With next week’s US CPI print and FOMC meeting offering the potential for further market volatility, it feels like these landmines are a fitting end to an incredibly eventful 2022.
We look back at the big themes that have driven cross-asset volatility and the conditions through which we’ve all had to adapt our trading. These include persistently high inflation, a worrying spike in the cost of living, and aggressive rate hikes, yet we saw resilient growth.
We can also look at more regional-focused issues. A UK gilt tantrum driven by the Truss govt’s unfunded mini-budget, the invasion of Ukraine, the MOF/BoJ intervening to buy JPY, and China’s COVID Zero policy.
The culmination of these factors created huge cross-asset volatility, decade-long market regime changes, and lasting trending conditions.
Looking into 2023
Markets live in the future, and we look forward to the key themes that could cause volatility throughout 2023. What’s important is not just to fully note these macro factors but to understand the trigger points that offer a higher conviction of when to express the themes – taking this further, knowing the markets/instruments and strategies to express the theme is obviously advantageous.
These themes could alter market volatility, range expansion, and market structure - so regardless of whether you’re purely automated or discretionary, it can pay to be aware. While there are many more, these are five potential themes that I am looking at closely for 2023 that, if triggered, would affect the markets we trade.
1. High inflation worries morph into growth concerns and a higher probability of a recession
US and global inflation in decline
- Market pricing (i.e., the inflation ‘fixings’ market) of future inflation shows US CPI inflation is expected to fall to around 3% by year-end.
- US M2 money supply has fallen from 26% to 1.3% - US headline CPI typically lags by 16 months.
- Manufacturing PMI delivery-lead times and supply chain data suggest inflation falls hard in 2023.
- Unit labor costs falling to 2.1%.
Growth: While the consensus from economists is that the US economy narrowly avoids a recession, and EPS expectations have not been revised down to reflect recessionary conditions - the markets see a higher probability of this outcome – I back the markets, where we see:
- All parts of the US yield curve are inverted – US 10-2 are the most inverted since 1981.
- The US leading index (which measures ten key economic indicators) has turned negative and falling fast – this has an exemplary record of predicting US recessions.
- Comments from the CEOs of Goldman Sachs and BoA warning of more challenging times ahead.
Themes to trade as we price in a recession
- Consensus EPS expectations are cut by around 20% (from the highs), lifting PE multiples – traders will assess the trade-off between earnings downgrades vs. a lower discount rate.
- Steeper yield curves are a trigger – while now is not the time to put on curve steepeners when short-dated US Treasury bond yields do fall/outperform, we’ll see a steeper yield curve – this could be the trigger for a sharp equity rally, led by financials.
- As the US data deteriorates, we will likely see equity market drawdown, US treasury buying, and selling of risk FX - it’s when central bankers acknowledge that growth is a greater concern the market will feel validated in its pricing of rate cuts – it’s here we see a risk rebound, broad USD selling, and housing + lumber outperforming.
- As bond yields fall, we should see solid outperformance from the JPY, CHF, and EM assets.
- USD initially works selectively vs. global FX but then reverses as conviction of the Fed cutting impacts and traders look ahead to a trough in the global growth slowdown.
- Gold and silver rally hard as a hedge vs. recession risk.
2. Central bank policy – assessing the potential for rate cuts
- The base case is rate hikes finish in Q1 23, followed by a pause – we then explore the possibility of rate cuts through Q4 23 – the Fed is clearly data dependent, so trends in the US (and global) data through Q2 will be key to markets.
- Since 1995 there have been five occasions when the Fed has moved from hikes to rate cuts – the average time it takes to play out is 10.6 months (the longest period being 18 months, the shortest being five months).
- G7 balance sheet reduction and liquidity drain - Quantitative Tightening (QT) is a big unknown. Federal Reserve liabilities are expected to fall towards $2.5t, a level where the market is concerned about the scarcity of reserves – traders will start to pay attention to the Fed funds effective – interest earned on excess reserves (IOER) spread for signs of scarcity and concerns that the repo market may be impacted and need support.
- It’s not just the Fed; the ECB and BoE (and others) will reduce their balance sheets.
3. China reopening and China's market outperformance
- We’ve already seen a plethora of measures announced, and Chinese markets have rallied hard – China is the elephant in the room when it comes to the global growth outlook for 2023 – a weak 1H23 seems likely, but this will then be followed by far stronger growth in 2H23 – after a poor 2022, Chinese assets could outperform in 2023.
- Long Hang Seng / short Nasdaq 100 could be a trade to look at if markets de-risk on a higher probability of a US recession
4. BoJ policy recalibration – time for the JPY to fly
- BoJ chief Kuroda steps down in April, but there are plans for a review of BoJ policy – it is inevitable that we’ll see a 25bp lift to the BoJ’s YCC target to 50bp.
- We’ve already seen signs that Japanese banks/pension funds are moving capital back to Japan to get a more compelling return in the JGB market – but could a major policy change cause tremors in global bond markets and promote significant inflows into the JPY?
5 - Politics & Geopolitics – great for volatility, bad for humanity
- Obviously one of the most important issues in 2022, not just for markets but humanity - always a hard one for traders to price risk around
- China/Taiwan – unlikely to be a 2023 story (hopefully not at all) but one that will come into the headlines periodically
- US and European/China relations
- Russia/Ukraine – could we hear more constructive signs of a ceasefire?
- Russia vs. NATO – Putin has already suggested that the risk of nuclear war rises if this escalates. It could dominate markets.
- Given the divided Congress, could the US debt ceiling become a market concern?