CIO Richard Madigan assesses the current state of the economy and markets—and shares how we are positioning portfolios now.
Market Thoughts: A glimmer of hope
- Central banks continue to reinforce their commitment to taming inflation. They can’t afford to sound dovish; they don’t want markets melting up. Doing their job gets harder ahead.
- Markets reflect a softish landing, a hard landing is not priced in. While a hard landing isn’t our base case, it’s not a zero probability. It isn’t time to be chasing after markets.
- Investors are looking through higher policy rates. We’re close to central banks readying to pause rate hikes. We still have quantitative tightening to get through.
- Policymakers are attempting to slow demand, and by extension growth, to regain control of still too high inflation. It’s working.
A glimmer of hope is the narrative currently seized by markets. We continue to see positive news both on inflation as it trends lower and global growth, which remains better than feared. That’s good news for the soft landing crowd, bad news for recessionists.
China’s move away from zero-Covid is adding to confidence. Their reopening lends support to global growth, which continues to slow. It’s constructive for Asia from an economic perspective. It’s also beneficial for global trading partners as well as multinationals that source demand from the region.
A reawakened China makes the job of central banks a bit more challenging. They’re ramping up demand, with commodity markets the first to react. That may keep headline inflation higher for longer than policymakers like. The re-opening of supply chains can help balance out that reflationary pulse, specifically as it relates to global input costs and trade.
With labor markets and wages stable, consumption will likely see support from lower inflationary pressure and savings rates returning to trend (Figure 1). While excess pandemic savings are being spent down, they’re at levels that remain supportive of a slowing, not breaking, economic backdrop.
Figure 1: Global inflation has likely peaked
Line chart of Advanced Economies (AE) headline and core consumer price indices (CPI) shown on a year-over-year (yoy) percentage change basis (y-axis) through December 2022. Monthly data points are displayed since 2011 (x-axis). Headline and core CPI are calculated by averaging the relevant CPIs of 22 advanced economies, weighted by each country's share of total nominal GDP in 2015. Prior to 2021, core inflation as shown was hovering around or below 2%; but starting in 2021, a marked inflation increase occurred, with both headline CPI reaching a high of 8% and core CPI at around 5% in October 2022. However, over most recent couple of months both headline and core CPI declined from peak levels, which may indicate a downward inflation trajectory.
“I want to take you higher” is the song playing in the background for central banks as they push rates higher. Their challenge remains guidance about what comes next. Both the Federal Reserve (Fed) and European Central Bank (ECB) continue to reinforce their commitment to taming inflation. They also need to acknowledge inflation is moving in the right direction without sounding dovish. They don’t want markets melting up.
In a January interview, Larry Summers emphasized policymakers need to maintain maximum flexibility. The phrase he used I found particularly grounding was to acknowledge central banks are “driving on a very, very foggy night.” I couldn’t agree more; they still are.
I continue to take both the Fed and ECB at their word. I’m anchoring on a terminal policy rate target for the Fed of around 5-5.25% by the end of the second-quarter. For the ECB, those numbers are 3-3.25% (Figure 2). Each central bank will continue to maximize policy optionality. Doing their job gets harder from here. Policymakers will soon pause rate hikes. That doesn’t mean they’re done hiking.
Figure 2: Major developed central banks continue with rate hikes
The fact that the difference between 10-year and 3-month U.S. government bond yields turned negative last October was noteworthy. I keep a close eye on that part of the bond curve to signal increasing market concern of recession. So does the Fed.
Term structure inversion has only deepened since. The tea leaf reading of that inversion falls squarely under the umbrella of choose your own adventure. Investors remain spilt on whether it’s signaling good or bad news. That tug of war is likely to continue.
For optimists, bond curve inversion indicates a Fed artfully walking the line of tightening policy rates while avoiding a hard landing. I share that view as a base case. It feeds into why we are neutral equities. Also, why we hold positions in high yield and investment grade credit.
If the U.S. Treasury curve inverts further, markets will likely anticipate the Fed is pushing the economy into a hard landing. While the difference between 10-year and 3-month interest rates may be the best predictor of a recession, historically it has told us very little about how soon a recession will happen or how severe it will be.
On average (note my qualifier), once term structure inverts a recession tends to follow about a year later. The size of the inversion provides an indication of how worried investors are about the economic outlook. It’s a good read on sentiment but its neither predictive of the severity of a recession, nor as important as the inversion itself.
