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Someone has to say it, and it might as well be me. Markets have a distinct 'Goldilocks' feel about them at the moment, or in the words of the FT’s editors; markets are beginning to eye the “immaculate disinflation,” which is a prerequisite for a soft landing.

This is a story about two trends; easing inflation and economies which are, well, neither too hot nor too cold. Soft US and UK inflation reports for the month of June have been key catalysts for the change in mood. Headline CPI inflation in the US fell to a two-year low of 3.0%, with core inflation dropping by 0.5pp, to 4.8%, a 20-month low. In the UK, meanwhile, headline inflation slipped to 7.9%, from 8.7% in May, while core inflation dipped by 0.2pp, to 6.9%.

These numbers don’t exactly scream Goldilocks, but markets trade at the margin of the economic data; it is the direction of travel that matters. Moreover, and more importantly at this point, the June inflation data were downside surprises after a string of upside surprises through most of 2023. The reaction to the UK inflation data was particularly pronounced, one of relief even, despite the fact that the headline and core both remain uncomfortably high for the Bank of England. The shift is clear as rain.

The first chart below shows that headline inflation in the US, UK, and Euroarea has more than halved since peaking just under 10% last year, and core inflation—which has been keeping central banks on their toes—is finally breaking lower, too. The second chart adds to the positive vibes. It plots two composite indices of price pressures in manufacturing and services—survey-based and the Chinese PPI in manufacturing—which are both rolling over.

The fever has broken.

Clear evidence of further disinflation rests in the surveys.

The economic backdrop to this downshift in inflation pressures remain lukewarm, which is exactly what markets like to see. In fact, coincident and leading indicators suggest that downside risks to global economic growth have faded in the past six months, even as inflation has cooled.

The global composite PMI has rebounded to well above 50, from a nadir of around 48 in the fourth quarter of last year, and growth in the CBP’s global industrial production and trade indices have improved too, at the start of the second quarter.

The chart below plots my diffusion index of leading indicators, which captures the net number of indices—using the OECD’s amplitude adjusted data—that are rising from a position above or below their long run-average. This index has clearly rebounded in the past six months.

Downside economic risks have faded.

Granted, this shift is barely noticeably in any of the major economies, except via the absence of the downturns that many economists were expecting at the end of last year. In Europe, the UK and Eurozone economies have stalled, but a severe downturn has so far been avoided, and labor markets remain resilient. Similarly in the US, recession calls have so far had to be postponed. Employment growth—which is key for Fed and market sentiment on the economy—has slowed, but it is still robust overall.

The Chinese post-lockdown recovery has been disappointingly weak, but at this point I am inclined to argue that this is a net positive for markets who are still more inclined towards buying a decline in inflation rather than selling a short-fall in economic growth. In the case of the former, China is serving up exactly the right medicine for markets.

China is cooling, which is not a bad thing for the global economy.

Almost by definition, a market rally propelled by Goldilocks sentiment and conditions is an unstable equilibrium. Either growth breaks lower, forcing markets to shift their focus to recession economics and price action, or inflation risks re-emerge, forcing central banks to re-tighten the monetary policy vice.

I wouldn’t want to bet against either of these outcomes at this point, which is perhaps why the net outcome is what we’re currently seeing on our screens; a market locked between inflation-curbing downside risks to growth, and nominal-growth boosting upside risks to inflation. I think this can go on for longer than many expect.

In the economy, the next key milestone will be when and where inflation stabilizes. As I have discussed in recent posts, the pace at which inflation levels out—which should happen in the first half of 2024—is a key swing factor for the policy mix next year, and probably in 2025, too.

If inflation levels out at a pace more or less consistent with central banks’ target, without recessions, we have achieved a soft landing. If it doesn’t, and I fear that it may not given now structurally looser fiscal policy, we are in an altogether more difficult situation.

I mean, who’s responsibility is it really to keep inflation at 2% if the economy doesn’t get there by itself? The answer to this question may not be as straightforward as we’re told by the textbooks and institutional separation between governments and “independent” central banks.

In markets, meanwhile, the first key milestone will be whether the string of downside surprises in DM inflation, and so far resilient economies, will be enough to push equities to new highs. We’re almost there.

Finally in bonds, curves should steepen, but we should keep a close eye on the mix between bull-steepening—falling front-end yields as the monetary policy vice loosens—and bear-steepening—rising long-term bond yields—as markets adjust to higher inflation for longer, which ultimately also means higher policy rates for longer.

In the meantime, investors will enjoy the price action in equities and bonds in the same way as I am currently enjoying the British summer; neither too hot, nor too cold.

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