One development of note since the start of February has been the upward revision of the ‘terminal rate’ – the maximum level to which central banks are expected to have raised their key rates at the end of the tightening cycle. Add in some unexpectedly positive indicators on growth, uncertainties over the pace of inflation and the likelihood (or not) of recession and it becomes difficult to reach a firm consensus scenario against which to make investment allocation decisions.
What seems likely is that investors may ultimately conclude that a tightening of monetary policy – especially as sharply as happened in the second half of 2022 – often provokes a recession, more or less deep, more or less long.
Surprisingly good news on growth
Since the beginning of the year, economic indicators have surprised to the upside, calling into question the recession scenario for 2023 which held sway last autumn.
If we define recession as a worsening of employment data over several quarters, we remain convinced that this is likely. The current rapid pace of job creation and very low unemployment rate in the US reflect an imbalance in the labour market that is incompatible with a sustained slowdown of (core) inflation towards the US Federal Reserve’s (Fed) 2.0% target.
If instead we choose to define a recession as a minimum of two consecutive quarters of contraction in GDP, the eurozone could yet escape it – just as has been the case since last autumn, when economists were forecasting a recession as early as Q3 2022.
In Q4 2022, according to the initial estimate, GDP in the eurozone grew by 0.1% (after 0.3% in Q3). However, the composition of this growth was weak, as apparent, for example, in the decline of consumption among French households.
Alternatively, we could decide to judge economic health via household and business surveys. If so, given the ongoing improvement in Purchasing Managers’ Indices (PMIs) and the recovery in the IFO business climate in Germany, we might conclude that the global economy will likely see a sharp recovery.
Indeed, the composite PMIs in the eurozone and Japan remain above 50, signalling growth, and those in the UK and US have moved back above 50, too. These are levels not seen for eight or nine months.
Such improvements in surveys and the resilience of economic activity to headwinds – such as the energy crisis in Europe – have led to an upward revision of the growth outlook for 2023, adding to the mood of general optimism.
Questions about inflation
The normalisation of global supply chains, lower shipping costs and easing commodity prices have helped to slow headline inflation in OECD countries from a peak of 10.8% in October to 9.4% in December, the lowest since April 2022.
That said, core inflation remains worryingly high. In the eurozone, inflation excluding food and energy stabilised at 5.2% in January. In the US, core services ex-housing inflation is still hovering at around 4.0% versus its pre-pandemic pace of 2.0%.
These measures will likely be the focus of investor attention, not least next month when the ECB (on 16 March) and the Fed (22 March) issue their macroeconomic forecasts of underlying inflation levels.
In December, their forecasts were 3.5% at the end of 2023 for core personal consumption expenditures (PCE) inflation in the US, and 4.2% in 2023 for the Harmonised Index of Consumer Prices (HICP) excluding energy and food in the eurozone.
If these are revised upwards next month, it would be a hawkish message.
For months, the ECB has reiterated that a recession would not be enough to curb inflation. In February, Executive Board member, Isabel Schnabel, again stressed that “a broad disinflation process has not even started in the eurozone. We will keep rates high until we see robust evidence of underlying inflation returning to target in a timely and durable manner”.
In the US, the minutes of the Federal Open Market Committee (FOMC) discussions on 1 February, published this week, revealed that many committee members ‘observed that a policy stance that proved to be insufficiently restrictive could halt recent progress in moderating inflationary pressures, leading inflation to remain above the Committee’s 2% objective for longer, and pose a risk of inflation expectations becoming unanchored’.
This is the main challenge that central banks – and investors – will face in the coming months: How should we respond when the economy slows but inflation remains high?
Different markets, different atmosphere
Further adjustments to expectations of a rise in key rates have led to significant rises in government bond yields since early February, with the US and German 10-year yields approaching or exceeding the symbolic thresholds of 4.00% and 2.50%, respectively.
These sharp movements may justify tactical adjustments in positioning – a return to neutrality or even overweighting of interest rate risk – but investors will need a certain fleetness of foot. Technical factors, such as large eurozone sovereign bond issuance and the Damocles sword of a debt ceiling imbroglio in the US, are likely to weigh on sentiment in markets.
Equity indices movements could be seen as challenging the perfect soft-landing scenario; they also reflect concerns over ongoing monetary tightening being increasingly likely to lead to a recession.
Indeed, as the US earnings season draws to a close, financial analysts have revised down their earnings outlook. For the S&P 500, for 2023 earnings-per-share (EPS) a fall of 10% is now forecast .
On the other hand, the earnings revision ratio appears to be troughing, which could be seen as a sign that analysts do not expect a long recession and have already taken into account a recovery in activity.
In other words, for equity investors, the reaction function of central banks seems clear: Should a recession materialise, key rates would be cut quickly to support the economy.
The only problem is that it is not exactly what central banks are saying.
After a sharp rebound in January and some hesitancy in February reflecting the changing consensus, we do not believe it wise to set any particular scenario in stone or dig in for the long haul with any particular position.
Grabbing the opportunities offered by rapid equity and bond movements or by sudden adjustments to the economic scenario will be crucial in the coming months.
The final outcome could be recession, although we envisage only a modest one. However, investors will likely struggle to define when this may occur, which could lead to market volatility in the meantime.
We are neutral on equities overall. We have slightly reduced our US equity overweight to take some profits, as one of the conclusions we drew from the earnings season was that margins are being squeezed at some US companies. This decision slightly reduced our asset allocation risk exposure.
Our overall neutral position is a product of sharply contrasting geographical positioning.
On the one hand, our overweight to emerging market equities is largely based on the view that the reopening of the Chinese economy will lift valuations.
On the other hand, we are underweight eurozone equities, whose valuations we see as too rich after their impressive rally in January and insufficiently reflecting the risks ahead.