No landing is good news, but mind the volatility

Anchors away

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You'd think signs that the US economy has once again defied recession worries would be a good thing. And it is. But it comes with a side dose of market volatility. That's because, as the former CEO of bond giant Pimco Mohamed El-Erian puts it, "this market lacks anchors when it comes to how it sees the interest rates." If you can look past the bond volatility, which may ramp up further as soon as Thursday, the outlook still remains bright overall because of stocks, though less so for bonds. Let's dive into that outlook covering the following points: What was a debate about a coming soft landing versus a recession has become one about no landing or a soft landing. That's great for stocks because it's good for earnings. But it isn't good for bonds. Still, as we await corporate earnings, companies haven't been warning about bad things. So that's good for market momentum. For bonds, though, the question is now about downside risk from potential economic overheating.

Scenario planning and probabilities

If there's anything we've learned from the pandemic and the period afterwards, it's that people's wants and desires, their living situation and their way of life are all still in transition. Even today, we still don't know what the new normal looks like. And that has wrong-footed all of us time and again in making predictions about the economy and preparing for the future. I like the way El-Erian put it in the video attached to this article. He's saying that with all the structural changes afoot, we have to think in terms of potential scenarios and assign probabilities to their likelihood. He also says the uncertainty means policymakers have to take out more insurance to prevent adverse outcomes because our predictive powers are now weaker. It's a bit like the hurricanes we have witnessed these past few weeks. Now that we know these storms can be so powerful and unpredictable, we simply have to take more precautions. The good thing is that, unlike in Europe or China, the structural changes the US is facing after the pandemic are mostly pro-growth. And that means the repeated recession scares since the Fed started its rate-hike campaign more than two years ago can increasingly be underweighted as likely outcomes. The bad thing is that this means there is a greater chance of scenarios unfolding where the economy overheats and inflation and interest rates remain elevated. Did the Fed just make a mistake? With that lead-in as the baseline, the Fed's recent outsized, half-point rate cut is starting to look like a mistake. Last week, for example, I pointed to the following chart: It shows you an economy that has been surprising to the upside for three months now. When I first posted it on Thursday, it showed upside economic data surprises just a tad more plentiful than downside ones. But now that chart is well into positive territory, a picture of how economists have underestimated the US economy's resilience. The Atlanta Fed's GDPNow tracker even says we could have 3.2% growth for the quarter just ended, higher than in the three months ended in June. Back when the Fed met in July, downside data misses were at their maximum and fears of a recession were rife. Former New York Fed President Bill Dudley even penned a column saying the central bank should go forward with a precautionary rate cut. But the Fed didn't do it. And so the Fed's own fears of falling behind and the knowledge that it had to take out more insurance in these uncertain times led to the half-point reduction in September. Fast forward to today, and the totality of recent data — from payrolls to jobless claims to job openings to production and investment — speaks to a US economy that never needed a jumbo cut. My analysis says the Fed took out its economic insurance too late and was too aggressive in doing so. In short, the Fed is boosting an economy that is already doing well in a world where oil prices have risen and core consumer price inflation remains above 3%. That's a recipe for potential economic overheating.

By the numbers 3.2% The forecast rise in consumer prices in the US excluding food and energy for September, well over the headline CPI rate of 2.5%, showing services inflation remains sticky.

Watch the coming inflation reports

The tail risk, a concept I described two weeks ago as something investors fear, is less about recession, the so-called left tail, and now more overheating, the right tail. But where the fear of a recession is immediate and palpable, it takes time for people to distinguish a normal economy after a soft landing from one that is overheating and fueling price pressures. Therefore, we now need to watch inflation reports for our early warning signal of right-tail overheating risk. The next one happens to be on Thursday, with core consumer price inflation expected to have held steady at 3.2% in September. Anything higher won't necessarily dent stocks, still living in a soft-landing nirvana. But bonds won't like it one bit. That anchor that El-Erian was talking about used to be around 4% for longer-dated US Treasury securities. That was a sort of ceiling for yields because the Fed has promised to reduce interest rates as inflation slowed to prevent conditions from becoming more restrictive. Their narrative has been that holding policy rates steady as inflation slows only increases "real" interest rates. But if inflation stops coming down or reverses course, that's no longer true. And there's a very real possibility they stop cutting until it is true. Suddenly, 4% yields don't look like a ceiling. They become a floor. And the CPI print we get Thursday will be our first look at this conundrum. Expect volatility. Stocks can rally off earnings At the end of the day, losses in bonds are contained. It's not like the Fed is going to raise rates. They just might bring them down more gradually. So there is a floor to price losses Treasuries can suffer as yields go higher. We just don't have an anchor telling us where that floor is. Stocks usually sell off in sympathy when bond yields spike. But that's only an initial reaction. As long as the worry isn't recession, bonds and stocks will move in opposite directions. With the left-tail recession risk diminished, that's what we should expect going forward. And the earnings season kicking off right now will be a big test there. The big banks are the first out of the gate starting on Friday. And their numbers will tell us a little about credit growth. But it's the smaller banks we need to watch, because they have more exposure to small businesses that have lagged as the economy has recovered from the pandemic. Next week, Big Tech earnings will start. That's where we can expect to see stocks react the most. But the fact that none of the big banks or Big Tech firms have issued warnings tells you we shouldn't expect a lot of downside. I'm expecting results to be good. And then the question is how much of the earnings forecasts we get is baked into stock prices already. The better the forecasts, the bigger chance of a rally. So overall, I'm still pretty upbeat about the US economy, and, therefore, US-based stocks. Bonds will probably take a hit due to increased volatility and worries about inflation. But if you look beyond the volatility, the outlook is pretty good.

Things on my radar

Private Equity is in a bit of a funk because rates remain high. Still things aren't falling apart because the economy is fine. One reason not to be alarmed there is big banks are ready to support leveraged buyout deals. On that, see this article here. My colleagues Mike and Ye recently wrote a good piece on the so-called 'no landing' scenario. Read it here. Fiscal is a big part of this. But as for the tax-cuts-pay-for-themselves mantra, it's a fairy tale.

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