What is a Soft Landing and What if the Market has it Wrong?
The recent rally in the markets has been brought on by talk of a soft landing. But is this really the case? The markets expectations are set really high. Lets just hope it does not get disappointed
Cartoons of the Week:
Don’t Believe the Hype
In 1988, the rap group Public Enemy released their second album, “It Takes a Nation of Millions to Hold US Back”.
On that album was a song Chuck D, the lead member of the group, stated was inspired by the book “Manufacturing Consent — The Political Economy of the Mass Media” by Edward Herman and Noam Chomsky.
That song was titled, “Don’t Believe the Hype.”
One of the verses went:
“I preach to teach to all”.
So here I am, in the first week of February, looking to tell you don’t Believe the Hype, with the hopes that this preaching will continue my teaching :)
Boy What a Difference a Month Makes
Welcome to 2023, the year when all the bad news magically disappears.
Looking at the market returns for January, which have picked up steam in the first few days of February, it seems all the issues we faced in 2022 left when the ball dropped on New Year’s Day.
Just look at the returns we have seen in January.
January Returns:
· S&P 500 +6.28%
· NASDAQ +10.68%
· MSCI EAFE +8.10%
· MSCI EM +7.90%
· MSCI ACWI +7.17%
· Bitcoin +38.35%
· MSCI China +11.78%
· Barclays High Yield Index +3.81%
· Barclays US Aggregate Bond Index +3.08%
These returns are on the back of a nice rally we saw in the fourth quarter of 2022.
In fact, over the past 4 months, the S&P 500 has rallied 14.3%!!!
This rally has led to positive highlights in the news like this.
Or this…..
Excitement is all around.
Even the “talking heads” are sounding excited.
Listening to these commentators and looking at recent market action, you would think we are in the clear.
And while I am excited to finally see positive returns, something just does not feel right.
You see, as I talked about HERE back in mid-January, the market was destined to ONLY look at inflation data right now, and as a result, get excited in the first few months of 2023.
It is to be expected. Inflation is what drove all the negativity last year. And since inflation is showing signs of moving lower, the market seems to be saying “Mission Accomplished”.
We know how this turned out.
With the market yelling Mission Accomplished, we have now baked in what many are calling a “soft landing”.
Can the market be wrong? Is the market looking too much at the past and not focusing on what is ahead?
Let’s take a deeper look into the Soft Landing thesis and what investors and the market may be missing.
What is a Soft Landing?
The definition of a soft landing is where the Federal Reserve raises interest rates, and then stops, without the economy falling into a recession.
That what exactly is a recession?
A recession is a slowdown in the economy. Usually, when recessions happen, unemployment moves higher, company profits fall, financial markets tumble, and housing collapses.
When a recession lasts a long-time and gets really bad, like in 1929, it turns into a depression. 2008 is what we would call a severe recession.
But it is all relative.
Recessions are usually bad for your net worth, financial conditions and generally make you feel bad about what is happening in the world.
If you want to learn more about what “technically” makes up a recession, I wrote about it HERE in July of last year.
Bottom Line: Recessions are bad. If we can have the Federal Reserve step in to calm inflation by raising rates, but not see a full blown recession, that is a positive for everyone.
History has shown us this is hard. When the Fed pulls back on liquidity, raises rates, and pushes the market lower, the economy usually tilts into a recession.
This is because the Federal Reserve controls the cost of money which in turn controls the price of goods and investments. I talked in more detail about this HERE and HERE.
A soft landing has only happened four times since World War II.
The four times we have seen a “soft landing” has been:
- November 1966
- August 1984
- February 1995
- December 2018
In all four of these cases, the Federal Reserve stopped raising rates and immediately started to cut interest rates.
History has shown us that the receipt for a soft landing is as follows:
- The Federal Reserve stops raising rate
- The Employment Market Stays Strong
- Inflation moves back into the comfort zone of 2% or lower
- The Federal Reserve immediately CUTS rates
What are Expectations in the Market Today?
Now that we have our receipt and know our ingredients for a soft landing, let’s see what the market is currently baking in.
