Peak fear?

With the exception of 2008, I don’t recall as grim a mood among the policymakers and investors attending the IMF Annual Meetings in Washington, DC, as last week.

The town felt like an echo chamber of concerns about nukes, geopolitical fractures, lack of policy coordination, recession, sticky inflation, monetary and fiscal policy miscalibration, and evaporating market liquidity. Here are my main takeaways, plus a few thoughts on why the consensus may now have become too bearish.

Regarding the growth outlook, there was a widely shared sentiment that “the worst is yet to come,” as IMF chief economist Pierre-Olivier Gourinchas succinctly put it at the meetings.

A mild recession in the United States, a deeper recession in Europe, and a growth recession in China now appears to be almost everybody’s base case. There was also broad agreement on the recession drivers: the war in Ukraine and the sanctions in response, the war on stubbornly high inflation by most central banks, and the war on COVID-19 in China. Moreover, most attendees believe that the risks to this dire outlook are skewed to the downside. Fears of a (nuclear) escalation of the war in Ukraine were palpable, as were worries about an intensification of the trade and technological tensions between the U.S. and China.

Also, concerns that inflation would be even more sticky and central banks would be forced to overtighten surfaced in virtually every meeting.

Europe viewed as most at risk

Negative sentiment on Europe was widespread, given the proximity to the war in Ukraine, the potential for bond market fragmentation as the European Central Bank (ECB) tightens, and worries that LDI (liability-driven investing) pension fund issues as in the U.K. might surface on the continent as well. In addition, many view Germany’s economic model as broken given the country’s past reliance on China for exports, on Russia for energy, and on the United States for security.

Likewise, the mood on emerging markets (EM) was fairly dark, despite the relative resilience that the asset class has shown so far.

While many EM central banks are further advanced in the tightening cycle than their developed market (DM) counterparts and the commodity producers within EM have seen big terms of trade gains, there was much hand-wringing by policymakers and investors about the global backdrop of a surging U.S. dollar, sharply rising rates, and sinking growth in the advanced economies and China.

Going into the IMF meetings, some had hoped for progress towards a coordinated response by central banks to stop or even reverse the continued rise of the U.S. dollar, but Federal Reserve officials made it pretty clear this is not in the offing and that the fight against inflation takes precedence.

Against the dim macro backdrop of looming recessions, sticky inflation, and aggressive central bank tightening, the view among attendees on risk assets was broadly bearish. Reflecting a broad sentiment, at the J.P. Morgan Investor Seminar the bank’s CEO Jamie Dimon told the audience: “You haven’t panicked yet. You are going to.”

Unsurprisingly, conversations about potential areas of “breakage” in the markets were ubiquitous. However, there was no clear consensus on where this was most likely to occur next, given the LDI issues in the U.K. had surprised most observers.

While I share many of these concerns, the contrarian in me came away from the meetings thinking that the consensus may now have become too bearish and that we may be at or close to “peak fear” in the markets, for three reasons.

U.K. lessons and U.S. midterms

It is now widely accepted that central banks need help from fiscal policy to bring down inflation sustainably, and this help may now be forthcoming. One reason is that the U.S. midterm elections in November look likely to produce a divided Congress, which would imply gridlock and no further fiscal easing in the next several years.

Another reason is the lesson that many governments are likely to draw from having seen the bond and currency markets react to the U.K. government’s announcement of large unfunded fiscal stimulus, which has now been largely reversed in response to market pressures.

Fiscal-driven inflation now looks less likely, which should help central banks do their job and keep longer-term inflation expectations anchored.

Calmer bond markets ahead?

Last but not least, rates markets could potentially enter a calmer period following the sharp sell-off in the course of this year and the wild gyrations in response to the U.K. fiscal announcements.

Markets already price in significant further rate hikes by the major central banks, and absolute yield levels appear much more attractive than they have for a long time, including the real yield on U.S. Treasury Inflation-Protected Securities (TIPS).

If bond yields stabilize at these higher levels rather than rising further, this could also help risk assets such as equities recover some of the year-to-date losses and help make highquality segments of the credit markets more attractive again.