Stocks rally in relief after Michigan inflation expectations get revised lower
New theme is inflation vs recession risk, focus on GDPNow estimate today
Major FX pairs stick to trading ranges, Russia defaults, gold bounces back
Relief rally
Stock markets closed the week on a high note, rallying in relief after the final print of long-term inflation expectations in the University of Michigan survey was revised lower. The Fed used this survey to justify its latest ‘super’ hike, arguing that a heavy-handed approach was necessary because public perceptions of inflation had started to edge higher.
It turns out that inflation expectations are still well anchored, so bets for a rate increase of similar magnitude in July were pared back in the aftermath, bolstering risk appetite. The S&P 500 climbed 3% on Friday and 6.5% on the week, with beaten-down growth stocks leading the charge in a reminder that bear market rallies can be vicious.
The striking part is that ‘recession’ has replaced ‘inflation’ as public enemy number one. Business surveys from Europe and America foreshadow a sharp slowdown in growth, market-based measures of inflation expectations have rolled over and the terminal level for interest rates has been pushed lower. Traders are saying the inflationary bonfire will be extinguished, albeit in a painful manner.
Dead cat bounce?
With growth concerns replacing inflation concerns, it seems premature to call for a sustained reversal in equity markets despite this latest bounce. Valuation multiples have compressed and it is tempting to think the market is getting ‘cheap’ here - the problem is that earnings estimates have not been marked down to reflect the gloomy mood in business surveys.
Commodity prices are perhaps the most important variable at this stage, as lower energy costs might be the only thing that can dispel both inflation and growth fears simultaneously. The Fed wouldn’t need to be so aggressive and struggling consumers would get a precious lifeline. Solving the energy crisis has become paramount politically as well, although the G7 leaders did not come up with any convincing strategies this weekend.
The next event that could shake markets is the latest update of the Atlanta Fed GDPNow model, after durable goods orders are released today. This model is fairly accurate and it currently points to zero GDP growth in the second quarter following the contraction last quarter. If it is revised down any further, the prospect of a technical recession would become much more realistic.
FX quiet, Russia defaults, gold recovers
The currency market has been quiet in comparison, with the only noteworthy move being a retreat in the US dollar. This echoes the shift in risk sentiment, since the underlying dynamics in the FX arena haven’t really changed. The dollar still offers an unparalleled combination of attractive yields and safety, while the global power crunch has deprived the euro and yen of their historical advantage - a massive trade surplus.
In other news, reports suggest Russia has defaulted on its foreign-currency debt after missing a payment on Sunday. The Kremlin says it has the money and is willing to pay but escalating sanctions have made payment impossible. There hasn’t been any visible impact in global markets, which suggests investors view this as a non-systemic risk.
Last but not least, gold prices opened with a gap higher this week after America, Japan, the UK, and Canada announced plans to ban new gold imports from Russia. The move sounds impressive but has come under heavy criticism for being merely symbolic.
Gold has been caught in the crossfire between inflation and growth nerves. Its trajectory will ultimately depend on what wins this battle - persistent inflation means higher rates that are damaging for bullion while recession fears translate into a shallower tightening cycle that benefits gold.