The opening data salvos of 2023 add to the case for the US Federal Reserve (Fed) to slow down on raising interest rates and there are now substantial mismatches in different markets’ pricing of economic outcomes this year.
What happened?
The latest US consumer inflation data (12th January 2023) showed a further slowing of momentum at the headline level but there was also evidence that core price pressures remain intact. The detail of the report showed that weakness in broader market rents is still not feeding into owner-occupied rents (which grew by 0.8 per cent month on month), while, excluding housing, healthcare, and airline fares, core prices are still growing at an annualised rate of 6.5 per cent. Chair of the Fed, Jerome Powell, has pointed to the core indicator recently as important for the central bank’s decision-making.
Our interpretation
The report was broadly in line with consensus and further cemented the market view that the Fed is approaching the end of its aggressive tightening cycle. On the face of it, the data support a further notch down in the pace of hiking by the Fed, with some members indicating the possibility of a shift to quarter-point moves, but there may still be enough there to keep another half-point rise on the table when the Fed next meets at the end of this month.
Beyond the short term, we are now confident that the hiking cycle is coming to an end with a terminal rate of 5-5.25 per cent for this cycle.
Our outlook
Moving further into 2023, we think the implications of the central bank’s tightening cycle (now showing up in slowing inflation) will be the key macro dynamic shaping asset returns. Both the actual change in rates and the length of time they stay above neutral will affect how big an impact the bank’s tightening has. Current Fed signalling - via its Summary of Economic Projections - indicates a continued tighter stance on policy which will continue to damage the economy.
Component analysis done by the San Francisco Fed shows that demand drivers of consumer price inflation are collapsing, which indicates weakening momentum in growth. Our own activity trackers are also consistent with elevated risk of recession, indeed a cyclical recession is our base case for the second half of this year. The main exception to this, and which does not suggest a recessionary outcome, is the labour market, which continues to show healthy gains, albeit at a slower pace. The concurrent decrease in wage earnings growth - while just one number - could indicate the presence of a positive supply factor in the labour market. This needs further careful assessment, especially if the wage growth trend is confirmed with a wider set of data.
Asset allocation views
In terms of market behaviour, current bond market pricing remains out of sync with the Fed’s signals, with investors pricing in outright cuts in official interest rates for the second half of 2023.
On the other hand, equity and credit markets show no significant pricing of a cyclical recession, creating a discrepancy between the different asset markets.
We are leaning towards the bond market signals and think that the tightening of financial conditions that have accompanied the inflation picture come with a potentially heavy cost to growth. Therefore, we prefer government bonds in our asset allocation and are still defensive on equities as we expect the growth downturn will lead to an earnings hit later in the year.
