In the real world, January is generally the grimmer month – redolent of dark skies, fraying resolutions, and Blue Monday – whereas things can start to look up in February as the first signs of spring begin to show. Not so in markets, where this year the opposite has been starkly true. As previously noted, markets made a sunny start to the year in January, as investors warmed to the idea that a strengthening disinflationary trend would soon steer central banks away from further tightening, even as the economy kept humming along – i.e., a ‘soft landing’. However, the narrative shift we pointed to in our last letter solidified across February in the wake of further macro data releases that undermined investors’ earlier confidence in a timely and smooth end to the current burst of inflation, pushing markets firmly down for the month. Losses came across the board – equities, credit, sovereign bonds, and commodities. Both the S&P 500 and the Nasdaq last week registered their worst weekly performances of the year and ultimately closed out February down -2.6% and -1.1%, respectively. Neither of these numbers was swingeing enough to erase January’s gains, though, and both indices are still positive YTD, while European equity barometers even remained positive in February – though not entirely immune from selloffs late in the month. Instead, the real pain was felt in fixed income markets, which have had a truly Janus-faced start to the year. Where the Bloomberg Global Aggregate Index clocked its best ever January, it chased this down with its worst ever February. Most fixed income indices are now at best flat YTD. Commodities also suffered from February’s gloomier mood: the broad S&P GSCI Index fell -4.0%, with both the industrial and precious metal sub-indices dropping sharply, at -7.9% and -6.2%, respectively.
At the root of investors’ souring sentiment was a continuing string of data releases suggesting economic activity remained robust and price pressures were not easing as quickly as they appeared in January. The message from early February’s big US jobs surprise and higher-than-expected CPI (both covered in our last note) has since been underscored by the January Personal Consumption Expenditures number (PCE, the Fed’s preferred inflation measure), which at +4.7% YoY also beat expectations (+4.3%). The fact the core US PCE numbers for 3m, 6m, and 12m now register +4.8%, +5.1%, and +4.7% (annualised) has a definite whiff of inflation stickiness. Meanwhile, the US jobs market clearly remains tight (the latest indicators being yesterday’s release showing Q4 unit labour costs at +3.2% annualised and weekly initial jobless claims falling even further than expected). Given this, it is not unreasonable to wonder if the Fed may yet return to 50bp hikes – though Atlanta Fed President Bostic yesterday pointed to an ongoing preference for 25bp increments.
Across the Atlantic, European data releases painted a similar picture of sticky inflation. Rapid declines in energy prices are taking the heat out of headline inflation – and, unlike the US, energy price inflation was always at the heart of Europe’s inflationary surge – but despite this, Eurozone headline CPI still failed to fall as quickly as expected, surprising to the upside at +8.5% YoY, versus an +8.2% consensus estimate. On a MoM basis, consumer prices actually rose +0.8%, compared with a January cooling of -0.2%. Even if easing energy prices are allowing headline inflation to slow, the real problem is now core inflation, which at +5.6% (compared to +5.3% expected) set a new record since the Euro’s creation. Prices rose across services, goods, and food, suggesting an inflation spike originally driven by surging input prices is now broadening out and at risk of becoming entrenched. Until both headline and core inflation are moving down together, the ECB will not have a signal to end their policy tightening – and hikes may continue into Q3. Indeed, yesterday’s bloc-wide inflation print and the upside surprises in the previous days in the standalone releases for France, Germany, and Spain have been accompanied by continued hawkish statements from ECB Governing Council members.
