After a strong start to the year, stocks are pulling back again while bond yields and the US dollar are rising. There is renewed fear that the US economy is too strong for inflation to come down significantly.
As a result, the forward curve for the peak Fed policy rate has shifted up 60 basis points (bps) in the space of one month. In addition, the market has moved from pricing 2 full 25 bps cuts in the second half of the year to now only pricing half a cut late in the year.
We recently flagged the potential for volatile economic data to cause market volatility, which we dub our “too hot too cold” thesis.
Our best judgment is that the broad trend of slowing growth and falling inflation remains intact, but uncertainty and the risk of a Fed policy error has risen.
The uncertain environment is fuelled by the fact the US economy has yet to show much sign of a slowdown under the impact of monetary tightening. Indeed, a literal interpretation of recent data is that the US economy is re-accelerating. While we would caution against this interpretation, there is no indication of an imminent recession or of the undue financial strains that typically precede a recession.
Where did the 2023 US Recession Go?
Consumers are not stressed and the labour market remains beyond full employment with an inventory of unfilled jobs. The banking system is in good health and the high-yield US corporate bond market remains well behaved.
While none of this guarantees the US economy will not fall into recession over the coming year or so, we do note the warnings stemming from a deeply inverted Treasury yield curve. Lags between policy tightening and a significant economic slowdown (or recession) are common (see figure 6). However, the state of the US economy, particularly the state of the labour market, is unusual, raising several key questions.
Does the apparent resilience of the US economy and tightness of the labour market mean the Fed needs to raise rates much more (perhaps to 6%) and for longer than it would otherwise need to do to bring down inflation?
Does a resilient economy and a potentially higher for-longer-profile for the Fed funds rate just delay the recession scenario until 2024?
On the optimistic side, are we just experiencing a combination of data volatility and policy lags, implying that the gradual slowdown in growth and inflation that was buoying markets in January will resume over coming months?
Policy Lags?
While benign disinflation remains our central case view, there is a risk that the Fed may over- tighten in its zeal to cool demand growth and bring inflation back to its target.
The Fed may have already delivered just about enough monetary restraint to cool growth and inflation. Certainly, if we add another two 25 bps hikes in March and May, which appear to be a virtual fait accompli, then policy rates (at over 5%) are set to be well above most estimates of “neutral”. It may just be that more time is needed to see the full impact of the Fed hiking cycle.
While our core view is that a broad disinflation trend is intact, the process is unlikely to be perfectly smooth, as we have highlighted previously. We are reluctant to change our core view based on last month’s “hot” data on payrolls and the January consumer price index (CPI) pick-up.
We continue to rationalise a greater-than-50% potential for a soft landing as opposed to a recession due to the unusual state of the US labour market. The usual unemployment surge and consumer retrenchment may well be absent from this cycle. The large pool of accumulated “excess savings” should also continue to cushion any slowdown in household consumption.
Core Scenario Should Support Stocks and Bonds in 2023
In a scenario of slower growth but a softish landing, both stocks and bonds should rally decisively from when the Fed looks set to end its tightening cycle. This looked to be playing out in January but the market has now backtracked somewhat. A sticky inflation scenario cannot be ruled out and raises the risk of a recession (first half 2024) off the back of a higher-for-longer Fed rate cycle. While this is the key risk we are monitoring, we expect the inflation downtrend to re-emerge over coming months, alongside slower but not recessionary growth.
So, we are still leaning towards the “benign disinflation” view, although we continue to watch the data pragmatically. We are mindful of the risks and uncertainty ahead, and we will adjust our view and strategy if evidence challenging our central case thesis accumulates.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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