Stocks See Rising Risk Of Recession That Ends Inflation

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by Tyler Durden
Wednesday, Mar 29, 2023 - 01:05 PM

Authored by Simon White, Bloomberg macro strategist,

Investors are more comfortable holding duration, while option markets are pricing in greater left-hand tail-risks, suggesting a prevailing view of rising recession risk and inflation continuing to fall.

When inflation is persistent and elevated, avoiding securities with higher duration is prudent. Up until the end of last year, this is generally what the market was doing, with higher-duration sectors such as tech lagging and low-duration sectors like energy leading.

Since the beginning of this year, this trend has reversed. The only GICS Level 1 sectors that have outperformed the index in 2023 are the three with the highest duration. This does not suggest a market that is particularly fearful about entrenched inflation or price-growth that is about to flare up again.

At the same time, option markets in equities have been pricing in greater downside tail-risks. Far out-of-the-money put skew has risen recently. Also, call skew has fallen. This reflects a market more expectant of downside than upside price surprises, which would be consistent with rising recession risk.

If we are to get a recession, the maximum inversion of the 2s10s yield curve would be consistent with a 35% peak-to-trough fall in the S&P, i.e. another ~18% from here.

The market appears to be leaning towards a mild recession which is enough to put inflation back in its box. This is an optimistic view given the rise of underlying structural drivers in inflation, such as elevated profit margins.

As discussed previously, the Fed may also soon see inflation as less of a problem, and cut rates sooner than the market is expecting, as the economy and markets face further stress.

Ultimately, this would add further fuel to structurally persistent inflation, but in the meantime equities look set to keep pricing inflation as a fading problem.