What a soft landing looks like

Has the Fed managed to achieve a soft landing? If so, Jerome Powell will go down in Federal Reserve history as a legend, and one of the greatest Fed Chairs who occupied that position.


There is some cause for optimism. The latest flash PMIs show that U.S. and China manufacturing PMI on the rebound, though the eurozone is weak, and U.S. services PMI turning up.


Not only that, the U.S. is outperforming the other major economic blocs since the COVID Crisis.




Winning the inflation fight

Moreover, the Fed and other central banks are winning the inflation fight. Inflation, however it’s measured, is decelerating.



Leading indicators of inflation, such as PMI output prices, are pointing to further deceleration in CPI.


As a consequence, the global monetary cycle is turning. Most global central banks have signaled pauses in rate hikes, including the Fed and ECB, and 31% have begun to cut rates.



China turns to stimulus

Across the Pacific, China is turning to stimulus. After Xi Jinping visited the PBOC for the first time since he took power, Beijing announced that it will RMB 1 trillion in bonds in the fourth quarter “to support the rebuilding of disaster-hit areas”, which is an unusual announcement as China rarely adjusts its budget mid-year. It could be argued that this round of fiscal stimulus is designed to spur economic growth, to offset the negative growth in government spending this year.


These developments should be bullish for the global growth outlook. The U.S. looks strong as Q3 real GDP growth came in at a better-than-expected 4.9%. China is stimulating. While Europe is weak, its export outlook is levered to China.



Investment implications

The appearance of U.S. economic strength and weakness in the rest of the world has resolved in U.S. equity leadership. That’s not surprising as investors bought growth in a growth-starved world. The onset of Chinese stimulus is likely to resolve in better performance in non-U.S. equities.


U.S. megacap growth stock leadership may be starting to stumble. The market reaction to earnings reports in this group have skewed negative. While leadership is poised to rotate away from megacaps, investors should wait for confirmation in the form of a break in the relative trend, which is still range-bound (bottom panel).


Keep an eye on commodities and the cyclically sensitive copper/gold and base/metal gold ratios. A new round of China stimulus would be evident in commodity demand and spark a global cyclical rebound.


An analysis of P/B versus ROE by country reveals that the U.S. market is a major outlier that’s very expensive. As growth returns to China and Europe, ROEs should improve in the other regions and boost the returns in the rest of the world.



Key risks

This bullish scenario of a U.S. soft landing and China stimulus faces a number of key risks.


The main risk of a disorderly unwind in the credit market. Already, Treasury yields have soared, and a Bloomberg article pointed out that the local currency yields of emerging market bonds are now below the 10-year Treasury. The surge in Treasury yields may be attributable to a supply-demand imbalance. Issuance has risen and important buyers have stepped away. The Fed is no longer buying and foreign central bank demand has been flat. This leaves domestic buyers to absorb the new supply. The Quarterly Refunding Announcement of Treasury issuance on November 1 will bring further clarity to this question.


As well, both the U.S. household and corporate sectors face the challenge of tightening credit conditions against a backdrop of rising interest rates. Similar readings have resolved in recessions in the past, which would derail the hopes of a soft landing.


That said, there are few signs of distress in the credit market. The relative performance of high yield to Treasuries is exhibiting a positive divergence against the S&P 500.


Another risk is too strong economic growth which causes further monetary policy tightening. Fed Chair Jerome Powell made that point in a speech to the Economic Club of New York [emphasis added]:

Still, the record suggests that a sustainable return to our 2 percent inflation goal is likely to require a period of below-trend growth and some further softening in labor market conditions…
We are attentive to recent data showing the resilience of economic growth and demand for labor. Additional evidence of persistently above-trend growth, or that tightness in the labor market is no longer easing, could put further progress on inflation at risk and could warrant further tightening of monetary policy.
What does the Fed judge to be “persistently above-trend growth”? Investors should gains some clarity on that question in the post-FOMC meeting press conference.


In conclusion, the U.S. economy appears to be undergoing a soft landing. The global economy may be boosted by a new round of Chinese stimulus. Investors can position for this scenario by rotating away from U.S. megacap growth equities to non-U.S. markets. However, the risk of a credit event and overly strong U.S. growth may derail that bullish scenario. The coming week, which will see the U.S. Treasury Quarterly Refunding Announcement, the FOMC meeting rate decision, and the October Jobs Report could go a long way to resolving those risks.


4 thoughts on “What a soft landing looks like

  1. What I don’t quite understand is the role of the bond markets in determining interest rates / the economy.

    Famously, James Carville said he would like to be reincarnated as the bond market, so as to be able to intimidate everybody. Clinton was highly focussed on creating an economic policy that didn’t have negative bond repercussions, while Trump and Biden weren’t/aren’t — at least not until recently.

    Obviously, bond prices don’t matter much when inflation is low. But once inflation is persistent and giant deficits are baked in, isn’t a Lizz Truss-style fiasco or 1970s stagflation inevitable?

  2. What I don’t see ending is federal deficits. They are a stimulus in that the money goes into the general economy. The trend is up. How can this reverse when there are interest costs, Medicare, SS, Military all of which are likely going higher.
    So if they do yield curve control like Japan did, this may help with interest costs, and help those holding long bonds, but Japan for many years had a surplus balance of trade not a close to 1 trillion a year trade deficit. So if the $ goes down what inflationary impact does that have?
    If we have a recession, we might have a “transient” reduction of inflation, but unless the gov’t stops spending and we get an awful collapse we likely will get stagflation.
    What is a soft landing? Is it no recession, or no market crash? What if we get a crash but no recession?
    Don’t forget reflexivity, if things start to feed on a crash, it just gets worse.
    My guess is that with the election year approaching that history will rhyme. Those in office don’t want to shoot themselves in the foot, they are fine with shooting their successors in the foot, the back, you name it lol, but we should have a time of fiscal largesse until then.
    When companies have to refi their loans in earnest does not start big time for another year or more. When that tsunami hits, we get almost guaranteed an impact.
    History is that currencies get debased…1933 your dollar no longer could be traded in for gold (don’t know when silver got nixed), 1971? Nixon closes the gold window, so we have pure FIAT and as debtors and no longer creditors of 60 years ago, it’s not our money. They will continue to debase it, but since everyone else is, we don’t see it as much.
    I don’t expect hyperinflation, but I expect continued deficits along with continued inflation.
    Why do they want 2% and not 0? Because 2% can paper over gov’t debts as a % of GDP?

    1. Federal Reserve is the banker of last resort. They are bound to step in if there is disorderly activity in the treasury markets, imo.
      Continuing deficits and the impact on economy and inflation is the big known unknown. I tend to think that inflation will persistently stay above 2 percent.
      Economic growth will be slower over time. Companies will adjust to the new normal.

  3. There was a very strong TWIST in the Chinese stock market on Friday. That might kick off the China rally and spread world-wide.

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