Easing inflation in the US and the slow exit from Covid signal an end to two of the key themes that have characterized 2022. However, this does not necessarily mean the start of a new risk on regime, with the full effects of policy tightening delivered and still to come, yet to be felt.
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Market regime shifts or trend exhaustions are typically met with a rise in volatility as the market's distribution of outcomes moves from a one-sided distribution to one that is equally distributed or skewed in the opposite direction. The longer the trend, the more volatile the pullback as long held positions need to be cut and in some cases reversed.
This explains the significant moves we saw last week following weaker than expected US CPI and supported by further signs of China reopening.
The result was the USD, US rates and global equities had their largest single day moves since the COVID crisis and before that, the peak of the GFC. Trades that reflected the prior regime of rising US inflation, hawkish Fed and a weak China experienced a historical reversal, all moving by more than 3.5+ daily standard deviations resulting in US financial conditions having their second largest single day easing since 1990.
The specifics of the US CPI print were certainly encouraging. Headline CPI and core were both lower than CPI fixings and consensus economic estimates. While this level of inflation remains high relative to history, there are clear signs of a softening in inflation and a narrowing of the pockets of inflation pressures. Viewed in the context of other data points, there is growing evidence of a slowdown in the US economy, despite the labor market remaining resilient.
In China, evidence continues to grow of a policy shift away from its zero COVID policy. There were a range of new measures released this week after the Politburo Standing Committee meeting that, together, will ease the restrictions on domestic mobility and international travel.
Altogether the developments in the last 3 weeks from China, global policy makers and with global inflation, all signal that the regime of maximal policy tightening driven by rising inflation and a weak China is potentially towards the end of its life cycle.
This, however, is not the same as saying we have shifted definitively to a singular new regime. Markets can move quickly, but the data and policy makers (especially in China) move slowly.
Uncertainty about the path forward remains very high. For example, a China reopening may reignite inflationary pressures globally. The Fed will be happy to have seen the first meaningful inflation miss, but discouraged by the level of financial conditions easing that followed, and, over the weekend, Gov. Waller was at pains to reiterate that they have a “ways to go” before pausing.
What this means is that the next few weeks and months of data points will be important for shaping the market backdrop as we head into the new year.
In our view, bearish exhaustion is high across markets and the market wants to believe in a soft landing of falling inflation combined with a shallow recession.
However, central banks remain hawkish (if less than previously) and, especially in the US, reactive. In the absence of a much harder landing, policy is likely to become more restrictive into the new year.
The job losses reported in tech, the collapse of FTX and implosion in crypto, alongside the weakness in housing, is the lagged effect of policy tightening and potentially the start of this hard landing. But, with unemployment remaining at cycle lows across DM, we are still in the early innings.
With this asymmetry, 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.