Kolanovic: Recession Isn’t In The Price

Pinpointing the terminal rate may be a fun parlor game, but where Fed funds ultimately peaks is less relevant than the fact that it’s high versus recent history and won’t likely come down materially for the foreseeable future.

That’s according to JPMorgan’s Marko Kolanovic who, on Thursday, warned that a recession probably isn’t priced into markets.

“Economic slowdown and weakening corporate fundamentals are happening in an environment where interest rates are very high, rising and likely to stay high as stated by the Fed on several occasions,” he wrote.

Some market participants found solace recently in a slower pace of rate hikes and softer inflation data. Suffice to say many believe the Fed isn’t likely to achieve the terminal rate tipped by the December dots, and even if they do, almost surely won’t hold terminal for any appreciable length of time.

On the heels of recessionary data released Wednesday and a cooler-than-anticipated read on producer prices, terminal rate pricing receded further, before blipping higher again Thursday, when jobless claims printed a new four-month low.

If you ask Marko, the debate over exactly where Fed funds will peak is mostly irrelevant. “Whether the terminal rate is higher or lower by a few hikes at this point does not matter in our view, given the absolute level of rates and shock that was introduced to the system in the second half last year,” he said, noting that layoffs are piling up and margin pressures are likely to build for corporates going forward.

Given the worsening data and likely profit recession, why have markets been buoyant of late? Well, not because a recession is priced in, Marko suggested. Flows played a part, and particularly from vol-sensitive mechanical cohorts. “Volatility significantly declined in December, helped by low trading activity and hedging of long option positions,” he said, adding that,

In Europe, likely misplaced optimism caused trend following programs to reverse positions from fully short to long. Along the way, many fundamental investors also covered their short positions, despite their negative fundamental outlook. Also, there is a January effect of new 401(k) allocations, rotation from growth to value, as well as increased risk positions by long only funds.

That can only go so far, though, assuming the macro deteriorates and profits disappoint, as many believe.

Kolanovic, an erstwhile bull who turned cautious late last summer amid persistent monetary policy headwinds and evidence that geopolitical tensions might prove intractable, noted that value shares and, relatedly, European stocks, are “basically flat over the past year, and close to previous highs.”

That, he said, doesn’t seem entirely consistent with a profit recession or an economic downturn, let alone both. As the annotations on the chart show, this is a bifurcated market. Big-cap US tech suffered a fairly deep, de-rating-driven selloff. Due to the weight of mega-cap US tech shares in US indexes and global equity benchmarks, some investors might’ve been inclined to believe that the “broad” market has priced a recession, when in fact it hasn’t.

“Keep in mind that over [the past] year we had unprecedented global monetary tightening, an energy crisis, an inflation crisis, geopolitical crises, a decline in earnings and significant increase of recession probability,” Kolanovic went on, calling Europe “particularly puzzling” given that local shares are “trading as if the energy crisis, war and sharp monetary tightening did not happen at all.” JPMorgan, he cautioned, worries that geopolitical tensions are “likely to escalate.”

If you’re wondering what’s changed since early last summer when the bank was more receptive to the idea that a recession was in the price, Kolanovic was direct. “At that point in time, recession-sensitive markets were almost 20% lower than now, earnings expectations were higher and terminal Fed funds were much lower than where they are projected to peak now,” he said.

As to the flow drivers mentioned above, Kolanovic thinks they’re “running out of steam.” The bottom line, he wrote, is that “markets heading towards recession are being further aggravated by central bank tightening.”