If you’re wondering why JPMorgan remains defensive in their asset allocation (and cautious in their general outlook), one explanation is the rather dramatic shift in recession odds.
In short: Economists and markets swung from pricing elevated odds of a US downturn to pricing slim or even no chance of a recession in the short space of 12 months. For JPMorgan, that’s indicative of complacency at best, and could be a contrarian indicator at worst.
“Markets have been pricing out recession risks this year in a more striking fashion than economists,” analysts led by Marko Kolanovic wrote Monday. That’s no small feat given that economists have themselves aggressively reduced their subjective odds of recession.
Economists put the odds of a downturn at less than 50%, much lower versus the beginning of the year, but still materially higher than the probabilities implied by markets, according to JPMorgan’s model.
The figures above show how market-implied recession odds have changed versus this time last year, when equities touched their bear market lows. A year ago, the S&P was pricing a recession as a near certainty. Now, the equity-implied odds are just one in four. The charts suggest no financial assets are priced for recession.
That, even as financial conditions have tightened. JPMorgan used an IMF framework which estimates the impact of changes in a half-dozen variables on the level of GDP after one to two years. Those variables: 12-month changes in the three-month short rate, IG credit yields, HY versus IG spreads, 12-month inflation-adjusted equity returns, the change in the real FX rate and bank lending standards for businesses.
As the figure on the left shows, the tightening impulse has receded, but it hasn’t abated entirely. JPMorgan was keen to note that the IMF’s analysis suggested FCI tightening takes between one and two years to “be fully felt.”
The read-through: Last year’s tightening isn’t even fully in the economy yet, let alone this year’s. The impact could be felt “well into 2024,” JPMorgan cautioned, adding that the SVB crisis suggested we’ve “already reached a point where the impact from the Fed’s cumulative tightening could be felt more strongly.”
In addition, the bank called the resumption of a positive stock-bond return correlation “an additional headwind.”
“The past two years’ shift in bond-equity correlation to positive territory has been posing a significant challenge for multi-asset investors, in particular risk parity strategies and multi-asset funds,” Kolanovic and co. said. “This is perhaps one reason risk parity funds have failed to re-lever on a sustained basis.”