A failure to communicate. “What we’ve got here is failure to communicate.” That line is from the movie Cool Hand Luke. It was said by Captain as Luke is given a hiding. I thought of it as I continue to watch investors battle the Fed and ECB on their “we’re all in” on tightening narrative. The key question… is the market Luke or Captain?
“Don’t fight the Fed” is a truism on Wall Street. And yet, the reality is an artful central bank wants the market to do the heavy lifting for it, especially when it comes to rate hikes. Investors are having none of it, they’re pushing back.
Markets want to be done with last year, quickly moving on to a more normal environment. “Buy the dip” was fun and simple, especially with easy money acting as the foundation for risk taking. Easy money is over. The cost of capital is rising and in my mind, risk premia don’t reflect the challenges ahead.
That is unless you believe the Fed is getting ready to pause and that they will cut rates this year. Investors hope the Fed believes—as they reach +5% on policy rates in the coming months—they’ve overshot. Maybe, but labor market strength and lessons learned from the 1970s give them the impetus to hike further. Then, to hold policy rates higher for longer. Hope is never a good investment strategy.
Valuations across risk assets reflect a softish landing. A hard landing isn’t in current market pricing. And while a hard landing isn’t our base case, it’s not a zero probability. That leaves us not wanting to over-reach for risk. Markets have run fast and furious, we’re due a breather.
Ultimately, a market is worth what someone is willing to pay for it. With some of the worst fears coming into this year ostensibly abating, investors are hungry to embrace risk. I chalk that up to human nature. Greed may be good, but it can prove short-lived.
I’m looking through you. The Beatles’ “I’m looking through you” is the current market theme song. If there’s a surprise ahead it may be that the current inflation, tightening and risk asset repricing cycles run longer than imagined, not breaking the global economy. We seem to be heading in that direction.
Markets, reinvigorated by risk-on sentiment, are looking past higher policy rates. The basic view is we’re closer to central banks being done with raising rates. Improvements in supply chain bottlenecks, a continued decline in both headline and core inflation and a slowdown in housing, retail sales and production are contributing to the feel good sentiment.
It’s interesting to watch the push and pull on sentiment. As it relates to central banks having to pivot sooner, we’ve gone from bad news being good news to bad news being bad. Inflation continues to roll over. That should only accelerate as the lag in rents and housing begin to weigh more directly on the pace of disinflation. That’s good news.
The bad news? Investors are rightfully reacting cautiously to falling growth. In the current environment, you can’t have disinflation without a decline in growth, as well as weaker wages and labor markets. Central banks are attempting to slow demand, and by extension growth, to regain control of inflation. It’s working. Hopefully what we’re seeing doesn’t prove to be transitory disinflation. Markets suffered enough last year at the hands of transitory inflation.
Slower economic growth begets slower top-line revenue growth. Margins in the U.S. remain above long-term trend levels (Figure 3). I expect we will see margins mean revert, moving lower. Layoffs are likely to continue. In aggregate, they’ve not yet been alarming. As headlines, they make for bad news.
Figure 3: U.S. corporate margins remain elevated
Staying the course. I’d characterize the earnings season we’ve just come through as good enough for equity markets to remain supported. That said, valuations in the U.S. are moving farther away from concern of recession. U.S. equity markets may be well below peak, but they’re not cheap.
We’ve been adding to European equities, funded from the U.S. I view that shift as defensive repositioning with upside. Europe is attractively valued both to its own history as well as relative to the U.S. In a broad market pullback, I expect Europe’s lower valuation to provide lower down-capture relative to the U.S. Should the global economy continue to surprise positively, Europe offers an opportunity for further re-rating.
European top-line and earnings growth are outperforming U.S. companies. Sectors in Europe we are focusing on include consumer discretionary, specifically luxury where consensus still seems to be underestimating earnings growth thanks to China’s reopening. In addition, we favor consumer staples with a focus on beverages. European banks continue to surprise positively as well.
We retain an overweight in portfolios to extended and investment grade credit, including European companies. We added to longer maturity bonds last year as rates pressed higher. We’re currently neutral duration. With yields higher, bonds can again serve as a diversifier of portfolio risk. They’re also adding carry, via higher interest rates.
I want to ensure portfolios are in a position that allows us to stay in the game if markets continue to press higher. Should we see a sell-off, we’ll quickly pivot, leaning into the pockets hardest hit. We’re staying the course in the overall level of risk we’re taking. We’ll undoubtedly see opportunities ahead, we always do. They tend to appear when least expected.
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