2023 to date has seen financial markets race higher. Valuations of equities, bonds and risky assets generally have rallied on expectations the US economy will achieve a ‘soft landing’: speedy disinflation, without a recession. Recent data suggests the US job market has remained robust. This raises the possibility that inflation could be stickier than expected, obliging the US Federal Reserve to tighten monetary policy much further. Faced with this wide range of possible outcomes, markets have charged higher, although we regard visibility on the path ahead for the US economy as poor.
US reports strong job numbers
The non-farm payrolls report published on 3 February showed the US economy added over half a million jobs in January, despite the Fed’s tighter monetary policy to rein in inflationary pressures. The unemployment rate hit its lowest since 1969 and the non-farm work week increased by 0.3hrs (the equivalent of adding around 700 000 jobs).
Strictly speaking, January’s increase in payrolls was all due to a smaller-than-average decrease in payrolls. Seasonal adjustments converted this into an increase. Along with sizeable net upward revisions, the data could be interpreted as equating, in total, to an additional 1.3mn jobs should hours worked have held steady.
Aggregate earnings growth – the product of hours, payrolls and average hourly earnings – jumped to 8.5% year-on-year from 7.3% previously. This was a 1.5% month-on-month rise versus 0.3% previously.
Hard, soft, or no landing for the US?
In terms of probable outcomes, this persistent strength in the labour market combined with evidence of slowing downward momentum in housing and upside in consumer confidence at the start of 2023 all point to moderating left-tail (i.e., recession) risk to GDP growth, but also rising right-tail risk (i.e., stronger growth than previously envisaged).
In this environment, investors are (understandably) somewhat befuddled.
Until a clearer picture on how the US economy will fare emerges, markets will likely continue to trade choppily.
How far does the Fed need to go?
Evidence of labour market tightness causing wage growth to pick up again and leaking into the core services ex-housing component of consumer price inflation (CPI) could well inject fresh urgency in Fed policymakers’ efforts to effect a re-tightening of financial conditions.
It is unlikely the Fed will be swayed by a single month of data, but the tone will bolster the hawkish case to ‘keep at it’ and push the fed funds rate to 5.25%.
In comments to the Economic Club of Washington on 7 February, Fed chair Jay Powell warned that the central bank might have to raise interest rates more than investors expect because it will probably take a ‘significant period of time’ to tame inflation given the stronger labour market data.
In recent days, other Fed officials have also pointed to the enduring strength of the labour market as a reason for the Fed to keep pressing ahead with tightening.
Chair Powell chose his words carefully, seemingly sidestepping opportunities to sound overtly hawkish. It may be that with markets having repriced rate expectations upward in the wake of the January jobs report, Powell felt less of a need to push expectations even further.
Notably, Powell flagged the employment data as supportive of the Fed’s view that in 2023, inflation may not come down as quickly as markets are pricing. Restrictive monetary policy may be required for longer, suggesting markets should not be pricing rate cuts in the second half of 2023.
Our macroeconomic research team continues to expect the Fed to raise the fed funds rate from 4.75% currently to 5.25% via two more 25bp increases, for it to then hold rates ahead of cuts in the third quarter.
ECB pre-committed to rate rise
After raising its benchmark deposit rate by 50bp to 2.50% on 2 February, the ECB has essentially committed itself to another 50bp rate rise in March.
However, it was more open on the subsequent policy steps. Economic data will ultimately prevail as the main driver of policy moves, but the view of our macroeconomic research team is that the ECB to raise rates by 25bp in May and June for a terminal rate of 3.50% with a high bar for rate cuts this year.
Japan to name new BoJ governor
With less than three months until Haruhiko Kuroda steps down as governor of the Bank of Japan (BoJ), there is speculation about who will replace the country’s longest-serving central bank chief.
Candidates may be deterred by the scale of the incoming governor’s task. After a decade of ‘unprecedented’ ultra-loose monetary policy, the next BoJ chief must steer Japan towards interest rate normalisation and avoid a return to deflation and a sharp economic slowdown.
Reports in the Japanese media suggest that the government has approached BoJ Deputy Governor Masayoshi Amamiya as a possible successor. His appointment would probably mean an emphasis on policy continuity and gradualism.
Japanese authorities denied the reports and pushed back the date at which nominations to parliament would be made to the week of 13 February, instead of on 10 February.
We will believe it when we see it
In summary, we remain sceptical about the notion of ‘immaculate disinflation’ for the US economy and therefore more cautious than the market.
Our multi-asset team is neutral on equities, where ‘immaculate disinflation’ could become problematic for profit margins if the cost of goods sold does not slow as fast as sales (or rises faster than revenues). That could lead to falls in earnings estimates, particularly in Europe, where estimates now appear overly optimistic relative to the latest macroeconomic data.
European equities are the main (and meaningful) underweight position in our multi-asset portfolios, against which we hold long US and emerging market stocks. China’s reopening has led us to increase our allocation to emerging market equities. Valuations look attractive now, and after a long period of negative earnings revisions, we anticipate more positive momentum from here.