But how do we know if we’ll have a soft or hard landing? That’s what the following three elements are about.
The chart below takes the chart from above but now adds the unemployment rate. You can clearly see that after the vertical green lines when we have a soft landing, the unemployment rate continues to decline. After every red vertical line, the hard landings, the unemployment rate starts to rise.
But how do we know if the unemployment rate will rise? I explained this in detail in my previous article (see here).
Below you see one of the charts I showed in that article. In orange you can see the US unemployment rate. In blue you have a breadth model. A large spike in the breadth model has historically always led to a big increase in the unemployment rate. Look at 1984, 1995 and 2018 on the chart below. These were all soft landings and never was there a warning signal from the breadth model. This time however, the model is indicating that the unemployment rate will rise considerably. The housing market, another great leading indicator for the unemployment rate is indicating the same (please see my previous article for charts).
We can also use this breadth model to differentiate between the two hard landings (one were recession is imminent and one where it is not). This helps us to know if there will be a significant stock market rally before the bear starts or not. As we already know, 1989 and 2006 are the two historical examples when we had a recession but the market first had a big rally before the started to decline.
Please have a look at the chart below. In green it indicates the moment when the Fed stopped raising interest rates for these two market cycles (1989 and 2006). In red I indicated when the stock market peaked. When the Fed stopped hiking, the breadth model was still very low and was not indicating any risk. The time between the green and red arrow provided a window of opportunity for the stock market to rally. However, eventually the breadth model gave a warning signal and a bear market started.
If we look at the model right now, we can clearly see that a warning signal has been given.
3) Inflation shock
The next element to differentiate between a hard and soft landing is whether or not the economy encounters an inflation shock. The chart below shows in blue when we are in a rate hiking cycle. The orange line is a representation of inflation shocks. When the inflation shock gets too big (and the orange line turns red), this has a negative impact on the economy and thus raises the possibility of a hard landing significantly.
When the blue line is rising (the Fed is thus raising interest rates) but the orange line is not rising too much (not becoming red, no inflation shock), we have a soft landing. We can see this in 1966, 1984, 1995 and 2018. I indicated these periods with a green circle.
When you have both the Fed raising rates and an inflation shock (rising blue and orange line, the orange line turns red indicating the significance of the inflation shock), you get a hard landing. These periods are indicated with red circles.
It’s also possible to have a hard landing without a significant inflation shock (indicated by orange circle). Please note that during these periods the unemployment rate rose and the unemployment breadth model gave clear warning signals.
If we look at the situation of today, it’s rather clear we have a significant inflation shock. This implies we’ll see a hard landing.
(Chart inspired by the work of Michael Kantrowitz from Piper Sandler.)
4) Tightening lending standards
Finally we can have a look at lending standards to differentiate between hard and soft landings. As you can see below, every soft landing was accompanied by easy lending standards. Every hard landing was accompanied by tight lending standards. Looking at the picture below, it’s quite clear we’re heading to a hard landing.
Source: Piper Sandler, Michael Kantrowitz
Now that we’ve had a look at the four elements, let’s put them all together to see what it means for the current market cycle.
The table below shows an overview of the elements discussed above for each cycle. If the box is colored orange, the element in question was present during the cycle in question. If the box is green, it’s not.
As we can see, a soft landing was only accompanied by a rate hiking cycle, that’s why in the last column the colored green (with ¼ points given because only 1 element was triggered).
The hard landings or recessions were always accompanied by 3 or 4 of the elements discussed.
Currently we 4 of the 4 elements that are giving a warning signal. In my opinion, a hard landing is guaranteed.
Is everything priced in?
In the beginning of this article I shared a chart that shows the general consensus among economists that we’ll see an economic recession.
If you’re a contrarian you can see this as a signal that we’ll have a soft economic landing.
Or even if we do have an economic recession, it won’t be a surprise and therefore it’s priced into asset markets and you can become bullish. (As I said earlier, I don’t agree with this line of thought. I’ll explain why later.)
However, if you are a contrarian and you want to make the case we’ll have a recession, you could use the following chart.
Source: Trahan Macro Research
The chart shows that the idea of a soft landing is being heavily discussed in the financial media. If everyone thinks we’ll have a soft landing, maybe we won’t.
