Existential Questions For 2023

As the curtain closes on 2022, existential questions abound.

Is the world headed for a global military conflict? Was Vladimir Putin’s attempt to seize Ukraine a preview of what we can expect, sooner or later, from Xi Jinping across the Taiwan Strait? Putin forced the West’s hand on sanctions — was that tantamount to the West showing its sanctions hand to Xi? Will the fallout from the Ukraine conflict result in permanent regionalization and thereby amplify the de-globalization set in motion by the pandemic? Or will Russia simply become a pariah state? How would that work? Can a pariah state have a permanent seat on the UN Security Council? Surely not. Would China not become a pariah state if Xi invades Taiwan? If so, would the P5 not need to be rethought? If yes, then what about the UN itself? If the Justice Department prosecutes Donald Trump, how many of his supporters will take to the streets? If Trump’s barred from holding public office (or jailed), what does that mean for US lawmakers still espousing his election lie or just Trumpism in general? Does Trumpism become illegal in the US? How detrimental was Liz Truss to the Tories? Did six weeks of Truss permanently condemn conservatives? Is so, condemn them to what, exactly?

On the macroeconomic front, there are just as many vexing queries, and many overlap with geopolitical concerns. If peak globalization is behind us, then how sure are we that peak inflation is too given that globalization was arguably the most important disinflationary enabler during The Great Moderation? If inflation simply refuses to return to 2% in developed economies, central banks may have to adjust their goals accordingly, laying bare the arbitrary nature of their inflation targets. Once that’s clear to the public, will expectations become unanchored? How do you explain a 3% target once you admit 2% is both unachievable and arbitrary? Why not 4%? Or 3.75368%? Labor is seeking to reestablish itself as an economic actor with clout. That’s a good thing for the middle class, but it’s inflationary, which is a bad thing for the middle class. How do you reconcile the two? Fighting climate change is inflationary, but so is climate change itself. How do you reconcile those two? Right-wing populism turned out to be just as dangerous this go around as it always is, but the socioeconomic problems that opened the door for the likes of Trump haven’t gone away, and with stagflation knocking, it’s probably just a matter of time before a left-wing populist ideologue wins an election somewhere in the developed world. What would that mean? And could you blame voters? (“Do you work in business?” Rishi Sunak asked a homeless man named Dean on Friday, while volunteering at a shelter. “No, I’m homeless,” Dean told his prime minister. “I’m actually a homeless person.”)

I could go on. And on. It’s tempting to say the world couldn’t possibly get any more dangerous or volatile in 2023 given all that’s happened over the past three years, but remember: Calendars are contrived. We aren’t “due” a reprieve. Life isn’t a game. The odds of the next 365 dawn-to-dusk increments being “good” don’t increase just because the preceding 365 were “bad.”

That said, from a “pure” markets perspective, it’s quite difficult to imagine another year like 2022 in succession. The uniformity of poor cross-asset returns was wholly anomalous.

With all of that in mind, below find excerpts from recent forward-looking strategy pieces penned by a handful of analysts, most of whom regular readers will recognize by name. Topics vary, and that’s on purpose — there’s quite a lot to ponder, after all.

Tightening cycles are generally periods of decelerated growth characterized by compression of risk premia and general risk-on sentiment. In contrast, since the beginning of rate hikes this year, risk assets have faced challenging conditions and volatility has risen to crisis levels, significantly higher than in any other cycle the last three decades. We believe that at the root of the new market dynamics are: Historically the most aggressive rise of inflation since the late 1970s which has created a massive uncertainty gap in the nature and extent of policy response, and unprecedented speed of rate hikes and open-endedness of the terminal rate with generally unknown, but potentially adverse, consequences. While this year brought in a number of dislocations across the rates manifold, in our view, appearance of high volatility is the most prominent anomaly. It is a function of several factors: The distribution of underlying uncertainties reflecting the structural breaks in traditional economic relations, forcing of monetary policy to operate on an unknown terrain, and market unpreparedness/reluctance to fully accept it. Resolution of one or more of these factors is likely to lead to a decline in vol. Slowdown in inflation and/or the first signs of its response to rate hikes would be interpreted as an announcement of a turnaround in monetary policy and open the door for the resolution of the underlying uncertainties. The discourse should shift towards the risk premium reflected in vol — it will begin to move from the actual interpretations of the aggressive rates path to its consequences. Both dislocations, high vol and anomalous upper-left corner, are likely to begin to converge. The pattern of vol decline would be a reverse of its trajectory on the way up with FX and the upper-left corner leading the way and long-tenor vega outperforming on the way down. — Aleksandar Kocic, Deutsche Bank

