Stairway to Heaven or Highway to Hell

 While peakflation nears, the market debate now moves to the pace of inflation deceleration and how the impending recession will shape Fed policy. We demonstrate that disinflation is imminent, in one way (soft-landing) or another (recession). Our study of past cycles since 1950s shows recessions are powerful disinflation agents and produce the largest dividends. US core inflation slides by roughly 1.5% pts from its cyclical peak in 12-15 months. However, we argue this time price stickiness will make the disinflationary path non-linear.

 Complacency is driving markets in the hope of a mild recession, led by stronger US private sector balance-sheets this time around. However, policy-led growth sacrifice can be just as large with excess inflation as with excess debt. Thus Fed’s navigation will only get more painful ahead. The current template for growth-inflation trade-offs resembles more of the 1970s/80s, than those of the past 30 years that informs some baselines. However, with core inflation half as that of 70s/80s, the output sacrifice ratios may be lesser vs 70s/80s. We see the impending recession around the average length.

 Our analysis of 9 distinct US peakflation cycles (of which 7 overlapped with recessions) since the 1950s shows that equities tend to fall in the run up to inflation peaks and rally in the months after the peak (up 10% in 12M, albeit with enough variance). But watch out for false signals, as starting macro conditions matter, making peakflation probably more of a necessary than sufficient condition.

 We do not believe that either the equity drawdown or valuations have reached levels consistent with the type of potential recession, implying that risk assets are yet to see their cyclical lows. Ironically, while 2023 will probably deliver a recession, it may also provide broadly positive returns across risk-asset classes, as 2022 will have front-loaded most of the recession risk into valuations.

 For India, peakflation cycles since 2000 shows that equities have generally recovered well. In the six US recessions since the 1980s, India has almost always followed suit both directionally and quantum-wise. We remain defensive in our sector allocations and prefer Banks and Autos, while being UW on IT and O&G. The pressure on the INR may sustain, but CY23 may augur well for the rupee. We are mildly positive on bonds and see 10Y yield easing to 7.00% by FY23-end.

Peakflation nears, while disinflation is imminent.

Soft-landing or another (recession) The markets appear to be at strange crossroads as peakflation nears, dreading sticky highflation while also being plagued by recession fears. Supply-side pressures (even as they ease) still threaten to unmoor inflation anchors, while growth pressures stem from a squeeze in household purchasing power and confidence amid food and energy shocks. Global growth engines are sputtering and recession risk is becoming large enough to meaningfully influence the inflation debate, exacerbated by aggressive ratehiking cycles. We contend that recessions are reliable disinflation agents, producing the largest dividends when accelerating inflation is a major cause of the downturn. The recent declines in commodity prices and market measures of inflation compensation reflect this potential disinflationary dynamic. Our study of the US inflation cycles of the last 60 years has revealed that recessions have almost always been disinflationary events. With the notable exception of Covid, recessions have generated a slide in core inflation of at least 1.5%+-pts from its cyclical peak in 12-15 months.

Fasten your seatbelts and be prepared to board the non-linear disinflationary flight!

While peakflation may have made way for disinflation--led by both supply and demand factors--the debate has moved to the pace of deceleration and how the impending recession will shape Fed policy in the next 6-12 months. Historical precedents show that inflation and recession cycles can overlap. Our analysis suggests that out of the nine US inflation cycles since the 1950s, inflation peaked in five of them while the economy was already in recession. Meanwhile, the period between the recession and the end of the inflation cycle could drag beyond 2.5 years in some cases. We do not rule out some price stickiness ahead despite peaking, as inflationary pressures have expanded beyond commodities to services, rentals and wages, while labor participation remains sub-GFC. In addition, long-run global disinflationary forces such as globalization and demographics are dissipating, making way for geopolitics-led supply-chain splintering and ‘greenflation’ from climate change transition

Fed’s navigation on hard or soft landing to get tougher: bracing for a mild or strong recession? Global central banks are trying to navigate a path with enough tightening to produce a significant disinflationary impulse with the (hope of) the smallest output gap loss. However, massive breaks in Phillips curve relationships make the endgame difficult. Yet, markets are somewhat prepared for a mild recession, reckoning that US household and corporate balance sheets look strong compared with the typical pre-recession deterioration. However, policy-led growth sacrifice can be just as large with excess inflation as with excess debt. The duration and amplitude of the next recession will be determined by how long the Fed needs to maintain restrictive policies to tame inflation. With the Fed funds rate already neutral, one has to expect a swift decline in core PCE this year to near 2% to think the Fed would like to avoid further growth sacrifice. We believe that the current template for growthinflation policy trade-offs resembles more of the recessions of the 1970s and 80s (which also saw meaningful job sacrifices), than those of the past 30 years that informs some baselines. That said, with core inflation running only half as hot as 1970s/80s (10% vs. 4.7%), there isn’t much reason to expect sacrifices to be as large as 40 years ago.

Peakflation vs. Recession: Choppy markets ahead, but could 2023 be in for a good run? Our analysis of 9 distinct US peakflation cycles since the 1950s shows that, on average, equities tend to fall in the run up to inflation peaks and rally in the months after the peak (up 10% in a year, albeit with enough variance). Separately, independent of the inflation noises, post-recession market behavior, on an average, has also been largely positive 12 months from then. But watch out for false signals, as starting conditions matter, making peakflation probably more of a necessary than sufficient condition. Fair valuations and the phase of the economic cycle are equally important. We think it’s overly optimistic to assume that the recession may be on the short side of history simply because of lower leverage, and hence hypothesize that the impending recession may last for an average of 10- 11 months rather than a short 6 months. Thus, we do not believe that either the equity drawdown or valuations have reached levels consistent with the type of potential recession, implying that risk assets are yet to see their cyclical lows. Ironically, while 2023 will probably deliver a recession, it may also provide broadly positive returns across risk-asset classes, as 2022 will have front-loaded most of the recession risk into valuations.

India’s tryst with Peakflation vs. Recession India’s inflation peak is behind us, and while we cannot fully rule out the possibility of a sub-7% print again in Q2, we see a deceleration toward 5.3% in Q4FY23. That said, the uneven risks of geopolitics and the impending pass-through of high input costs prevail. Note that we have not been in the aggressive rate hike camp for India (See, Hikes FOMO: Be careful what you wish for) and have argued for a judicious policy mix. We see the terminal rate not crossing 5.75%. While India’s inflation may reach its peak earlier than the DMs, our analysis of peakflation cycles since 2000 shows that equities have generally delivered modest returns before inflation peaks, and then recovered well with a moderate variance. Interestingly, the PMI has historically risen before inflation peaks, and then fallen. Long-term rates have generally fallen after inflation peaks, while short-term rates have continued to rise. In the six US recessions since the 1980s, India has almost always followed suit both directionally and quantum-wise, except for in 1981. Our equity strategy team remains cautious, while keeping an eye on uncertainty regarding global externalities and dollar liquidity. We remain defensive in our equity recommendations and prefer Banks and Autos and are UW on IT Services and Oil and Gas. We see the pressure on the INR remaining, but CY23 may augur well for the rupee. We are mildly positive on bonds and see 10Y yield easing to 7.00% by FY23-end.