“That’s Highly Illogical, Captain”

By Michael Every of Rabobank

Perhaps nobody gets original Star Trek memes anymore, and I am showing my age. Then again, it seems nobody gets original logic anymore, and trying to use any also shows one’s age.

The market continues to price for a dream scenario of inflation having peaked then coming down sharply, but not overshooting to the downside; only the very mildest of recessions by any historical standards; a rise in US unemployment to ease wage pressures and supply-side overheating globally, but again the smallest ever seen in a recession; a near-term US rates peak below 5%, despite repeated Fed calls otherwise, then rapid rate cuts; that the US keeps cutting while the rest of the world hikes; and the rest of the world doesn’t cut rates even more than the US despite net exporting to it, and the historical record that when the US sneezes, everyone else catches cold… at a time when China is still catching Covid.

As a conversation yesterday noted, partly this is due to the relatively good news that has come out in 2023 so far against 2022’s ultra-gloomy backdrop and projections. However, as was also stressed, the range of scenarios ahead is truly broad, and yet the market seems to have settled for a happy median that seems the least likely to transpire.

Spock of course knows a thing or two about probability as well as logic:

• What if unemployment is sticky, and so core services inflation is sticky, and so we see a rates pause, but then they have to go up again in H2 2023?

• What if unemployment surges after a lag like it always has done in a US downturn so far, and we get a recession and deflation as the backdrop to those ‘nice’ rate cuts?

• What if supply-side goods inflation picks up again before services inflation cools? After all, China is reopening, and its appetite for commodities may grow again; the Ukraine war is about to enter a new phase, perhaps disrupting agri-commodity flows, as the US and Germany agree to both send tanks – but Germany is only sending 14(!), the kind of deliberate inaction that still risks a longer, grinding war with more destabilising effects; and won’t energy prices rise as the US Strategic Petroleum Reserve is rebuilt, and far more so if energy demand doesn’t fall back because we don’t have a recession?

• What if current market pricing for rate cuts pushes commodity prices higher as the US dollar falls, and as commodities emerge as a geopolitical/inflation hedge?

• What if the Fed actually wants to see lower asset prices and keeps acting until it does, the inverse of the past pattern?

• What if the US stumbles into recession, but others globally outright crumble?

None of this is being answered substantively by markets, where the possibly correct expectations for any one asset class are not being carried over with any kind of internal logic to all others. Then again, they can’t even get the NYSE to work properly now, so why listen to them anyway?

I don’t know how much more often or how much higher I can raise one eyebrow, original Nimoy-Spock style. (On which note, Nimoy wrote two autobiographies: “I am not Spock” in 1975, and “I am Spock” in 1995.) However, it seems I will have to keep practising as the market keeps indulging in highly illogical and improbable thinking. Indeed, let’s recall some classical logic errors evident almost every day in markets:

1. This is true because it has not yet been proven false.

2. This must be true because if it were false that would be horrible.

3. This is true because people say it’s true.

4. That idea is bad because bad people believe it.

5. This is true because that smart person says it’s true.

6. If this is not 100% true, then it must be 100% false.

7. This happened after that, therefore that caused this.

For one example, global yesterday’s PMIs can be seen as backing a stagflationary view of the world, not a happier outcome. That was not how they were dressed up by markets.

For a second example, in New Zealand we see a Bloomberg headline this morning saying, ‘Kiwi Bonds Surge After NZ CPI’. All well, and good. Except that CPI number was 1.4% q-o-q in Q4, down from 2.2%, but higher than the 1.3% expectation; y-o-y inflation was an unchanged 7.2%, a tick higher than expected; tradeable CPI was 1.4% q-o-q vs. just 0.8% expected, despite lower commodity prices in Q4 already being reversed in 2023 as China reopens; and only non-tradeable CPI was 2 ticks weaker than expected at a still staggering 1.5% q-o-q, so 6% annualised, or three times the RBNZ’s CPI target. Yet the tiny Kiwi bond market indeed surged before someone who has watched original Star Trek started to sell. How many of the above logic errors were made in that early trading and pre-release market consensus call?

For third example, Aussie Q4 CPI was far higher than expected, making a mockery of claims that Down Under inflation is over. Instead, we saw q-o-q CPI hit 1.9%, almost a y-o-y figure, and well above 1.6% consensus. The y-o-y rate hit 7.8%, up from 7.3%, and vs. a 7.6% expectation. More worrying, the trimmed mean was 1.7% q-o-q and 6.9% y-o-y, the weighted median was 1.6% q-o-q and 5.8% y-o-y, and December m-o-m CPI was 8.4% y-o-y vs. a 7.7% market call. Worse, this was all before China reopened, before commodity prices started to push higher again, and before yields dipped, breathing new life into local ‘buy the housing dip’ headlines. But don’t worry, Aussie rates will still peak at a low enough level not to harm the housing market,… right? Perhaps, but it’s both highly illogical and improbable, Captain.

If only I could give markets the Vulcan nerve pinch – but more Aussie data like today will do the job for me, I think.