The surge in equities and fall in long-term bond yields in the first few weeks of January suggested that investors were buying into the idea of an ‘immaculate disinflation’ – that slowing inflation would be painless for growth in 2023. It sounded like ‘three cheers’ for central banks – notably the US Federal Reserve (Fed) – in the fight against inflation. More recently, though, markets have become erratic again.
Such volatility may well be due to investors facing a bewildering range of scenarios – immaculate disinflation, a soft landing, ‘goldilocks’, stagflation, recession. Given the divergent signals from markets and the economy, almost any of these scenarios could be defended.
Eurozone – Better than expected growth
As in December, eurozone business surveys surprised to the upside in January, particularly those covering Germany. Business confidence, as measured by the IFO, shot to its best level since June after three consecutive increases. Even so, the IFO index is lingering well below its long-term average and the IFO ‘business cycle clock’ is still indicating ‘crisis’.
Purchasing managers’ indices (PMIs) for the eurozone as a whole are sending a more optimistic message. The flash estimate for the eurozone PMI composite index rose to 50.2 in January, up by nearly three points from October, reflecting an expanding economy after six months of contraction. PMIs in France’s manufacturing sector and Germany’s services sector are showing the same pattern.
Industrial production in November exceeded economists’ expectations by a clear margin. Companies operating in energy-intensive sectors appear to some extent to have overcome the difficulties they faced at the end of the third quarter.
If these positive trends firm up, the eurozone could well escape recession in the short term.
Reasons for feeling good
So, what could explain the improvement in business optimism – and indeed also in household confidence, as shown by the European Commission’s survey?
For one thing, the global supply chain is returning to normal. The Institute for Supply Management (ISM) says “A fundamental shift started about six months ago. Certain components, like integrated circuits, still are impacting manufacturers’ ability to move goods. But, by and large, the pressure has eased.” This could explain the improved prospects for German carmakers, for example.
Elsewhere, lower gas prices in Europe, lower consumption in a (so far) relatively mild winter and high gas inventories at the start of 2023 should preclude energy rationing. This is likely to be reassuring for businesses and households.
What’s happening in China also matters. The abandonment of the zero-Covid strategy could curtail activity in the short term, but the reopening of the economy can be expected to increase global demand and relieve production and supply chain issues. A sharp acceleration in Asian economies could, however, lead to renewed increases in energy costs.
Challenges ahead for the US economy
US retail sales fell by 1.0% in November and by 1.1% in December, suggesting inflation is finally starting to drag on consumers. This could stretch into Q1 as momentum slows.
Regional Federal Reserve manufacturing surveys have been contradictory, with a sharp decline in the New York region and a rise in the Philadelphia Fed index. However, both indices were in negative territory. Industrial production fell by more than expected in December.
It would appear that the Fed’s rapid monetary policy tightening in 2022 (boosting rates by 425bp since March) to reduce core inflation to its 2% target is working through into the economy.
Which scenario to favour?
It is tempting to succumb to the sirens of the ‘ideal’ scenario in which growth and employment slow enough to bring core inflation down without plunging economies into recession.
However, our base case is – for now at least – more cautious. The (moderate) recession that is now threatening the global economy should not keep developed market central banks from continuing their monetary tightening, at least in the coming months. The pace of rate rises is likely to be less rapid though than it has been over the last six months.
In the US, the Federal Open Market Committee (FOMC) meets next week and futures markets have priced a 25bp rate increase. It would be helpful if Fed chair Jerome Powell’s comments after the meeting set clear milestones for the coming months.
The deteriorating economic environment is only slowly being reflected in companies’ earnings expectations, especially in the eurozone. Should bond yields decline in the coming months, it would likely support selected stock market sectors.
As a result, despite the geopolitical risks still present, we do not want to be too underweight equities. We are only slightly so, though we favour the Chinese and US markets over Europe ex-UK.
After the unprecedented losses and high volatility in bond markets in 2022, investors should consider returning to this asset class to take advantage of carry in a normalising rate environment. After years of ‘lower for longer’ rates, however, the transition to a new era in bond markets will not happen overnight.
Our allocation has a significant position in euro investment-grade (IG) credit. Here, we believe spread levels reflect overly high default rates given balance sheet strength for many companies.