George Saravelos, global head of currency research at Deutsche Bank wrote in a note Thursday that the Consumer Price Index issued Wednesday has caused a huge shift in the market. He made the case that based on the moves in the S&P 500 and the US dollar, which finally touched parity with the Euro on Thursday, the markets are now pricing in a 100% likelihood that before the end of the year the economy will sink into a recession.
Saravelos noted that if one uses the peak in the Fed funds futures curve as a proxy for recession-expectations, it becomes apparent the market’s perception of the timing of the next recession has moved enormously since February. As of February, investors were expecting the recession to arrive in December of 2024, however that has gradually been inched back until on Thursday, when they expected it to hit in January of 2023.
Saravelos also noted that the most important factor now driving the market was the fear of recession, even more so than inflation. He added there were a few factors investors would want to keep in mind.
As the labor market remains strong, keep an eye on demand. When strong jobs markets meet declining demand, profit margins and productivity suffer, and this could be especially bad for risk assets. Saravelos notes however the labor market will have to turn somewhat, before the Federal Reserve will change course and cease their relentless policy tightening.
Saravelos also notes you will want to watch out for bubbles. The risk of leverage unwinds will increase the longer Central Banks maintain tight monetary policies. He noted Scandinavia will be particularly exposed to leverage.
The market is also assuming there will be an aggressive easing cycle from the Fed next year in response to the recession. He notes that historically, over the last 30 years, central banks always pivot quickly into looser policy as soon as economic growth slows.
Saravelos also notes that during the seventies, when inflation persisted for roughly a decade, the price to earnings ration declined over time, from 20 to 7. As of Thursday, according to FactSet data, the forward price to earnings ration for the S&P 500 was roughly 16.
Fed funds futures indicate the first Fed rate cut will come next summer. However what will determine that is how long inflation persists, and whether or not we see a sudden dramatic slowdown in the economy between now and then, which will force the Fed’s hand.