The BoJ decision to widen the YCC band was a surprise in the sense that it’s been viewed as a “when,” not “if” matter. Markets knew the BoJ eventually had to true-up the 10-year point with the rest of the JGB curve and fundamentals, and eventually, begin a gradual policy alignment with the rest of the world’s already robust tightening. Nonetheless, most everybody expected this move to come after the Kuroda term ended in April 2023, with most expecting a “phase-in” executed in smaller increments over time. So now, from a vol curve perspective, you flattened that April 2023 vol “uncertainty” hump because the BoJ ripped the Band-Aid off, the toothpaste is out of the tube, etc. The first part of this event risk is cleared. The BoJ needed to get JGB and yen market function right here, so this first move was critical — it removes the left-tail risk of any further sharp yen downside as well (say goodbye to all those asymmetric dollar-yen 250 bets). But yes, there should still be more movement of the YCC band higher in due time, despite Kuroda saying otherwise. Of course, there’s also an authentic macro story here, which is that prices are higher with growth also above trend, while too, inflation expectations continue to rise, which is why yen (stronger) in my eyes was the best way to play “short USD” in 2023. This move happening ahead of schedule takes some of the luster out of the remaining risk / reward in the trade, as this was the “easy part.” The next incremental YCC adjustment after this initial move becomes more difficult, because with the Fed nearing the end of their policy tightening, UST yields have stopped going meaningfully higher, so a “unilateral” move higher in JGB yields from additional YCC adjustment risks a more unruly market impact. From here on the currency side, any dollar-yen potential for 120-130 and beyond is likely a waiting game on US recession, likely requiring a Fed messaging pivot towards outright policy-easing / rate-cutting to get that rates differentials kicker. The biggest question now is whether this yen strength and domestic bond market yield pick-up will see repatriation back home from many Japanese investors out of foreign bond markets, who since NIRP began in early 2016, have moved large amounts of money into overseas fixed-income. This should be bullish for Japanese banks and insurers, and yet shouldn’t come close to hurting corporate Japan, as the 25bps in the scheme is relatively negligible. — Charlie McElligott, Nomura

In the post-pandemic global economic landscape, it has become clear that not every nation has had the same experience or inflation/growth implications. Geopolitics have further complicated the process of returning to the new normal as evidenced by Europe’s energy crisis and the associated inflation trends. This combined with the FOMC’s target of containing US inflation at all costs has led the Fed to step back from being the de facto central bank to the world. Such a move was unquestionably warranted, although the implications for higher nominal Treasury yields and the associated USD outperformance have been pronounced and will linger into 2023. The most direct manifestation of global growth concerns to Fed policy will occur via the multinational impact on equity vol and the flow-through to financial conditions. At present, financial conditions are off the tightest levels, providing Powell with flexibility in the event 2023 commences with additional stock weakness in the face of continued Fed hikes. It’s worth highlighting that as equities rally in anticipation of a Fed pivot, the easing implications for financial conditions actually reinforce the Committee’s need to push to a higher terminal rate. — Ian Lyngen and Ben Jeffery, BMO

The overarching market narrative and the principal macro worry is shifting from inflation to recession. If a recession is the case, we should expect significant dollar and US interest rate reversals when it comes. We are still waiting to see that. For US equities, receding inflation is incredibly significant, but remember, should the recession narrative take on more weight in 2023, the S&P 500 is undoubtedly not priced for a hard landing. Taken together, I am not in love with the risk/reward on US equities from a bull or bear perspective and the market behavior in recent weeks only underscores that instinctive call. Trust me, stocks are a horrible indication of what the economy is doing — much better to focus on bonds and the US dollar for that stuff. Therefore, since it pays to wait in USD cash, I have no problem sitting out a few hands on SPX and seeing how the cards fall in early Q1. — Stephen Innes, SPI Asset Management

There were few takers in December 2021 for the view that 2022 would end with rates here, with the promise of them moving higher. However, the risks were visible: The logistics industry was tearing its hair out over how Deep the Ship was that we were in, and military experts were doing the same over Russia’s troop build-up. Have lessons been learned as we head into 2023? On rates, the market is only very reluctantly being disavowed that imminent pivots loom. The room for further volatility in terms of the level of yields, if not the flattening of curves, as well as in key FX crosses, as the reality of what is actually happening sinks in remains. On geopolitics, there is still little market focus on potential flashpoints outside Ukraine — although CEOs are aware — and the market is pricing that the Ukraine War is dialing down despite Ukrainians and Russians both saying they are in this for the long haul, and the former just saying that the latter will try for Kyiv again at some point eventually. In logistics, markets are confusing a collapse in demand with an improvement in supply. First, the absence of ships off the port of LA/Long Beach is due to the slump in retail sales, but also due to firms moving to other, now more strained, US ports: Don’t believe charts showing LA/LB backlogs as a metric of supply chains “healing.” Second, if the scale of COVID disruption about to hit China had coincided with demand remaining where it was, we would again be seeing stories of goods shortages and even more rampant supply-side inflation. Third, while ocean carrying rates on most (not all) routes are back to more normal levels, that is in the face of a looming recession: And blank sailings and scrapping older tonnage aims to bring supply down to lower demand to keep freight rates up. — Michael Every, Rabobank

Note that rapid increases in real interest rates and removal of liquidity have historically been followed by crises as the receding tide of easy monetary policy exposed systemic weaknesses and vulnerabilities. The rapid 1994 rate hike cycle in the US resulted in the Orange County bankruptcy in the US and the Tequila Crisis in Mexico, which had global reverberations and caused significant instability in both US and global markets. While emerging economies have addressed many of the weaknesses exposed during the 1994 and 1997 crises, the current US hiking cycle is the most aggressive since the early-1980s. Moreover, global financial linkages have increased rapidly in the past 40 years (the last time the Fed hiked rates this aggressively), and derivatives use has skyrocketed (which embeds leverage), potentially creating more vulnerabilities in global financial markets. The UK LDI debacle this year was one example of risk management failures as systemic weaknesses were exacerbated by poor market liquidity, which created a downward spiral for the entire UK pension fund industry. US life insurance companies also use derivatives to obtain exposure to long-duration assets but do not have strict LDI matching requirements. In fact, US pension funds have seen their funded ratios rise from 97.9% at the end of 2021 to 112.9% in October 2022, and they have been receiving long-end swaps or buying long-end Treasury STRIPS. The swap trades can result in margin issues, especially since insurance companies tend to own fewer Treasurys than corporate bonds. Japanese lifers may also run into margin issues if the BoJ undertakes too sharp of a shift in their YCC policy, creating a VaR shock. — Priya Misra and Gennadiy Goldberg, TD