The last part of 2023 was characterised by a vigorous pricing-in of the ‘soft landing’ narrative – the view that the US economy will see inflation return to the Federal Reserve’s 2% target with growth slowing down rather than falling into a recession. The market’s estimate of how easily and quickly this could happen improved at that time, supported by better inflation data and the Fed’s own estimate of how much it would cut policy rates in 2024.
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The market’s assessment, however, went well beyond the Fed’s. While the central bank’s ‘dot plot’ forecast showed three 25bp cuts in 2024 were likely, futures markets pointed to six cuts (see Exhibit 1). We were always sceptical that the Fed would go quite so far.
The market’s relatively benign outlook (‘benign’ in so far as slowing growth is much better than a recession) appeared to turn into an outright positive one with the publication of fourth-quarter 2023 GDP data.
The first release (still subject to revision) showed the US economy expanding by 3.3% at an annualised rate versus the prior quarter. That was well above our estimate of the long-run potential growth rate of 1.75%. This is more a ‘Goldilocks’ scenario – that growth can remain steady or even accelerate, while inflation nonetheless continues to fall.
Goldilocks on its way out
The latest data has put paid at least to the Goldilocks scenario. The reversal began with US non-farm payrolls data which showed a much stronger labour market than most had expected. Subsequently, the January Services ISM (Institute for Supply Management) index came in above forecasts (53.4 vs. 52.0 forecast and 50.5 in December), with the prices paid sub-index notably strong.
The conclusion was that growth, instead of wilting under the burden of 525bp in policy rate increases, appeared to be regaining momentum, and that this would prevent inflation from slowing as quickly as had been believed, if in fact inflation did not actually start rising again (particularly given the renewed shipping bottlenecks in the Red Sea).
As a result, the market’s estimate of how many times the Fed would cut rates has changed. Fewer rate cuts are now priced in (see Exhibit 2).
Goldilocks’ departure stalls equity rally
The resulting rebound in real interest rates has had the predictable effect on equity markets (primarily via lower valuations for growth stocks): the rally has stalled.
The declines have nonetheless arguably been somewhat modest relative to the change in market interest-rate expectations. This is at least partly due to the broadly positive earnings news we have had from the current corporate reporting season.
With about half of the S&P 500 companies having reported (but only around 80 for Europe), earnings results have come in positive and better than expected. So far, reported earnings have risen by 2.1% in the US and by 0.3% in Europe, but excluding the energy sector, the growth rates jump to over 5%.
More importantly, better-than-expected results have been coming in, with positive earnings surprises of 6.2% for the US relative to expectations and 2.2% for Europe. While the figure for Europe looks somewhat low, it is much better than it has been for some time – in previous quarters, it has been negative (see Exhibit 3).
The soft-landing narrative is a function of growth and inflation and hence the risks to this scenario stem from data for these two factors not confirming the market’s expectations.
The risks for growth more recently have been that it is too strong, but given that the Fed’s policy rates are still high and restricting economic activity, growth will likely eventually start to slow. The risk will then be that it slows too quickly, particularly once the ‘excess savings’ of US consumers dry up. A sharp slowdown would likely see a decline in both bond yields and equity prices.
Inflation could yet prove more persistent than forecast. This could occur either because higher-than-expected growth pushes inflation back up again, or even if growth slows, structural factors could keep inflation above central bank targets for a while longer.
Looking at core personal consumption expenditure inflation (the Fed’s measure for its inflation target), it is currently running at 2.9% year-on-year – above the Fed’s target of 2%. In the decade prior to the pandemic, it averaged 1.6%, so the goal is actually higher inflation than we had historically (see Exhibit 4).
Looking at the components, core goods inflation is currently negative, though as mentioned, shipping bottlenecks could quickly change that. Services inflation is more than one percentage point above pre-pandemic levels, and one consequence of the strong labour market is that wage inflation is rising again (at least as measured by average hourly earnings).
Another worry is housing inflation, which is twice the previous rate. There is some comfort in that it makes up just 15% of the PCE index, as opposed to more than one-third of the consumer price index (CPI).
With policy rates high enough for long enough, inflation will fall, but the current year-on-year rates of some components illustrate there is still some way to go.
The conclusion, then, is that in contrast to the beginning of last year when pessimistic forecasts (happily) turned out to be wrong, investors today should be more cognizant of the risks that the current optimistic forecasts may (unhappily) turn out to be too sanguine.