Macro Pulse: Shifting Risks; Not Yet Shifting Reality

Uncertainty’s grip on markets

There are two important things to note from this year’s selloff. First: contrary to most major market moves, this selloff isn’t driven by a disruption to the fundamentals, such as economic growth or earnings. Instead, it’s uncertainty itself driving the leg down.

Second, not all elements of the market are participating equally. Equity markets have borne the brunt of volatility, while credit spreads have seen relatively smaller moves. This makes sense to us. Uncertainty may drive changes in businesses’ hiring and capital expenditure plans; it reduces growth upside. However, a slower-but-still-growing economy shouldn’t impact companies’ ability to pay back debt, especially with cash management improvements among public issuers since COVID-19.

Looking ahead: what calms the market from here? 

After a strong downward mood, any good news (stability, or lack of “bad news”) from policymakers or the data can create a bounce. But for markets to really stabilize, we believe the markets need clarity from policymakers:

• Tranquility from Trump: Trump’s White House has never faced the political test of a bear market – even during the pandemic, when we saw a steep but short-lived selloff. President Trump could provide several sources of comfort to investors: rolling back tariffs on Canada, Mexico, and Europe; announcing rollbacks in regulation that spark animal spirits around M&A; or cementing the extension of the Tax Cuts and Jobs Act.

• The Fed puts its “put” back: Eyes have naturally moved to next week’s Fed meeting, but more broadly, a return to dovish messaging from the Fed could do wonders to support equity price action if warranted. We could see this in the form of greater signaled cuts: consensus now expects up to three 25bp cuts this year, brought on by the shifting balance of risks to growth. The Fed could also support sentiment by accelerating the end of Quantitative Tightening, removing the current balance sheet drag.

Neither of these shifts looks likely in the near term. So, should investors be prepared for things to get worse?

We’ve often written that the durability of U.S. economic growth today – driven largely by high-income consumers – is more at risk when the market pulls back. High-income consumers have been powered by 1) strong equity price appreciation, 2) renewed investment income, and 3) record levels of home equity. If equities were to see a 20% drawdown from highs – a bit over 10% from here – this could create a major hit to consumer confidence, and therefore to consumer activity, and therefore to business profits, and therefore to economic growth.

We believe a 20% selloff threshold clears the bar for policymakers to change tact and could prompt a rollback of tariffs and more dovish messaging from the Fed. Accordingly, a 20% selloff doesn’t necessarily represent a descent into recession; it could be a buying opportunity if policy steps in to assuage investors.

What do changes in policy and market pricing mean for key macro factors?

Growth: Investors are lowering growth forecasts and raising inflation projections for 2025. This aligns with our base case of gradual economic deceleration, which factored in Trump's policy agenda, including slower growth and higher inflation. But forecasts—and market expectations for Fed policy—will remain highly volatile given the range of possible outcomes. Recession is still not our base case this year; the likelihood has risen from 5% to 15% in our view. But a stagflation-lite scenario, including slower growth and still-sticky inflation, is increasingly likely. See allocation approaches below.

Inflation: After making significant progress, the underlying inflation impulse has stabilized (i.e. no further disinflation is visible). Key to our view that inflation will remain “sticky” is that disinflation in shelter appears to be ending; downward momentum in new tenant rents, a leading indicator of shelter prices, has halted.

Then we have tariffs. We’re not buyers of the view that tariffs represent only a one-time increase in prices.  Our view is that price levels are already very high and are impacting consumer behavior, making further upward pressure particularly detrimental to consumers and therefore drag on growth. Again – expect a stagflation-lite scenario.

Fed policy: Sticky inflation means that the growth outlook must deteriorate considerably for the Fed to get more dovish. The Fed will likely hold in March.

Tightening financial conditions – including deteriorating equity and bond market valuations – can influence the Fed’s growth outlook. But we expect the bar for the Fed to respond to market activity is not yet passed. 2018 gives us a reasonable comparison here – it took 20% equity market downside before the Fed paused rate hikes.

The 10-year Treasury yield: Absent recession, we believe the 10-year will remain rangebound and volatile between 4.0% - 5.0%.

The 10-year yield moves when (1) 10-year inflation expectations move, (2) long term growth expectations move, or (3) investors’ risk tolerance changes. Right now, it is the latter item contributing the most to downward pressure on the 10-year – investors are concerned about risk. We therefore anticipate that volatility within the 4.0% - 5.0% range is “live.”