On Wednesday, the Federal Reserve raised rates by 25 basis points (0.25%) to push their Federal Funds Rate to 4.75%.
The first ingredient in our receipt is to see the Federal Reserve stop raising rates.
If we listen to what Jay Powell, the Federal Reserve chairman, then no, they are not done raising rates.
But, we do not care what people say, we care what people do.
Right now, when we look at the Atlanta Fed Probability Tracker to forecast what the MARKET is expecting, we see clearly the market expects the Fed to stop raising rates soon AND to start cutting rates near the end of this year.
This is easier to see in the next two charts by Bloomberg.
When we look at our receipt for a soft landing, it seems the market is baking in both ingredient #1, the Fed stopping rate hikes, and ingredient #4, Fed Cutting Rates.
As for ingredient #2, strong employment, we talked about this already HERE a few weeks back.
We are in a very tight labor market. As seen below, look at the gray dots (2022). When we plot the unemployment rate on the horizontal access(lower is a stronger employment market), and the Job opening rate on the vertical excess (going up means more job openings), we have not seen a market this strong in a very long time.
So with three of the ingredients already baked in, we just need ingredient #3 (inflation moving back to 2%) to say we have fully baked in a “soft landing”.
The market is forecasting a significant slowdown in inflation.
Looking at the 5-year outlook, you can see below the market has pushed the breakeven rate back to 2%.
When we look at Forecasts by banks like Deutsche Bank, we clearly see most are expecting inflation to fall very quickly back to a “normalized” level by the end of this year.
So the recipe and ingredients are in place for a soft landing.
This is why the market has exploded higher. This is why stocks, bonds, bitcoin, and others have rallied so much over the last few weeks.
But, this, my friends, is the real risk.
If we do in fact have a soft landing, and the market has now already priced that in, then where does the additional upside come from?
BUT…and this is a big but….What happens if the market is wrong? What happens if inflation stops going down and stalls OR unemployment picks up? What then.
Then the market will have to reprice itself. And if that happens, we may see some very ugly months for equities and all risk assets.
Robert Armstrong at the Financial Times highlighted this risk recently in his article:
“We are worried about the Fed-market gap, not because of credibility but because of market risk. Suppose the Fed is right and the market is wrong, and the path to lower inflation does not run smooth. Say in a few months we get some bad news on inflation, forcing the market to move its estimate for the peak policy rate up and extend its expectations for how long high rates will last. That could lead to a very large, very fast repricing in markets.
Remember that the S&P 500 is 15 per cent off its lows of October, while junk bond spreads have tightened by a full percentage point. If that were to reverse all at once, as the economy was already shrinking, that could easily turn what might otherwise have been a mild recession into a severe one. This does not strike us as a particularly unlikely scenario, simply because inflation tends to be volatile and markets are very jumpy about rates right now.”
Final Thoughts
One of my core beliefs in life is not to have expectations.
If you want to live a wealthier, healthier, and happier life, drop your expectations.
In my view, expectations are the root of all evil.
Think about your life over the past week, month, or year.
Think about the hidden expectations you have baked into your life over this time. Did you expect a certain service level when you went to that restaurant that you did not get? Did you expect your kids to do something they did not do, or did you expect your partner and loved one to do something or interpret something differently than what they actually did? What was your emotional response? Did the service level at the restaurant impact your viewpoints on the food you ate? Did you get upset at your kids or loved ones because they did not meet this fake expectation you have made up?
Most all of our personal expectations are false narratives created by our mind and ego to take us out of the here and now. Once your expectations kick in, you now become victim to these made-up assumptions, which will ultimately control your emotional well-being.
Just like us, the market is driven by expectations which drive the market’s moves in the short term. Right now the market is expecting nirvana. The expectations currently being backed into the market are extremely high.
When reality kicks in and does not meet these high expectations, the market will again get upset, pout, and rage quit.
Expectations create undo drama in our lives AND in the markets.
Ryan Reynolds hit the nail on the head when he talked about expectations.
If the market is right, most of the good news is already baked in. But, if the market is wrong and the economy does not hit its high expectations, it is setting itself up for a huge disappointment.
Have a wonderful weekend….