The net effect of these prints’ suggestion of stubborn inflation on both sides of the Atlantic has been a rapid repricing of interest rate expectations. Futures markets’ estimate for the Fed Funds peak has been pushed up and out in the last few weeks; having priced a high-water mark below 5% in the summer at the start of February, futures now anticipate a 5.5% terminal rate in September. European rates are now priced to reach record highs later in the year. Not only that, investors have grudgingly come to accept the central bankers’ message of ‘higher for longer’, pricing a Fed Funds rate of 5.28% in December, up strongly since the start of last month. This major revision of investor expectations has pushed yields up: US 10Y yields yesterday closed above 4% for the first time since November and the yield on German 10Y bunds are at their highest point since 2011. Meanwhile, the policy-sensitive US 2Y yield is at a high not seen since July 2007 and its German equivalent is higher than at any time since 2008. These moves have once again pushed the US yield curve to a new record inversion, now at its steepest in 42 years – an indicator usually understood to scream ‘recession’.
For all the hope of an ‘immaculate disinflation’ alighting on a soft landing, historical precedent always suggested the landing path from 2022’s soaring inflation was likely to be more akin to the precarious run into eastern Congo’s Walikale airstrip than a smooth descent onto the pristine acres of asphalt at Doha International. The latest data show the central bankers’ job is not getting any easier – and comforts us in our view that the descent path will be shallower and longer than previously hoped. It may also yet prove more turbulent. The risk of further upside inflation surprises remains. This could come from developments connected to Russia’s war on Ukraine but Europe’s largely successful response to drying up of Russian energy supply (helped, as previously discussed, by a mild winter) has largely drawn the sting from this threat. Input inflation could also draw on other sources. China’s post-reopening recovery seems to be gathering pace – putting a big new source of demand on commodities, including the Liquefied Natural Gas Europe has largely turned to in the absence of piped Russian supply. China’s manufacturing sector is ramping up. The country’s purchasing managers’ index hit 52.6 in February, the biggest expansion since 2012. Exports are returning to growth after the December slump. And, perhaps most importantly, domestic consumption appears to be gathering steam, judging by high-frequency indicators such as cinema ticket sales and urban traffic (the former already exceeds 2019 levels while the latter is at least in line with pre-Covid measures). Even the battered real estate sector looks to be moving onto surer footing, with new house prices up +0.1% MoM in February, the first monthly rise in more than a year. If this housing recovery gains strength, a host of hard commodities stand to benefit. One dimension of January’s risk-on market climbs was strong gains for Chinese stocks as investors piled into a China reopening trade – though this too reversed sharply in February, especially in the offshore category, as Hong Kong’s Hang Seng Index dropped -9.4%. Sentiment remains choppy, with big gains in recent days, as investors await the outcomes of this weekend’s ‘liang hui’ (two sessions) meetings of China’s ‘parliament’. Xi Jinping has promised ‘forceful’ changes to the government system, upping the Party’s (and his) direct control of financial and economic policy. The meetings will confirm Xi’s third term as state president (on top of the more important roles atop the Party and the military, confirmed at the Party Congress last autumn) while also installing a new top team across government portfolios. The weekend’s decisions will also shape the strength and direction of China’s economic recovery this year – and Western central bankers have said they will be watching. Both the ECB’s Lagarde and the Fed’s Brainard have noted the danger of ‘inflationary pressure’ coming from a resurgent Chinese economy that the IMF expects to grow +5.2% this year, contributing c.40% to total global economic growth this year.
Amidst what remains an uncertain macroeconomic outlook, we believe patience is merited. Inflation is coming down but by no means as quickly as previously hoped – and upside risks are still present. Rate hikes will continue into the next meetings – and perhaps even longer in Frankfurt. As such, we prefer to barbell fixed-income allocations on an inverted curve, coupling short-maturity exposure with long-end securities hedging what remains an elevated risk of inflation. We also see pockets of idiosyncratic opportunity elsewhere. The latest development this week in the seemingly relentless Brexit tale – ending customs checks between Northern Ireland and the UK on those goods destined to remain in Northern Ireland and securing Northern Ireland’s access to the European Single Market to avoid a hard border with the Republic – may be an encouraging signal for UK equities, that remain very cheaply priced. And a Chinese recovery that continues to ramp up offers numerous downstream opportunities, especially across emerging markets and commodities.
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