The recent release of the minutes from December’s meeting of the Federal Open Market Committee showed US monetary policymakers worried that investors continued to misperceive the central bank’s commitment to bringing inflation back to its 2% target. It will require higher-for-longer interest rates and a meaningful slowdown in growth to achieve this given the current strength of the US economy, in particular the labour market.
The latest Job Openings and Labor Turnover Survey still showed more than 10 million open posts, and consensus estimates for the upcoming non-farm payrolls data are for another month of
200 000+ new jobs and robust wage gains.
This strong growth explains why the Federal Reserve’s (Fed) own projections show headline PCE (personal consumption expenditure, which historically is about 30bp lower than the consumer price index (CPI)) falling to only 3.1% by the end of 2023 and not reverting to its 2% target until after 2025.
This estimate is in line with consensus forecasts of economists gathered by Bloomberg. They see CPI inflation at 3%. Market prices, however, are currently pointing to a rather lower rate of around 2.4% (average over the last month, see Exhibit 1).
Inflation may be slowing, but…
Recent data out of Europe appears to support the view that inflation is now on a quickly decelerating path there. Prices rose at a slower rate than forecast in Spain, Germany and France.
These pleasant surprises, however, were driven more by the unexpected drop in natural gas prices thanks to a mild winter and the impact of government price controls. Prices are now lower than they were prior to the February 2022 invasion of Ukraine, though still well above those of 2019. It is less clear that core inflation has truly begun to fall.
The market’s expectation of a quick deceleration in inflation is what supports the view that in the US, the Fed will consequently be able to cut rates (‘pivot’) soon. Fed funds futures project official rates falling in late summer even as the Fed’s estimates show this happening only in 2024.
Market expectations moved up slightly following the Fed’s December meeting, but they are still well below the peak rates seen last November (see Exhibit 2).
No, policy rates will be higher still
If the market is wrong (as we believe), the outlook for both equites and fixed income is poor in the near term, and remains poor for equities in the medium term.
As the market realises that policy rates will be higher for longer, nominal yields should rise. That increase will likely be driven by real yields. As was painfully demonstrated last year, this has a swift, negative impact on the valuations of growth stocks.
In the medium term, fixed income yields should stabilise at a higher level, offering positive carry opportunities for investors.
Equity markets, however, still need to reflect the coming slowdown in earnings growth. Despite US 2023 earnings-per-share (EPS) expectations dropping by nearly 8% from last summer, they still forecast growth versus 2022 of 4.5% (this is down from 10%).
This may seem modest, but even a mild recession would likely see earnings declines rather than gains (see Exhibit 3). Nor is the optimism limited to a few sectors. Every sector outside energy is supposed to post better figures, ranging from 6% to 24%.
China has pivoted on Covid
The second main driver of global markets has been the other pivot – that of China moving away from its strict zero Covid policy to an approach centred on learning to live with the virus.
The risks of the new strategy are clear to us. Hospitals could become overwhelmed and economic activity could decline due to either widespread illness or many individuals self-isolating. Ultimately, though, the economy should be able to reopen fully.
The best opportunities in equity markets, then, will likely come from relative returns in the months ahead. We see better comparative opportunities in growth stocks in the US and in Chinese equities relative to those in Europe ex-UK.