Last week we saw a blizzard of financial and economic data. Much of it is supportive of risk assets. But the week ended with a sour taste in the mouth – does the good economic news, especially strong labour market data, mean that investors’ expectations for interest rates peaking over the coming months are wrong?
If so, stock and bond markets may be ahead of themselves and due a correction.
There are too many contradictory signals to be confident that interest rates are about to peak and that a fresh global economic cycle will start later this year.
For example, U.S. unemployment is at a record low, threatening to create a wage-price inflation problem. So far this year, an 8.2% rise on the S&P500 has coincided with a fall in corporate earnings, pushing (already high) valuations still higher. And in fixed-income land, we see a highly inverted Treasury yield curve. This has, in the past, been a good indicator of an on-coming recession.
The economic data was broadly supportive
New IMF GDP growth forecasts suggested that the U.S. and Euro zone will avoid recession this year. In part because of lower-than-expected European gas prices, the re-opening of China and the continued strength of labour markets despite some of the sharpest increases in interest rates in the developed economies in history.
Of the major economies, only the U.K. is expected to suffer two consecutive quarters of negative GDP growth this year.
The Fed, ECB and the Bank of England raised interest rates and warned of the continuing risks of core inflation remaining stubborn this year if wage growth did not moderate. If this was meant to warn investors that interest rates may yet surprise on the upside, the message was undermined by the heads of the Fed and the ECB at their respective news conferences. Both indicated a more dovish stance than that came with their announcements.
Global stock markets rallied on the combination of improved economic growth forecasts and the prospect of an imminent end to interest rate hikes.
Q4 corporate earnings growth is negative, but brushed aside
Meanwhile, fourth-quarter corporate earnings generally disappointed. Factset has calculated that, with half the S&P500 companies having reported so far, there is an average profit fall of 5.3% over the fourth quarter of 2021. The first quarterly fall since Q3 2020.
Big tech was a notable disappointment. Meta’s share price bounced on news that it was cutting its massive R&D spending in metaverse-related projects and would return $40bn to shareholders in the form of a share buy-back. This helped draw attention away from a 4% fall in revenue over the same period the year before and a below-estimates 55% fall in profits.
Apple recorded its first revenue fall in nearly four years, while both Amazon and Alphabet reported slow growth in advertising revenues and -along with so many tech companies this year- promises to reduce costs. But the NASDAQ sailed through the corporate earnings announcements, as did other stock markets, as the general risk-on sentiment helped lift all markets.
Some investors argue that the corporate earnings fall we are currently seeing was forecasted last year and is accounted for by the S&P500 falling a fifth in 2022. They are already priced in.
Strong earnings from Shell and BP helped take the FTSE100 to a new high at the end of Thursday. The index also benefited the Bank of England, explicitly suggesting that its cycle of rate hikes may be at -or close to- the peak.
The bitter lemon of non-farm payroll
But there was a sour taste in the mouth of stock and bond investors by the end of Friday, which followed much strong than expected January U.S. non-farm payroll data.
A staggering 517,000 new jobs were created against forecasts of 185,000. The unemployment rate fell to a record low of 3.4%. There was some moderation in wage growth, from 0.4% month-on-month to 0.3%, but the new jobs data suggests any complacency over moderating wage growth is premature.
Given that the Fed, ECB and the Bank of England have all emphasised the importance of bringing wage growth down, to anchor inflation expectations and to ensure a wage-price spiral does not become embedded, Friday’s labour market data was a bitter lemon for financial markets to swallow.
Confidence in interest rates peaking over the coming months has been shaken.
What is the inverted yield curve signalling?
Meanwhile, what to make of the inverted Treasury yield curve? The 10yr yield is currently 77bps lower than that of the 2yr.
Aside from a spell at 80bps last December, this is the largest inversion since 1981. Is it simply that bond investors share equity investor’s expectations of lower inflation and interest rates? Or are they pricing in a collapse in growth also? If so, corporate earnings will suffer, as will stock markets. Unfortunately, there is a high correlation between an inverted U.S yield curve and recession a year to eighteen months later.
Investors should continue to treat financial markets with caution. The outlook is murky. The next bull market may have begun, but they rarely start with record-low unemployment and the bond market predicting a recession. No wonder that this is unloved rally for many professional investors.
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