Super Bowl Sunday has arrived, and here in Philadelphia—the land of the Eagles—excitement is boiling over. But there is another matchup that is playing out every day in financial markets: The battle between Team Soft Landing and Team Hard Landing. Too trite? Not by a long field goal. As last week’s volatile price action showed, interest rates, monetary policy and equity valuations are being sucked into the rivalry. Unlike the Super Bowl, the outcome won’t be clear after just one game. We look at how to navigate the coming year as these two teams battle for the economic cycle.
There are an infinite number of possible paths the economy, policy and markets can take. The consensus around the trajectory of growth in 2023 is coalescing around two narratives. Some think we are in for a recession—or a hard landing. Others think the Fed will successfully navigate a soft landing, where growth slows but does not face a prolonged or broad contraction. To be clear, we are rooting for team soft landing—a recession is a bad outcome for everyone. But helping investors navigate a lackluster economy and expensive valuations during a Fed tightening cycle is our ultimate definition of victory. Let’s meet the teams—our two base cases.
Out of the tunnel is Team Soft Landing.
Team soft landing endured a deep slump throughout much of 2022, as a sluggish economy and historic rate hike campaign weighed on its prospects. But suddenly, this underdog has made a resurgence and presents a formidable foe for Team Hard Landing. Like a quarterback putting an injury-riddled team on his back, the labor market has kept hopes of a soft landing alive, despite myriad challenges. Employment remains the most robust aspect of the U.S. economy, with the jobless rate hitting a new 50-year low of 3.4% and more than 500,000 new jobs added in January, a one-year high.
Team Soft Landing’s prospects have always been reliant upon its star player not burning out. The stellar labor market drove wage growth to around 6% in early 2022, far beyond what the Federal Reserve would condone in relation to its 2% inflation target. Some progress has been made on this front, as wage growth has decelerated to 4.4%, and the inflation data has shown signs of improvement. Together, these developments have reintroduced Team Soft Landing as a real threat to win the trophy. The questions now for investors are: What would an economic soft landing entail? Are the odds on offer from the bookie (the market) fair?
A soft landing scenario would generally entail the Fed achieving some combination of demand softening and labor market resilience. It is difficult to pinpoint exactly what this would look like, but our working assumption is it would include below-trend real GDP growth—somewhere around 1% this year—and a modest rise in the unemployment rate to 4-4.5%. This is by no means a Goldilocks economic scenario—the Fed is, after all, specifically aiming to stunt demand—but it would represent remarkable resilience in the face of a massive cost of money shock. In this case, we see an extended Fed pause as more likely than interest rate cuts; if Team Hard Landing has watched any film, it would know the last time Team Soft Landing won (in the mid-1990s), the Fed held rates steady for almost three years.
Clearly, a Team Soft Landing win does not suggest fixed income is due for significant positive mean reversion; indeed, it is challenging to see long-term rates going meaningfully lower, and the latest employment report illustrates the upside risk of an uncooperative macro data point for yields. Equities are certainly fans of this squad, but it feels more like they are rooting against Team Hard Landing than for anyone. A soft landing still implies a significant deceleration in nominal GDP growth (read: corporate revenue growth), which has historically been negative for margins. Current consensus estimates imply S&P 500 EPS growth of 0% in 2023, and we see that as a fair assumption should a soft landing occur.
This brings us to our final point: The bookie has moved the lines in favor of Team Soft Landing, and quickly. The new year rally in stocks has sent the S&P 500 forward price-to-earnings (P/E) ratio to 18.5, the highest since April 2022 and a 78th percentile reading over the past decade. If you’re placing a bet on this team today, the payout may be disappointing—expensive starting valuations and uninspiring earnings are not generally a recipe for success. While U.S. equities will prefer this to a recessionary scenario, we believe the return outlook still calls for investors to reach for alternatives and assets with more reasonable valuations outside the U.S.
S&P 500 valuations are well above average
Source: Bloomberg Finance, L.P., as of February 7, 2023.
Introducing Team Hard Landing.
