Friday 17th February 2023
Following on from the euphoria of the liquidity-driven ‘everything’ rally in January, a much more cautious tone has permeated financial markets since the beginning of February. Stocks have not joined bonds in selling-off, but any gains have been hard won – and often short-lived. This is because the latest data from Europe and the US (e.g., the +3.0% rebound in US retail sales in January vs. +2.0% expected) suggest that the near-term economic outlook on both sides of the Atlantic is for continued expansion, extreme tightness in labour markets, and a deceleration of the disinflationary process that began in late 2022, most notably in the US. This has prompted investors to reappraise their forecasts for monetary policy in 2023 – and has caused considerable volatility in rates markets. Futures are now pricing in a much higher terminal policy rate in the US (i.e., for a higher peak of the Fed Funds in the present hiking cycle), at 5.3%, which is expected to be reached in late July. This is up from a low of 4.8% as recently as the 2nd of February when Fed Chair Jerome Powell suggested that disinflation had begun in earnest and hiked the Fed Funds just +25bps in what was a break with the recent past. However, the blowout non-farm payrolls report the next day – which revealed that the US had added c.520K new jobs in January (vs. 185K expected) – sent a jolt through markets, and nothing has been quite the same since…
We still expect inflation in the US and Europe to fall in the months ahead, but to do so at a slower pace than we did previously. Record low unemployment (just 3.4% in the US) and still-robust demand for labour from corporates (which are benefiting from an easing of energy cost pressures around the world even if the cost of debt is rising) have led to an increase in the bargaining power of workers vis-à-vis management; and, unsurprisingly in the current environment, these workers are demanding higher wages to offset the cost of living impact of higher prices. In a number of European countries, such as the UK, rows over pay and benefits have resulted in aggressive and highly visible strike action. But in the US, too, wage growth is likely to feed through to higher services price inflation even as falling energy, transportation, and other input costs reduce goods price inflation. Indeed, in flexible economies like the US wages tend to adjust faster than in less flexible economies to labour market conditions…
The prospect of more, perhaps ‘sticky’ services price inflation to come is likely to mean rates stay ‘higher for longer’ than if the inflation downglide went as smoothly as seemed likely when growth was slowing sharply towards the end of 2022; and this is the message coming from hawkish members of the Fed’s rate-setting committee (i.e., the FOMC) such as Mester and Bullard who have mooted a return to +50bps hikes if needed (perhaps as early as March). Their position was further supported by the +5.6% core CPI print for January (being ahead of expectations and almost in line with December’s CPI), and by revisions to the 2022 US core CPI figures, published on Friday last week. The revised data shows somewhat lower inflation through the first six months of 2022 followed by a slower deceleration from the August peak. What this means is that the declining inflation trend through the latter half of last year was not as marked as previously thought (and the drag on demand from higher rates was likely less than hoped). It is no wonder that multiple reports suggest that the hawks on the FOMC are in the ascendency once again. The ‘Fed Pivot’ narrative – which took hold in Q4 2022, became consensus last month, and reached its peak with the apparent conversion of Powell himself following the February FOMC meeting – seems to have withered. The ECB, meanwhile, has been more consistently hawkish than the Fed in recent months (not least because the ECB remains a long way behind the curve in raising rates) and we see no prospect that this will change until significant further tightening has been implemented. The big worry today, then, is that a hawkish Fed and ECB spark hard landings for the US and/or European economies in the latter half of 2023. Certainly this risk is rising.
So how are we positioning in light of this changing inflation picture? Well, in fixed income, and given the heavily inverted yield curves in the US and Europe, we continue to like shorter maturity instruments in investment grade credit. These offer higher all-in yields than are available on mid-maturity and mid-to-long-end bonds. In high yield, too, we prefer the shorter maturities. Despite the inversion, the all-in yield on shorter maturity high yield bonds is somewhat lower than on longer maturities. But the reduced credit risk at the short-end makes these maturities more attractive from a risk-return perspective (particularly given uncertainty today). We also favour an approach that uses ultra-long-end bonds as hedges against the possibility of recession given their traditionally negative correlation with risky assets. Equities, as nominal assets, continue to be a conviction of ours in an inflationary environment like today’s (albeit held in a diversified manner, including hedges on a tactical basis). Higher rates favour cash generative, mature, so-called ‘value’ companies (and banks in particular, all else being equal). But selection here is crucial given cyclicality in many such businesses and the risk that recession takes hold by year-end. Emerging markets, too, are particularly attractive in our view. Many are benefiting from buoyant commodity prices (and China’s re-opening), offer considerable value relative to developed markets, and have already seen local rates peak (giving policymakers there more space to deal with deteriorating global growth if this takes hold in the latter half of 2023). But, overall, we think that being diversified and nimble in today’s market is crucial. The direction can change at a moment’s notice.
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