‘Tail Risks Are Diminishing,’ Kolanovic, JPMorgan Say

There are three possible scenarios for US growth, according to JPMorgan. One involves the risk of an “imminent” recession, another entails a recession next year or the year after and the third roughly corresponds to a “soft landing.”

If you ask the bank, “the probability of the ‘soft landing’ scenario has increased.”

That assessment is, of course, based on the combination of July’s cooler-than-expected read on prices (both consumer and factory-gate) and that month’s upbeat jobs report. In addition, strategists including Marko Kolanovic cited the Atlanta Fed’s GDPNow tracker which, while still early, shows the world’s largest economy on solid footing midway through the third quarter.

The bank cited a trio of developments which, in their view, argue that we’ve likely seen “peak inflation.” In addition to tentative signs that the breadth of price increases may be poised to recede, JPMorgan cited moderation in market-based and survey-based indicators of inflation expectations along with what looks like a top in the number of countries reporting rising 12-month core inflation (figure below).

“There is evidence that a peak in inflation is not a US-specific development,” the bank wrote. There were caveats. Only half of the countries represented in the chart have reported CPI for July, for example, and the “asymmetric” energy price shock makes Europe a special case.

A recession in the euro area, which seems likely, should be “manageable so long as the US and China are still growing,” JPMorgan said. In my assessment, China isn’t growing. Activity data for July and this week’s surprise rate cut from the PBoC suggest the situation is deteriorating in real time. If there’s a silver lining, it’s that policy panic seems to be setting in, and once the ceremony for Xi’s de facto coronation is over, it’s possible Beijing could embark on a larger stimulus push or even dial back “COVID zero.”

JPMorgan still expects another 75bps hike from the Fed in September. Market pricing recently leaned in the direction of 50bps, and official rhetoric seems predisposed to the smaller increment — at least for now. JPMorgan sees a downshift in the pace to 25bps increments in November and December.

Whatever the case (and whatever the pace), the bank said July’s CPI report “reduces the tail risk of a policy mistake.” “The positive reading for markets is that clearer signs of a peak in inflation reduce the urgency and scope of further tightening, particularly at a point where the normalization process has already brought policy from highly expansionary to neutral and not far from what’s implied by a simple Taylor rule with unemployment and inflation expectations,” Kolanovic and colleagues said, adding that market-based recession probabilities seemingly overshot the odds implied by the data (figure on the left, below).

When juxtaposed with positioning that’s “as defensive as it could get” (figure on the right, above), there may be considerable scope for additional upside.

Kolanovic noted that the 200-day moving average is “now in sight” for the S&P and suggested exposure adds from CTAs and vol targeters could be a tailwind as cross-asset vol moderates. Regular readers are well apprised of that thesis. He also noted a “dramatic improvement in market breadth,” defined here as the percentage of stocks above their 50-day moving average.

Ultimately, the message from the bank’s strategists was constructive, with allowances for a long list of macro challenges. “Whether it is the end of the hiking cycle, inflation peaking, or dollar rolling over, we see the recent improvement in markets as more fundamentally driven,” the bank said. “Tail risks [are] diminishing post-CPI [and] sentiment improving for risk assets.”

The mainstream financial media is keen to juxtapose JPMorgan’s relatively upbeat view with overtly cautious outlooks emanating from, to name the most high profile examples, Morgan Stanley and BofA.

I have, of course, documented the bear case in something approximating exhaustive detail. It’s thereby incumbent upon me to note that not everyone is convinced that equities will careen to new lows in the months ahead. With that in mind, I’ll offer my customary critique of the way everyday market participants typically assess the accuracy of forecasts. You can be right on the bullish side 100 times and be derided for the one time you were wrong. Bears, on the other hand, enjoy a luxury rarely afforded to practitioners in other professions: They only have to be right once in their careers to be celebrated as geniuses. That makes (some) sense for hedge fund managers. After all, a single billion-dollar score gives you a lot of leeway to be wrong in smaller amounts thereafter. It’s far from obvious that the same logic applies to strategists, though. Generally speaking, they need to be right more often than they’re wrong. And, over time, stocks go up (sans the Japan asterisk).

Finally, I’d remind readers that contrary to the impression one might get based on mainstream financial media coverage, Morgan Stanley’s Mike Wilson isn’t always bearish, nor BofA’s Savita Subramanian. Wilson, like Kolanovic, correctly predicted the post-lockdown rally. They, like Goldman’s David Kostin and every other top-down strategist, are just trying to get it right. It’s not easy. Especially not in 2022.