On Tuesday 7th March, the Chair of the US Federal Reserve (Fed), Jerome Powell, warned that US interest rates will probably have to be raised “higher than previously anticipated”.
Good news is bad news?
Despite the second most aggressive series of interest rate rises in history (see chart below), the resilience of the jobs market and rebounding consumer confidence jeopardise the Fed’s mission to bring down inflation.
As I alluded to in the latest monthly outlook, we are in a world where good news is bad news and vice versa. This is because markets interpret positive economic data as a sign that the Fed will have to stay aggressive in its war on rampant inflation.
Following Powell’s speech, equity markets in the US and Asia fell, the US Dollar strengthened, and government bond yields ticked higher. These movements are a result of markets attempting to anticipate and price in a new, higher, terminal interest rate for the US and, importantly, how this impacts relative valuations of financial assets around the world.
The chart below shows that an additional 0.50% of interest rates rises has been priced into markets since the end of 2022. The dotted green line shows market expectations for the path of interest rates as at 31st December 2022 and the beige line shows the same on Friday 3rd March:
Why have markets wobbled in February?
One of the key positive market narratives has been that the Fed will be victorious against inflation and that it will, therefore, be able to stop raising interest rates in mid-2023 before immediately starting to cut them again. We believe that the strong gains we enjoyed from October to January were a result of hope being pinned on this outlook and may well turn out to be a classic bear market rally.
However, the beige line in the chart above clearly shows that the market no longer believes this prediction will materialise. Instead, the terminal rate is higher and interest rates remain high for the whole of this year. According to the latest market view, the Fed will only be able to cut interest rates in early 2024. If this is correct, the this means more downward pressure on both bonds and equities for the remainder of this year.
Regular readers will know that we have been cautious for some time and that our view is that the US will enter a recession at some point. This view has not changed but, instead of expecting the onset to be around the middle of this year, the unusually robust jobs market, and other economic data, means that we now expect this towards the beginning of 2024.
If we are correct, then we concur with the market expectation for the path of interest rates as we would expect the Fed to cut interest rates in a recession to stimulate demand.
What about the “soft landing” narrative?
More bullish market participants believe that the Fed will be able to tame inflation without inflicting a recession on the economy. This has been dubbed a “soft landing”. Whilst this is, in theory, possible, maintaining economic equilibrium will be incredibly challenging.
There is an old adage in investment circles, “don’t fight the Fed”. Perhaps clinging to hopes of a soft landing is indeed fighting the Fed, who have been explicit that they will be unfaltering in their mission to bring inflation down. Looking at inflation numbers, headline inflation certainly looks to have peaked. However, core inflation (which doesn’t include some more variable items) is still nowhere near the Fed’s long-term 2% target, and is well above the month-on-month rate to reach the Fed’s own forecast of 3.5% by the end of the year:
Furthermore, the bond market is signalling its expectations of a recession loud and clear in much of the developed world. In the US, the government bond yield curve is the most inverted it has been since the 1980s (an inverted yield curve is where investors demand more income to hold shorter dated bond than longer ones to compensate them for the risk of holding the bond through a coming recession):
Whilst we could be accused of confirmation bias, the messaging from both bond markets and the Fed gives us some comfort .
So, how will this play out in portfolios?
We think our relative caution is warranted, and we have been warning of continued market volatility for some time. I would like to reiterate that message now:
Bond and equity markets are likely to remain volatile until we see either a sustained fall in inflation, or a recession. As I have mentioned before, markets are forward looking discounting machines which attempt to value in today’s prices what cashflows will look like in 12-18 months’ time. If our view is correct then equity markets have not adequately discounted recession.
Whilst this might mean downside from here, we do expect the US recession to be quite short and mild. Therefore, equity markets should find a bottom quite quickly, then start to price in economic recovery, which would be good for equity prices.
Bonds, on the other hand, represent good value in our opinion, particularly UK issues. Whilst income yields might rise a bit further over the coming period (meaning falling prices), the risk reward profile of most types of bonds is skewed to the upside from here.
Light at the end of the tunnel
Whilst 2022 was a year to forget, 2023 looks as though it will be just as treacherous. Whilst we don’t expect portfolio losses of the magnitude of last year, we do expect a roller coaster of a ride. Having said that, as time goes on, we move closer to the light at the end of the tunnel and the outlook becomes slowly brighter.
Until next time, stay well.