This team seemed invincible for much of 2022, with the question of when, not if, this outcome would dominate, quarterbacked by higher interest rates and the aggressive Fed rate hike cycle. Team Hard Landing, after all, has brought an end to expansions in six of the last seven rate hike cycles, with a broad and prolonged economic contraction starting about two to four quarters after the Fed’s last rate hike. Given that we expect the Fed to keep hiking into the second quarter, we still think there is a high probability that Team Hard Landing will appear late in Q4, in line with the historical pattern.
Team Hard Landing seems to have support from the bond market, where the three-month to 10-year yield spread is negative and the yield curve remains deeply inverted. Historically, this reliably predicts recession, but says little about how severe an economic contraction is. Should Team Hard Landing emerge victorious late in 2023, we expect a recession to likely be relatively mild. The current expansion has been short, and financial excesses that could make a recession worse have not had time to build. While high interest rates create cyclical headwinds in interest-rate sensitive sectors—the housing market has clearly been sacked—there are medium-term tailwinds that point to resilience. Housing remains chronically undersupplied, and demographics point to robust demand. In autos, demand has remained solid, as inventory was hampered during the pandemic. Finally, while any hard landing includes job losses—the hallmark of recession—companies may view labor as a scarcity and be more reticent to fire than in prior business cycles. In our hard landing scenario, the unemployment rate rises to 6%, a relatively mild outcome compared to prior downturns.
For financial markets, much will hinge on the Fed’s policy response to a hard landing. Our expectation is the Fed raises rates to 5% before pausing in the second quarter. Should signs of a recession materialize—job losses are the biggest red flag of a recession—the Fed is more likely to cut rates more cautiously in this cycle. We are coming off the highest inflation in 40 years, arguably worsened by the Fed’s one-two punch of zero interest rates and quantitative easing. Our hard landing scenario includes 200–250 basis points (bps) of rate cuts spread over two quarters, with the timing of late 2023 or early 2024.
A Team Hard Landing win is a tough pill to swallow for markets, as well as the economy. In a mild recession, earnings could fall -15% (the low end of the historical contraction in earnings). Equity prices typically bottom before earnings, so in this hard landing scenario, the start of a new bull market could begin to materialize in the second half of this year.
Replay of last week’s action.
Last week perfectly encapsulated the head-spinning nature of this Soft Landing vs. Hard Landing matchup. On Wednesday, the FOMC increased its policy rate by 25 bps (as expected), but references to the “disinflationary process” being underway and an emphasis on data dependency in Fed Chair Powell’s press conference read as dovish and sent 10-year yields down 9 bps to a five-month low of 3.33%. Just two days later, the blockbuster jobs report more than reversed that move (and then some). Like a kick returner in the open field, investors must keep their head on a swivel, as narrative-shifting data can seemingly come from anywhere in today’s market.
10-year U.S. Treasury yield
Source: Bloomberg Finance, L.P., as of February 7, 2023.
The best part is the commercials.
Fans watching the big game often root for one team or the other, with varying degrees of passion, but the next day the talk around the water cooler is often the commercials. The commercials are for everyone. That’s why Anheuser Busch will top the ad spending list with almost $42 million dollars in three minutes of commercial time during the big game. The commercials don’t pick sides. Investors are caught in the Soft Landing vs. Hard Landing matchup, a contest that is far from decided, and is causing volatility in traditional assets to remain heightened. The reality is the trajectory of the economy plays out over quarters, not days or weeks. Alternatives may play a critical role for investors seeking to navigate either economic outcome of the coming year, and potentially stabilize portfolios while this rivalry plays out.
Up next…CPI
The next big moment in this knock-down, drag-out battle will come next Tuesday as the January CPI release will provide the latest on the direction of inflation. While inflation gliding gracefully back into its neat 2% box has become near-consensus, we think Q1 data could challenge that narrative as durable goods deflation reverses and services inflation remains hot. Markets remain highly sensitive to incoming economic data, especially around prices and the labor market; although we will know next week who has come out on top between the Chiefs and the Eagles, the outcome of the battle in financial markets will continue to be waged.
