Markets have been remarkably well behaved since Easter, as most markets are up by 1-2% across the board with very little volatility. This is despite weak manufacturing data, and in recent weeks, many commentators (including the fund managers we talk to) have increased the probability of a hard recession. The US consumer remains very strong, and sticky services sector inflation is putting upwards pressure on short-term rates, (the market is now discounting another 0.5% rise in US cash rates over the next few months). This might seem inconsistent, but if we look just a little further out on the bond yield curve, bond markets at least are is forecasting trouble, implying that US rates will start declining rapidly at the end of this year. This is actually not a bad environment for equities, as earnings have been quite resilient so far in the early stages of the US reporting season, with CEOs talking about a potentially weak outlook rather than tangible or immediate declines in demand. The large US banks tend to report first, and the results and guidance seen so far have been pretty solid, which has allayed investor fears around the US banking system in general. Meanwhile, bond market pessimism means that the long-term rates that analysts use to discount future cash-flows are falling (due to a potential recession that equity analysts can’t quite see yet). The following chart, showing the evolution of expected cash rates, tells quite a distinct story, where the Federal Reserve continues to raise rates until they see the whites of the eyes of a recession which materialises in the second half of the year. Meanwhile, this implies that the RBA manages to avoid raising rates again in Australia, with a global recession arriving just in time to head off mounting inflationary pressures. So, in summary, the probability of a soft landing seems to have increased last week, and the market is hoping that the inflationary setback being endured by the UK is very specific to that economy.

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It also helped that China’s GDP has surprised on the upside this week. There is some debate as to whether these numbers are consistent with the data that China’s trade partners are reporting, but regardless Australia’s iron ore stocks seemed to like the story, which helped to make Australia one of the better performing markets. The local banks were also up a percent or so, but most other Australian stocks were either flat or down. So far this year, there has been little sign of any Australian goods exporters benefitting from the apparently very strong Chinese consumer. The best performer over the last week or so has been Japan, where the commodity trading stocks that Warren Buffet owns have led the market higher, but the strength in the market has been notable across pretty much all sectors and stocks.    

Adding to the lighter tone in markets, the gold price fell back slightly, and credit spreads narrowed, indicating that corporate bond markets are also starting to discount a softer recession. This feels like a bit of a slack tide in the economic cycle, and it is uncertain that this reporting season will provide any impetus either way – it might be a while before we find out whether the dour outlook of government bond markets is justified, or whether the sanguine stance of the equity market still has merit.

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