Markets have generally made a strong start to the year, continuing the improvement in performance that took hold around mid-October last year.
Despite the better trend, investors still appear skittish as uncertainty oscillates between fears of a too hot (inflation) and too cold (recession) macro backdrop. These bear case scenarios have been interspersed with what appears to be the market’s central case view, “benign disinflation” (the goldilocks scenario) leading to good performance from both equities and bonds so far this year.
US Macro Heading the Right Way despite Lingering Bear Scenarios
As we have previously discussed, growing evidence of a meaningful decline in US inflation has been the key to the better performance from both equities and bonds in recent months, and we continue to see this as the dominant narrative for 2023 notwithstanding likely volatility.
Alongside signs of easing inflationary pressure, the ongoing strength in the US labour market has eased fears of a 2023 recession. However, bears continue to fret about the inflationary (and interest rate) implications of a tight labor market, despite evidence that US wage inflation is now also easing.
While the benign disinflation scenario has carried the day so far this year, market hopes for a gradual slowdown in the US economy were challenged somewhat last week, not by soft data, but by a super strong US jobs number. The market was looking for an on-trend increase of 188,000 new jobs in the non-farm payrolls, but instead got an incredible 517,000 jobs surge.
This has raised fears that the US economy might actually be reaccelerating rather than slowing down. Uneasiness was also heightened by a surprisingly strong rebound in the ISM services survey of business conditions (which jumped to 55 from 50).
This stronger-than-expected data has raised fears of a “higher for longer scenario” in respect of the Fed, and also sent US 10-year yields higher after a decent rally. The US dollar also bounced. Despite some wobbling in equity markets, the new uptrend appears to be intact so far, and incrementally less hawkish comments from the Fed Chairman Powell have also helped quell equity market fears.
The blow-out US labor force number challenges the bear view that the US is sliding into recession. Even if jobs numbers likely overstate the strength of the US economy, they do at least hint at considerable resilience.
On balance, we still see the overall body of evidence as indicating the US economy is slowing. The labour market does remain an area of resilience and is central to our view that the US can avoid a genuine hard landing. Hence, while we think there is some information in January’s labour force data, we are cautious against reading too much into the hot January print. Weather patterns were unusually warm and January has historically had a habit of giving misleading signals in respect of future labour market trends.
While we cannot rule out future data volatility, our core view remains for falling inflation over the year and slowing but not recessionary growth trends. This should allow the Fed to pause and cut later in the year, which should be a decent backdrop for US and global stocks, notwithstanding some likely volatility as Goldilocks battles the bears.
RBA Proving a Belated Hawk?
Domestically, the higher-than-expected Q422 inflation outcome, as well as last week’s consequently more hawkish rates guidance from the Reserve Bank of Australia (RBA), has seen local interest rate expectations rise. The local share market wobbled but has so far taken the higher rate profile in its stride. It looks likely the RBA will hike rates by another 25 basis points (bps) next month to 3.6%. The RBA may well then pause on hiking at the April meeting, which would make the May meeting (following the release of Q1 inflation data) a key date. Economists and the rate markets seem to have converged on a 3.85% peak (at a minimum). This looks plausible given the RBA’s comments around the need for further interest rate increases and its implied upgrade of 2023 inflation.
We feel the economy can cope with a 3.85% interest rate peak, although when combined with the roll-off of fixed rate loans that is coming this year, we expect a substantial consumer slowdown as we move through 2023.
A robust labour market, significant residual household savings and the demand boost from migration should protect against a hard landing. The futures market has actually moved back above a 3.85% peak to a peak rate of 4%. This is after having reduced expectations to a 3.6% peak ahead of last week’s meeting. It is interesting that interest rate markets are not pricing in a full cut later in 2023. Indeed, they do not have much cutting priced in for 2024 relative to US rate pricing.
The positive interpretation is that the market thinks the economy can cope with further rate rises and does not believe a hard landing is on the cards. The more negative interpretation is that the market believes the RBA needs to keep policy on the tight side for an extended period to help squeeze inflation out of the system.
If the RBA is forced to move above 4% and hold rates there, the risks of an economic hard landing undoubtedly rise, despite the resilience of the economy to date. We still see a move above 4% as unlikely, and we still see the inflation and growth dynamics as likely to allow the RBA to ease by year end.
In summary, domestic economic risks remain manageable but tail risks are edging up as the RBA tightens the screws. Inflation and wage outcomes will be crucial as we move through this year. We think inflation can come down faster than the RBA is suggesting, given global trends and the likely slowing in domestic demand that is set to unfold. However, residual stickiness in inflation in coming months does raise the risk that the RBA “overtightens” this year.
Expect More Volatility but Don’t Let the Bears Get You
We expect more volatility as investors periodically fret over risks to the benign disinflation scenario (too hot, too cold). Nevertheless, our core view remains constructive.
While acknowledging how the strong start to the year for equities has crimped near-term return prospects, we think 12-month prospects for equities (and bonds) remain respectable. We continue to emphasize high quality, earnings-resilient equity portfolios as inflation ebbs and growth slows.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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