While many in markets have been advocating a turn, the US Federal Reserve (Fed) and European Central Bank (ECB) met this week with post-Covid dislocations still visibly lingering in their respective systems.
June’s round of monetary policy meetings kicked off with two surprise hikes: central banks here in Australia and offshore in Canada both resuming moves after a period on pause. The culprit is more persistent core inflation and its slow progress towards target, and we think the pattern is likely to be repeated elsewhere. Labour markets remain exceptionally tight and the services sector continues to benefit from strong pent-up demand. The fight with inflation is far from over and even with the strong tightening they have already delivered, policymakers have more ground to cover, regardless of whether they have been right to focus on spot labour market and inflation data.
A hawkish start to the middle of the year
At its June meeting, the Fed took a break from a further tightening of rates. That was in line with expectations, but a more hawkish stance and hints of a higher peak rate - which is in line with our own views - came as a surprise to most market participants. The updated dot plot signalled that more tightening lies ahead, with the median dot showing a year-end funds rate of 5.6 per cent, a 50 basis point increase from the March projections.
Chair Powell emphasised the disappointingly slow decline in core inflation so far this year was the main reason for the additional hikes now expected by Federal Open Market Committee (FOMC) participants. With the acute phase of the banking system stress out of the way, the Fed’s policy focus clearly remains on price stability, with the ongoing resilience of the labour market seen as a driver of persistent inflation. While markets currently price in less than one full further hike we believe the Fed might have to deliver two more, with a non-trivial risk of the policy rate reaching the 6 per cent handle.
Further to go
The ECB also delivered a hawkish message at its June meeting, going ahead with another quarter percentage point hike that was well-telegraphed and widely expected.
The bank’s statement repeated that underlying price pressure remain strong but also acknowledged “some signs of softening” in recent data. Importantly, staff projections for core inflation have been upgraded for 2023-2025, while growth projections have been downgraded slightly, stressing the sharper growth-inflation trade-off faced by the ECB in coming months as it gets closer to the end of the tightening cycle.
The main question going into this meeting was how much further the ECB expected to raise rates from here. President Lagarde's message on the next step was clear - the Governing Council assumes it will hike again in July "barring a material change to the baseline".
Beyond that, the central bank is keeping its options open for now, stressing a data-dependent, meeting-by-meeting approach. Lagarde stressed that inflation at 2.2 per cent in 2025 is not a satisfactory outcome, begging the question of whether one more move from here would be enough to bring inflation back to target within two years in the next update of staff projections. While we view the single hike expected by markets as a more likely scenario, we believe risks to the terminal rate of 3.75 per cent are skewed to the upside, given significant uncertainty about the inflation process and the central bank’s focus on lagging data.
Still in the recession camp
Despite recent upgrades to consensus growth expectations for 2023, we remain convinced developed markets will see a slide into recession over the next 12 months. Major economies continue to show overall resilience, but the forward-looking data signals are becoming more mixed. The soft data is flashing red, particularly in the manufacturing sector, credit growth is slowing, and consumer confidence is rolling over. At the same time, labour markets remain hot, fuelling wage growth further and preventing underlying inflation pressures from easing.
Clearly, we are not in a broad disinflationary regime yet. And if they are worried about inflation getting stuck at high levels, central banks have to do more - not just in terms of higher terminal rates but also in terms of keeping rates at higher levels for longer. We predicted this ‘higher for longer’ signal for markets previously and expect the central banks to stick to this line for some time - even if in the end they may have to cut rates earlier than anticipated.
The higher-for-longer stance in turn reinforces our conviction that the US, Europe, and the UK will see recessions in late 2023 or early 2024 as tighter policy transmits more forcefully through the credit channel into the real economy. We are already seeing signs of a slow-moving credit crunch with credit growth slowing across the board. There are also signs of default rates picking up.
The transmission lags in this cycle have been long and variable due to the shocks that Covid delivered to the system, and the continued focus on keeping monetary policy tight means the risks to growth remain firmly to the downside as we move further into 2023. Indeed, risks of a deeper balance sheet recession are likely to rise if such restrictive levels of nominal rates, and meaningfully positive real rates, are carried over into 2024.
Cautious on risk despite continued market melt-up
Fidelity International's Solutions and Multi Asset team retains its cautious stance on risk assets in light of the recession risks and we have recently moved to an underweight stance on equities, judging the market rally as very narrow.
Leading indicators of earnings are worsening and valuations are not particularly attractive, especially in the US, while technicals are also now a headwind as seasonality becomes negative. However, we are aware that economic data is only moderating slowly and that markets lack any real direction, meaning that they could grind higher for the time being, assuming no tail risks appear.
We maintain a neutral stance on fixed income overall in light of high and persistent inflation and central banks’ determination to keep tightening policy, compellingly confirmed by the June meeting decisions. Within fixed income we prefer government bonds to corporate credit, especially high yield, and within equities we prefer emerging to developed markets. Despite China’s recovery being uneven, we still believe that the broader theme of emerging markets vs developed markets is intact, and that the domestic benefits of accelerating consumption in China could be a good diversifier for portfolios.
