2023 has been quite a year already. When we look at trends and expectactions, it’s clear to us that growth and inflation have both shown staggering resilience thus far.
In the US, core personal consumption expenditures inflation – which excludes the more volatile food and energy components and is among the Fed’s preferred inflation metrics – was up 0.6% in January, topping survey expectations. These expectations were looking for more moderation for the month.
And the latest incoming US data both on the inflation and the employment side triggered renewed fears of a prolonged rate-hiking cycle among market participants. In fact, the market consensus now agrees with the Fed on its ‘higher for longer’ narrative, pushing up the expectations of the peak in the federal funds rate from 5% at the beginning of the year to as high as 5.7%.
Admittedly, the reassessment of the near-term path of the US policy rate was fuelled by the revision of the seasonal adjustment factor for some inflation metrics, as it made the cooling of price pressures in the US economy look less advanced. On top of the fact that such adjustments can dramatically change investor perception of the state of the economy, it was clear to us from the outset that disinflation would not follow a linear path and that asset prices would be subject to considerable volatility along the way, driven by the oscillating relative dominance of inflation over growth concerns.
In this context, the most important aspect, in our view, is that the underlying trend is unchanged and continues to point southwards.
Pandemic supply issues vanish but challenges remain
As evidenced by the Global Supply Chain Pressure Index by the New York Federal Reserve, the pandemic-induced supply constraints proved to be transitory and vanished entirely, but those resulting from the intensified global geopolitical competition and the decarbonisation of the world economy remain.
What does that mean for central banks?
Fundamentally, Western central banks face two options: either to bring demand in line with structurally reduced supply, or accept higher inflation to support economic activity and capital formation to ease supply limitations gradually over time.
Our view, aligned with a recent finding by the Cleveland Federal Reserve – is that the Fed will settle for 3% inflation on average, but without admitting it. In fact, rigidly sticking to the existing 2% target would inflict severe damage on the US economy, as it would have to coincide with an unemployment rate of 7.4%, notably more than double the current rate, according to the Cleveland Fed’s model estimates. Such a scenario would not only constitute an inferior outcome, according to a welfare analysis presented in the corresponding working paper, but also be politically elusive at a time when we are approaching the next US presidential election cycle. It should also be remembered that the refinancing of record government debt further limits central banks’ ability to raise rates.
What about the European Central Bank?
In Europe, the European Central Bank (ECB) is confronted with a tougher dilemma, as the supply shocks have been more pronounced than in the US. Recent communications from policymakers suggest that European central bankers err on the side of caution, driven by what they want to avoid rather than what they want to achieve.
Philip Lane, a member of the ECB’s Executive Board, recently made some comments indicating that he sees the ECB’s policy reaction function remaining decidedly asymmetric, with inflation risks tilted to the upside. He shared the view that persistent overshooting of the inflation target increases the likelihood of inflation expectations becoming unanchored, which could trigger a wage-price spiral and thus be more damaging to the economy, as opposed to persistent undershooting, in which case a simple adjustment of monetary policy would be needed to deal with the situation.
Conclusion for investors: sometimes, rewards may far outweigh risks
Admittedly, February was a tough month for equity investors outside Europe, with market weakness permeating the fixed income and commodity space as well. Overall, however, markets have been remarkably constructive in adjusting to higher interest rates for longer.
From a market technical point of view, February represented a pause in what we have identified as a sustainable bull market in equities. Both positioning and market sentiment remain overly pessimistic and the amount of cash sitting on the sidelines remains high, which implies that the pain trade (i.e. market movement that would hurt most investors) remains up in the short term.
There is an increased likelihood that incoming economic data surprising to the upside could catch many investors off guard. Remember that in a market environment where gloom still reigns supreme, the upside potential is far greater than the associated downside.