Much of the data continues to feed the view that we have seen peak inflation and, importantly for markets, peak Fed hawkishness. Certainly, year on year US consumer price inflation (CPI) peaked last June, with every data point falling since then. Other economies, such as the Eurozone and the UK, seem to be following this trend, albeit with a bit of a lag, while Japan is facing very different issues, including challenges to its Yield Curve Control policy.
Nevertheless, markets across assets are rallying hard. Somewhat logically, government bonds are rallying around peak CPI inflation, but even risk assets, such as equities are benefiting and seem to be looking beyond any recession. In fact, since the beginning of the fourth quarter and into this year, equities have rallied, government bonds have rallied, corporate bond and emerging market bond spreads have narrowed, gold and industrial metals have rallied and the US dollar has weakened.
Many investors will be pleased, after a difficult 2022 in general – though is it right to be positioning for an early cycle recovery when the Fed hasn’t finished hiking? Moreover, the Fed rightly views these market moves as an easing in financials conditions, which only complicates the rate outlook, as does the proverbial policy drag.
Markets are currently pricing in 50bps of Fed cuts this year but what about services inflation, which is closely tied to the labor market, and is something the Fed is focusing on? As the graph below shows, services inflation shows little sign of slowing, despite what’s happening to CPI.
Source: Bloomberg, data from 31.01.2000 to 31.12.2022
Can markets have their cake and eat it? Specifically, can they get slowing inflation and avoid a recession? Financial market history implies that it is possible, even if it’s not normal. Currently it does look like wishful thinking, with markets focusing on peak inflation, and assuming peak hawkishness, as well as not yet focusing on stage two, i.e. recession, or preferring to assume it will be avoided.
Therefore, a key risk for markets in the short term is that the Fed remains more hawkish than consensus expects and the broad-based market rally ends up looking premature. The US, UK and European central banks all meet right at the beginning of February and so we will get some clarity soon. Markets are currently assuming a 25 bp hike by the Fed but the press conference after will no doubt better set the tone.
In short, there seem to be some contradictions in how markets are behaving across assets. For our part, the better inflation environment and risk of recession encourage us to be constructive on government and investment grade bonds. As for equities, we are less positive and continue to have a bias towards Europe and for reducing the US exposure. We also retain our significant exposure to commodities, especially gold which is well positioned in such an uncertain environment.
However, as devout pragmatists, we will happily, and quickly, adjust portfolios if we see the sweet spot of a much less hawkish Fed and a soft landing actually in play. At this stage, the data simply isn’t conclusive enough.