by David Picton & Team, Picton Mahoney Asset Management
As we turn the page on the first quarter, stock markets feel euphoric. It appears that for the all-important U.S. economy, investors believe that a soft landing is in the cards: inflation has been tamed, but a recession has been avoided. And there is strong evidence indeed, at least at present, for a Goldilocks-like, soft-landing outcome. Inflation has come down substantially from its pandemic peak, while U.S. Gross Domestic Product (GDP) estimates have stabilized in the 2% range.
The U.S. Federal Reserve (“Fed”) is now acting as though the fight against inflation has been won and that it is only a matter of a short time before it will be cutting interest rates. The Fed has jawboned financial conditions into easing, by clearly signalling its intent to enact multiple rate cuts as soon as falling inflation data provide the necessary justification to do so.
Our view is that a soft landing is very possible. That said, equity investors have likely priced that in already and we worry that there is much that could still go wrong. We think there is some probability that a recession could still happen; some economic indicators are deteriorating just as they did prior to past recessions. There is also some probability that the Fed may be making another policy mistake by easing financial conditions, and then monetary policy, before the inflation battle is truly won. We worry that if the Fed cuts rates too soon, it risks renewing inflationary pressures sooner than expected, given various supply-side issues that have not had time to resolve themselves.
There are times when markets present a compelling set-up for buyers of stocks. Unfortunately, we do not believe this is one of those times. A lot has to go right for economic data to continue to support the soft-landing narrative; however, stock market valuations are rich, positioning is nearing extremes, and bearish sentiment has evaporated.
Given this backdrop, even if an immaculate soft landing occurs, we think there is a good chance that markets will pull back enough to warrant being cautious in the short term, while waiting for a better entry point. Longer-term, we see a significant risk that inflation will return sooner than expected, forcing the Fed to embark on another tightening cycle, right on the heels of completing the anticipated easing process. That could shorten the next cycle considerably, while also causing a much more significant decline in risk assets.
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