You have two options
The market is navigating different outcomes and in the simplest terms, here’s how it shapes up.
1) High inflation with ongoing growth and Fed hikes above 4%
This is the scenario the market grappled with for most of the year and the results speak for themselves. It was the worst H1 for the S&P 500 since 1970 and the worst for the Nasdaq ever.
2) A recession but inflation under control
The word ‘recession’ never sounds good to investors but I’d argue that done right, this is the better scenario. As the market has shifted its focus to recession, borrowing costs have come down and a terminal rate of 3.25-3.50% in Fed funds is priced in, coming down to 2.75% about 8 month later.
Unfortunately, markets have gotten drunk on cheap money for far too long and are hopelessly addicted now. Everything is leveraged. If rates top out and we can kick the can down the road on popping the bond bubble, then there’s scope for a ‘recession rally’ as bizarre as that sounds.
The third scenario
The nightmare scenario is stagflation, where we get a recession and inflation doesn’t fall. That might be possible if the world continues to be short of commodities, or loses faith in central banks. I think we priced in a chance of this in the past few weeks but given how quickly consumer sentiment and industrial orders are declining, along with commodities, this has grown more remote.
Overall though, I don’t see a ‘recession’ scenario as that bad, especially since I think the hit to the jobs market will be modest.
This article was written by Adam Button at www.forexlive.com.