Market pricing for prospective Fed cuts in the back half of 2023 is indicative of elevated recession odds.

Policymakers continue to suggest a deep downturn shouldn’t be the base case, but at least some traders beg to differ.

As illustrated and discussed in these pages on too many occasions to count (most recently here), H2 easing bets are markedly out of step with a Fed still wedded to a “higher for longer” narrative.

In that context, it’s worth noting that raw materials appear to agree with rates. “Commodities tend to be the worst performing asset class as inflation normalizes, especially if there is a recession,” Goldman’s Christian Mueller-Glissmann remarked.

Since March (i.e., since SVB collapsed, ushering in a period of intense stress among some regional lenders in the US), commodities have priced in growth risks alongside rates.

“Global data is surprising to the downside and broadly slowing again, from China to Europe,” Nomura’s Charlie McElligott said. “The increasingly evident ‘drag’ is feeding a larger pivot back towards ‘bonds as your hedge,'” he added.

That’s good news in at least one respect: At least there is a hedge. Last year, bonds were a source of portfolio vol — they were the sponsor of a market event. That was disastrous for multi-asset investors.

Recently, the bond-stock correlation has reverted to the 21st century norm, which “strengthens the world of 60/40 balanced funds, risk parity [and] secular growth equities, as the end of the tightening cycle looks more evident into the global slowdown,” McElligott went on.

“Late-cycle dynamics should eventually take the driver’s seat,” JPMorgan said this week, adding that “signs of [a higher for longer] regime becoming less likely can be found in correlations, which have normalized from distorted levels in 2022.”

Notably, commodities are among the only assets currently pricing a recession consistent with JPMorgan’s one-year probability model. The other is small-caps.

Large-caps are (famously) oblivious, but such assessments miss critical nuance: The reason big-cap benchmarks, and particularly US benchmarks, appear to be whistling past the recession graveyard is precisely because they’re dominated by duration proxies. Those shares have rallied alongside bonds, which are responding to growth worries. We shouldn’t let that get lost.

Goldman’s Mueller-Glissmann reiterated that US rates and raw materials have “priced more growth risks” since March. Panning out a bit, the GSCI “is tracking a more bearish outcome than on average post-inflation peaks,” he noted.

The figure on the left below is certainly worth highlighting. Since inflation peaked last summer, commodities are tracking very close to the historical recession path and nowhere near the path trod during post-inflation peak episodes not followed by a downturn. Indeed, the current trajectory is below the 25th percentile.

On the right, you can see the variation. And there again, the pessimism is evident. Energy is sharply lower, industrial metals are well off this year’s peak and precious metals are outperforming.

Still, Goldman doesn’t expect the worst. Although the bank anticipates a slowdown in the US during the second half, their economics team is above consensus for global growth, and the recession fears inherent in recent oil price declines are “excessive,” the bank suggested.

As for equities, the story continues to be the tension between buoyant mega-cap growth shares (for which lower yields are a boon) and the idea that a narrow rally (a function of mega-cap buoyancy) is a fragile rally.

“This ‘slowing economy = cooling inflation = end of tightening = rally in duration’ thesis supports the valuations of mega-cap tech and their future cash flows, particularly as we are in thrall to this AI frenzy, which ties into many of the S&P’s largest companies,” McElligott wrote, underscoring the point. “A small handful of stocks are almost single-handedly supporting the US equity market [while] economically-sensitive cyclicals are getting rinsed.”