Markets remain on edge with the recent equity correction beginning to show signs of stabilising, even if it is too early to call an end to recent volatility.

The 2022 market narrative was fairly clear, if painful. Higher-than-expected inflation caused a sharp rise in interest rates which hurt both bond portfolios and equity valuations, particularly the “long duration” tech-heavy US equity market. Signs of financial system stress were notable in their absence, emboldening central banks.

2023 has been once again volatile with a strong start to the year followed by a sharp correction. However, the dominant narrative driving markets has become as volatile as the markets.

January optimism

January was a very strong month for equity performance with inflation fears easing. At the same time, hopes for a soft landing edged higher as the US economy appeared to be slowing at an orderly pace. Better-than-feared data out of Europe and a surprisingly orderly China reopening also buoyed sentiment toward the global economy and therefore equity markets.

February’s “no landing” concerns

In contrast to January’s goldilocks optimism, February ushered in the “no landing” narrative as stronger-than-expected US economic data and a renewed pick up in US inflation raised concerns that the Fed may have to take rates higher, and keep them there for longer, to contain US inflation pressures.

This no landing fear saw a significant repricing of interest rate markets, particularly at the short end of the yield curve, as expectations for the Fed Funds rate were ratcheted up.

March reveals banking stresses

The interest rate sell-off pressured equities through February, though the sell-off was relatively contained. This “higher-for-longer” interest rate scenario has dramatically reversed over the last week, with “surprising” signs of stress in the US/global banking system.

While actions by US and European regulators have been swift and decisive, central banks have been given a reminder that aggressive policy tightening comes with tail risks. The history of Fed tightening cycles is littered with banking crises.

The recent equity pullback takes the total correction in the US stock-market (which admittedly comprises two very distinct phases) to around 6%. As of 17 March, the Australian market is down around 7% from its early-February peaks.

While the downshift in equities is understandably unsettling, equity volatility has not been particularly dramatic in the context of bond market volatility, as shown in figure 3.

With banking sector fears seemingly easing again, can markets revert back to focussing on the more fundamental questions of growth and inflation?

While volatility may persist for a while, ultimately, we think the problems in the global banking system are likely to prove more isolated than systemic, and so markets will eventually focus back on macro fundamentals.

From this fundamental macro perspective, our core view remains relatively sanguine on both the growth and inflation outlook.

Nevertheless, the US Fed has to negotiate a seemingly stressed financial sector (at least at the edges) against a seemingly too-hot US economy. This hot-cold state of the US economy and financial system will undoubtedly be resonating within the Fed.

Our analysis of the most recent readings on arguably the 2 most critical pieces of US economic data – labour market figures and the US CPI – suggest a robust headline story, albeit with a more mixed underlying picture.

The February labour market data released on March 10 was seemingly very strong again, with a headline 311,000 jobs created versus consensus at 205,000 (the 30-year average is closer to 150,000 jobs).

This ongoing story of a strong labour market is a large part of why the Fed had become more and more hawkish, particularly its February comments when the January figures printed over 500,000 new jobs.

This was, of course, before banking system stresses caused the interest rate markets to abruptly reverse course.

Concerns over the tightness of the US labour market certainly have some validity with a still near-record inventory of unfilled jobs. However, the details of the most recent jobs report were more mixed.

February job gains were very concentrated. Three sectors – hospitality, retail and education/healthcare – contributed well over half the jobs gains. Many other sectors (there are 15 sectors in the survey) showed modest jobs growth or job declines (most starkly, the tech sector). Thus, the US labour market is still showing headline strength. However, there are signs labour market strength is fading in a number of sectors.

Elsewhere in the labour market report, despite the strong rise in new jobs, a lift in the participation rate saw unemployment tick higher while average hourly earnings growth also edged down.

So, the labour market remains tight in aggregate but does not look to be dangerously overheating. This would suggest the Fed has a bit more work to do, but is not as far behind the curve as some have suggested. Policy works with a lag.

This week also delivered the February CPI report. Headline inflation eased somewhat with lower month-on-month and year-on-year readings. Headline inflation has now eased from a peak of 9.1% in June 2022 to 6.0% (6.4% in January).

This is better news for main street but Wall street’s focus is the core CPI which came in at 0.45 basis points for the month. This was above expectations with the year-on-year rate edging down only marginally from 5.6% to 5.5%. At face value, the stickiness of core is a concern as inflation remains well above the Fed’s 2 - 2.5% target area.

Once again, the detail was more mixed with 70% of the gain in core inflation coming from the “shelter” component, which is 43% of the core inflation basket. Outside the shelter component, core CPI is running at 3.6%. This is still on the high side but not nearly as worrying as the 5.5% overall core print.

In our view, the shelter component is likely overstated due to a slow-moving sampling method for calculating rental growth. More up-to-date alternative measures suggest rental growth is decelerating quite rapidly.

We expect the shelter component will come down significantly over the balance of the year. This may not in itself get core inflation all the way down to the Fed’s target by year end, but slower economic activity will also likely make a decent contribution to lower inflation as we move through the year. We see the potential for core inflation to edge down to 3% by the end of the year, which should ultimately keep the Fed happy and cheer up equity and bond markets.

However, with the Fed having little faith in its forecasting models and very much playing what is in front of it, the high current inflation readings are likely to keep the Fed on a tightening bias in the near-term, which could create further volatility, particularly with intermittent banking sector flare ups emerging.

As discussed, while banking sector stress has seen the market swing violently in respect of Fed tightening expectations this week, an easing in stress at the time of writing has seen the market settle on a 25 bps hike on March 22 and then a probable pause.