The general conclusion to make from these two charts (consensus of economists on a hard landing and heavy discussion in the media on soft landing) is that they don’t matter. In 2000 and 2007 when there was a lot of talk about a soft landing, we saw a recession. And if you look at the chart of the economists you see that indeed sometimes when they are worried nothing happens (1984, 2018) but sometimes they are worried and they are right (1974, 2008).
The framework I outlined above is much more robust than just thinking everything is priced in because something seems to be consensus.
We already saw that market action around soft landings is very consistent. The next thing to analyze is the market action around hard landings.
In a soft landing, stocks bottom when the Fed pivots, each and every time.
In a hard landing, this is different.
The vertical lines in the following chart indicate all bear market bottoms. The green lines are soft landings and the black lines are hard landings.
The circles in the bottom panel indicate when the Fed pivots and stops raising interest rates. The green circles are soft landings, the red circles are hard landings. As you can see, the stock market bottom for soft landings (green lines) occurs when the Fed pivots (green circles). And the stock market bottom for hard landings (black lines) occurs after the Fed pivots and in general has executed several rate cuts.
So, what’s the trigger for the market to bottom around hard landings?
As we all know, the stock market is a leading economic indicator. It will bottom before earnings and GDP do. There are however other leading economic indicators and the stock market is coincident with those, it’s not leading them.
Take a look at the following chart. It shows the movement in the S&P500 and the ISM PMI, two leading economic indicators. It’s clear that they both move together. One is not leading the other.
The following chart from Michael Cembalest (J.P. Morgan) shows stock market action during hard landings as well as when several economic indicators bottomed. The red dots indicate when earnings bottom. As you can see, earnings usually bottom a long time after the stock market bottoms (the DotCom collapse being the exception).
Now have a look at the blue dots. These represent the bottom in the ISM PMI. It’s clear that they bottom very close to the actual bottom in the stock market.
Source: J.P. Morgan Asset Management, Michael Cembalest, The end of the affair
As Michael Cembalest explains : “In the history of US recessions (with the exception of the dot-com collapse of 2001), equity markets bottomed well before the bottom in GDP, payrolls, S&P 500 earnings and housing starts and the peak in household/corporate delinquencies. The ISM survey has been the most reliable coincident indicator of a bottom in equities, which is why we pay so much attention to it.”
The following charts shows this as well. The vertical red lines show when the stock market bottoms during hard landings. As you can see, this coincides very closely with a bottom in the ISM PMI. The vertical green lines show the stock market bottom around soft landings. These don’t coincide with a bottom in the ISM PMI but, as we’ve shown before, with a Fed pivot.
So to know when the stock market bottoms, we need to know when the ISM PMI will bottom. The following chart shows the ISM PMI in orange and a model that predicts the ISM PMI in blue.
As you can see, we are nowhere close to a bottom in the ISM PMI.
Over the last year, the Fed has enacted on one of its fastest rate hiking cycles ever. Most of these rate hikes haven’t affected the economy yet. The effects on the economy will become visible as we proceed throughout the year.
Every warning signal that has preceded a hard landing is currently flashing red. And now that we know how the market behaves around hard landings, I think that the markets will be very surprised about what will be coming and that we’ll make new lows later in the year.
If we take a quick look at Europe, consensus seems to be that the worst is behind us. The following model from Nordea disagrees however. Europe will enter recession and neither central banks nor consensus is ready for it.
Source: Nordea, Mikael Sarwe
Other elements like credit spreads and the equity risk premium are indicating that the market is way too complacent. I’ll explain this in a future article.
To be clear, the stock market won’t bottom the month that the ISM PMI bottoms. But it will bottom in the months around it. For the time being, there is nothing in the models I follow that’s indicating a bottom in the ISM PMI in the near future. Once I see the models indicating a bottom, I’ll be looking for the signals of a sustainable bottom in the stock market. Right now, it’s still too early for that.
Can I be wrong? Absolutely. I’m wrong all the time. Luckily the market will tell me when I’m wrong. We saw significant price action in several asset markets last week. Several stock markets lost significant levels (I shared some charts on twitter). If these levels can be regained, I’ll have to respect market action.
Thank you very much for reading my article.
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