The new year stock market rally ran into the sand last week. The reality of weakening growth and hawkish talk from central banks are biting into investor sentiment.
Tight labour markets in the major economies remain a cause of sticky core inflation. Corporate earnings are under severe pressure from inflated input costs and reduced demand. China is re-opening, bringing risk to global inflation. Also, in Asia, the surely inevitable abandonment of the Bank of Japan’s yield curve control (YCC) policy threatens to lift bond yields everywhere, with unpredictable consequences for financial markets and the global economy.
Strong labour market frustrates the Fed
The news included weak U.S. retail sales and New York state manufacturing data, signalling to many economists that a recession lies ahead. Another closely-watched leading indicator of recession, the spread of 10yr Treasury yields over 2yr yields, is firmly in ‘recession ahead’ territory, with the spread inverted at 0.7%.
Meanwhile, last week, central banks, ever keen to burst a stock market rally that threatens to stoke inflation (through the wealth effect), warned investors not to underestimate their resolve to bring inflation down to 2%.
Lael Brainard, the vice-chair of the Fed, said, ‘inflation is high, and it will take time and resolve to get it back to 2%…we are determined to stay the course’.
The Fed is targeting wage growth, which is a key contributor to core inflation and is still rising monthly. To bring down wages, the Fed wants to see a rise in unemployment. But last week’s initial jobless numbers illustrated the continuing tight labour market conditions: claims fell to 190,00 in the week ending 14th January, from 250,000 the previous week and compared to forecasts of 214,000.
In the tech sector, earnings announcements have been overshadowed by the announcements of large job losses at tech giants Amazon, Alphabet Microsoft, amongst others. This brings to 200,000, the estimated number of lost tech jobs over the last twelve months. Yet such is the demand for I.T. staff across the country, that sacked staff are quickly re-hired elsewhere.
Christine Lagarde promised delegates at Davos that the ECB would ‘stay the course,’ and suggested -rather chillingly- that investors might want to ‘revise their position’ on the outlook for Eurozone interest rates. The market now anticipates two further 50bp rate hikes.
Also at Davos, Jamie Dimon of JP Morgan warned of a U.S. recession to come and of market wishful thinking that the Fed will stop rate hikes at around 5%. Nicolai Tangen of the Norwegian sovereign wealth fund warned of a possible severe inflationary shock coming from the re-opening of China after the government lifted Covid-19 restrictions. Industrial commodities prices, such as coal, copper and iron ore, are buoyant thanks to improved Chinese demand.
And then there is Japan
The Bank of Japan (BoJ) surprised markets by continuing its yield curve control (YCC) policy, which keeps 10yr government bond yields below 0.75% through massive purchases of the bonds on the open market, i.e., by quantitative easing.
Investors breathed a sigh of relief. But there is an increasing sense that we are on borrowed time, especially after Friday’s core CPI came in at a robust (for Japan) 4% year-on-year.
The YCC has contributed to a weak yen in recent years, supporting exporters and fuelling inflation. Indeed, the policy’s stated objective is to rid the country of the scourge of deflation.
But many in Japan fear it has done this too well, and the central bank is under political and popular pressure to end its YCC. This will allow bond yields to rise, the yen to strengthen and inflation to fall.
The impact on global financial markets could be dramatic if the BoJ abandons YCC. A stronger yen will negatively affect the large exporters that dominate the Japanese blue chip stock markets. Increasingly attractive Japanese government bond yields, coupled with a stronger yen, may lead to higher yields on U.S. and European bond markets as borrowers compete with Japan for investors’ money.
With core inflation now above the BoJ’s 2% target for the ninth successive month, the central bank’s YCC policy looks increasingly redundant. But ending it is fraught with danger for investors everywhere.
When will the bear market rallies end?
We will continue to see bear market rallies in risk assets over the coming months. A sustainable rally, i.e., the start of the next bull market, will only start when central banks are convinced that core inflation has not become an embedded problem. This will require breaking wage growth, which will require weaker economic growth.
It will also require no inflation shock from China’s re-opening and no surprise tightening of monetary conditions arising from Japan abandoning its YCC policy.
Investors should remain invested, possibly taking advantage of volatile conditions over the coming months and preparing for the inevitable upturn of the next economic cycle.
When might that be? Perhaps in the second half of the year. Amongst the poorly received economic data, last week was a pleasing report from the IMF. Its economists are not as gloomy over the outlook for global growth in the second half of this year and 2024 as they were at the end of December, thanks to weaker energy prices.
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