Stock markets have enjoyed a strong rally over the past four months amid optimism that inflation could fall back to target without a painful economic adjustment, despite the sharp interest rate increases implemented over the past 12 months. In this note we look behind the equity market strength to developments in some of the economic data and consider the likelihood of inflationary pressures dissipating without a significant economic slowdown. Our conclusion is that we are not yet ‘out of the woods’, and we continue to recommend caution.
The ‘Happy’ Roadmap for 2023
After last year’s precipitous ascent in interest rates in developed world economies, 2023 was expected to be all about a moderation of inflation and a resulting turn lower in interest rates. In recent months, inflation in the all-important US economy seems to have followed this script. Having surprised to the upside time and again through the first three-quarters of 2022, inflation appeared to peak and begin to fall back in October. Readings since then have mostly surprised to the downside, igniting hope amongst investors that victory was in sight in the battle to re-establish price stability so that interest rates could begin to fall, and economic growth could be allowed to safely re-accelerate once more – ushering in a new expansion phase.
Such sentiment saw equity markets consolidate and begin to move higher once more. From its October lows, the S&P500 Index of the largest US companies recovered by 16% to mid-February – halving the losses suffered by investors since share prices began their descent at the start of 2022. Bond markets were similarly cheered, with the yield on the US 10-year government bond moving down from 4.25% in late October to 3.37% by mid-January. The ‘soft landing’ scenario – where inflation drains away without impacting economic growth too much or taking unemployment meaningfully higher – seemed to be the central scenario being priced into financial assets. Hopes for a soft-landing were bolstered by an improvement in some indicators of the health of the US economy, suggesting that interest rate hikes have not sapped economic growth. Data here includes resoundingly strong new job creation, extremely low unemployment and resilient retail sales.
A Dose of Reality
We remain doubtful that such a rosy outcome is likely. While the idea of the economy remaining strong as inflationary pressures disappear of their own accord is hugely appealing to policymakers and investors alike, it doesn’t appear plausible. To believe that inflation can return to the 2% target while US unemployment is at a 50-year low, and wages are growing far in excess of a level that is consistent with this target, is simply too optimistic.
In support of this view, the latest twist in the data has seen the soft-landing narrative begin to morph into something much less cheery: a ‘no landing’ scenario. Here growth does not slow – and inflation does not fall back to target. To us, ‘no landing’ simply indicates that inflation isn’t responding to the policy measures taken to date – that the medicine of serial interest rate hikes has not been strong enough, or applied for sufficient time, to return US inflation to target. It is not a happy outcome; further interest rate increases would follow, increasing the pain inflicted on those sectors of the economy that are very sensitive to higher interest rates, such as housing. It also seems likely that higher interest rates for a longer period would increase the likelihood that when the economic slowdown does arrive, it will be of the hard variety. This, of course, will provide further challenges for investors.
In recent days this message has begun to get through to financial markets. Government bond yields have started to climb once more, with the 5-year US government bond yield rising from 3.64% to 4.19% through February (see chart). This indicates that bond investors now believe that interest rates may need to rise further – and have to stay at elevated levels for longer to force inflation back towards target. Such developments have halted the stock market rally, at least for now, with US equities peaking at the end of January.
Last Friday, new data confirmed that optimism that inflation might ease while economies remain strong might well prove misplaced. The Personal Consumption Expenditure (PCE) measure of US inflation ticked higher once more with an annual core measure (which excludes food and energy) of 4.7% for the year to January, up from 4.6% in December. For completeness, the headline number was reported at 5.4%, again higher than expectations and higher than the December reading of 5.3% (see chart). Of course, these numbers might be a one-off, but taken together with coincident indicators of economic resilience elsewhere, investors would do well to take heed of the mounting evidence before them.
Portfolio Positioning
We have been surprised that the scale and speed of the interest rate increases across the developed world has not, thus far, had greater impact on economies and in particular, labour markets. This may be down to the much-discussed time lags in the transmission of tighter monetary policy to the real economy or possibly to changes in the structure of markets, such as that for labour, which alter the sensitivity to higher interest rates. Either way, it now seems more likely than not that the path back to 2% inflation will be prolonged and uneven – and may well involve a recession.
From a portfolio perspective, flexibility remains our watch word. We continue to look favourably on the now higher levels of income available from high quality bonds and indeed are recommending additions here, given that yields have ticked higher again in recent weeks. Aside from the yield on offer, bonds should provide a degree of protection as and when economies eventually slow under the weight of successive interest rate rises. While there is, of course, some risk that yields rise further still (bond prices fall), in our view this is becoming an increasingly asymmetrical bet – with interest rates and yields unlikely to be sustainable at higher levels in the medium term.
Turning to equity allocations, these have been much reduced from the recommended positioning twelve months ago. Within equities we continue to believe that earnings visibility and quality should fare better than the market more broadly, but we are taking advantage of recent strength in markets to reduce portfolio sensitivity to a prolonged period of elevated interest rates – as we judge the risk of such an outcome has now increased.
Finally, with regard to overall portfolio positioning, we believe that re-risking via additions to equities in due course will prove profitable and are carrying out research to identify the appropriate funds. At present, however, given the uncertainty surrounding the path of growth and inflation, and therefore interest rates, this seems premature.
