Following the US Federal Reserve’s (Fed) mid-December meeting and publication of a new ‘dot plot’ showing the Federal Open Market Committee’s (FOMC) policy rate forecasts, US Treasuries rallied through the end of last year, with yields reaching a low of 3.8% on 27 December. The fall in (real) yields spurred a corresponding rise in rate-sensitive growth stocks, with the NASDAQ 100 gaining another 3.4% on top of the 16% move since October.
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While recent relatively soft economic and inflation data did support the market’s prevailing ‘soft landing’ narrative, it seemed to us to do so rather too much, too quickly. Core inflation in the US had slowed only slightly from November to December, and weak economic data can easily provoke worries that such weakness could lead to a recession.
The market’s current optimistic outlook stands in sharp contrast to the expectations most investors had at the beginning of 2023, when a recession seemed assured. In the same way that the negative consensus warranted considering how things could go better than expected (as they did), the current positive consensus suggests we should consider what could go wrong.
The risks to the outlook centre around both growth and inflation. The soft-landing view is that inflation slows to target without a recession, and hence the Fed would be able to cut policy rates by 175-200bp over the course of the year.
The first risk is that growth turns out to be more resilient and therefore inflation less likely to decelerate, in which case the Fed would need to keep rates higher for longer. This scenario is arguably what we saw after the latest stronger-than-expected US private non-farm payrolls data.
The flip side to that risk is that the Fed has already kept rates too high for too long and the economy will yet slip into a recession. The surprising decline in the US ISM Services index from November’s 52.7 to 50.6 in December illustrates this scenario. A spike in geopolitical risk could be another trigger.
Inflation scenarios negative for equities
We see it as more likely that inflation will prove sticky and decelerate more slowly than core inflation’s rapid fall being likely to continue. The drop from 5.5% to 4.0% in 2023 was arguably the easy part – supply chains were re-established and the initial pent-up consumer demand was satisfied (see Exhibit 1). From here onwards, it could be trickier.
Core goods inflation has been low recently, but ongoing deglobalisation trends suggest goods inflation could be higher in the future than it was prior to the pandemic. Services inflation depends largely on wage growth, and the US labour market still appears to be strong.
Finally, housing prices (‘rent of shelter’), are rising at 6.5% year-on-year – far above the 2.9% rate that prevailed pre-Covid. We all remain ‘data dependent’, but a scenario where inflation moves down only slowly or even stabilises at a higher-than-2% rate (particularly when US GDP growth is forecast to have been 2.2% in the fourth quarter of 2023, still above a 1.75% trend rate after more than 500bp in policy rate hikes), is certainly possible.
Incidentally, all three of these scenarios are negative for equities in the short-term, while at least one (recession worries) is positive for bonds.
We, too, anticipate that the US will achieve a soft landing and that policy rates will decline over the course of the year. The critical question is how quickly, and how far, rates fall.
Eurozone growth weak
The eurozone certainly does not need to worry about growth being too robust. Manufacturing purchasing managers’ indices (PMIs) were below 50 – pointing to contraction – in all the major economies (even if slightly less so for some countries in December), although services PMIs are holding up better, the notable non-trivial exceptions being Germany and France.
Headline inflation, however, was 50bp higher in December than the month prior, ending a seven-month streak of declining headline inflation. The gain, though, was more due to technical factors as several governments removed energy price caps in place from last year.
Even as growth remains weak (we see the eurozone recovering to just a 0.3% quarter-on-quarter rate of growth by the end of the year), the inflation risks from wages and hence services are meaningful. Many unions are still backing strikes to obtain higher salaries or bonuses, and these gains have not yet shown up in inflation indices. This is likely one reason the European Central Bank has also maintained the message that it is too soon to declare victory over inflation.
On the other hand, Europe is probably more vulnerable to a negative growth shock, particularly if energy prices were to jump, and the region will not benefit from pre-election spending to the degree expected in the US.
The main advantage for European equities is that they are the most attractively valued major developed market based on forward-price-earnings (P/E) ratio multiples.
The z-score of the current P/E is -0.4 compared to 1.1 for the US and even 0.1 for Japan (historically the ‘cheapest’ market). Not coincidentally, though, Europe also has the lowest consensus earnings growth forecasts for 2024, at about half the rate expected in Japan and a third of that in the US.