Sympathy for investors who piled into risk assets in the New Year is in short supply from many market commentators. There is a degree of schadenfreude that the January rally has been partially reversed.
Stock market investors had made light of central bank warnings over the stubbornness of core inflation and their determination to prevent inflation from becoming embedded in wage growth demands.
But equally surprising was the rally in Treasuries in January, despite the stubborn core inflation. It also seemed to ignore the Fed’s quantitative tightening (QT) program, as it shrinks its balance sheet by approximately $16bn a month.
Admittedly, both the Fed and the ECB fumbled in their respective press conferences after the last round of rate hikes. Crucially, Jay Powell of the Fed indicated that the recent rally in asset prices was not of particular concern -even though it was clearly helping support the ‘wealth effect’ and demand and loan growth. This gave hope to some investors that the terminal interest rate may be lower than they had priced in.
It now seems that we must wait a little longer for a sustainable bull market for stocks and credit. Perhaps until the second half of 2023…as we, and many other commentators, suggested in the New Year.
Then came the cold shower
Soon after the first February rate hike came the reassessment by investors, as economic data from around the developed world (even the U.K!) came in stronger than expected.
The most significant surprise to the bulls was January’s non-farm payroll data, showing half a million new jobs being created compared to expectations of a third of that number. Last week saw more data add to the picture of an ongoing tight labour market contributing to stubborn inflation.
Friday’s strong PCE inflation data (the Fed’s preferred measure), showed a rise in both headline and core inflation on a year-on-year and month-on-month basis. This followed lower-than-expected unemployment claims, relatively strong producer price inflation data and strong January retail sales numbers.
Bond yields have risen substantially in February*. The S&P500 is 5% down since its recent peak on 2nd February, while the tech-heavy NASDAQ is down 11% over the same period.
It is no surprise that tech stocks have been hit particularly badly, being ‘jam tomorrow’ stocks whose finances are particularly sensitive to borrowing costs.
European stock markets have fared better from the greater concentration of value (‘jam today’) stocks. These are less sensitive to interest rates. The FTSE 100 has touched 8,000 for the first time.
Why the schadenfreude?
At the end of last year, strategists at Goldman Sachs and JP Morgan asset management arms, amongst many others, were forecasting a difficult first half of 2023 for stocks and credit.
Interest rates would continue to rise against a backdrop of stubborn core inflation, aggravated by tight labour markets fuelling pay growth. A mild recession in the U.S. and the eurozone, and a deeper one in the U.K., would hurt corporate earnings and dividends. That remains likely, hence the schadenfreude.
The second half, in contrast, looks likely to be marked by a stabilising of interest rates. As the effects of tight monetary policy bear down on the economy, labour markets slacken and pay growth falls. A drop in core inflation allows for the Fed and other central banks to start cutting interest rates, perhaps from the end of this year. A new economic cycle then begins.
This scenario is unchanged.
The New Year rally was not loved by many investors. Its demise will not be mourned.
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*By 60bps on the 10yr Treasury, to 3.96% as of Friday’s close.
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