The Goldilocks Scenario Continues
February 9, 2024
We started the year with new all-time highs for the S&P 500 and the NASDAQ Index. Equity markets are still repricing due to potentially lower interest rates, combined with continued economic growth. The recent economic data in the U.S. shows continued economic strength. The initial estimate of last quarter’s real GDP growth is 3.3% annualized, well above the 2.0% consensus. Real GDP is the growth rate adjusted for inflation. Nominal GDP cooled to 4.8% in the fourth quarter after averaging 6.1% in the previous two quarters and 6.2% in the previous year. The data confirms the signal from the Q4 GDP release that consumer spending continues to power the US economy. With both real growth and inflation well above the pace of the past cycle, the Fed will not be in a hurry to cut rates. We believe that the job market will weaken this later year and inflation will fall enough for the Fed to ease monetary policy later in the year.
- A Blockbuster Jobs Report
- Did We Already Experience a Recession?
- Inflation is Key
- What Will This Mean for Financial Markets?
- Equity Market Support
- China’s Post-Covid Slump
- Fixed Income is Attractive
- Rising Floor for Oil Prices
- Portfolio Positioning
A Blockbuster Jobs Report
The January U.S. Employment report came in well above consensus expectations, delivering a strong positive signal on labor market conditions. The improvement was broad-based across industries, with all sectors experiencing an acceleration in job gains last month. Moreover, the increase in the prior two months was revised up. Treasury yields jumped in response to the stronger-than-anticipated report with the yield curve bear-flattening as investors reduced the odds of an early start to the Fed’s easing cycle. Ultimately, the employment report confirms other recent data indicating that the U.S. economy is still resilient and that a recession is not imminent. Meanwhile, inflationary pressures are moderating. The core PCE deflator eased from 3.2% to 2.9%, slightly below expectations of 3.0%. More importantly, the annualized 3-month and 6-month growth rates of core PCE inflation, which Fed Governor Christopher Waller highlighted as important indicators in a recent speech, fell further and are both now slightly below the Fed’s 2% inflation target. Fourth quarter 2023 GDP data showed a “goldilocks scenario” combination of falling inflation and steady, broad-based real growth.
Did We Already Experience a Recession?
While many investors are still waiting for a recession to hit the U.S. economy sometime this year, the irony is that the U.S. economy might have already gone through a “near recession”. The U.S. economy was weak in the first half of 2022 after the post-pandemic boom. GDP contracted two quarters in a row and domestic final demand barely grew. This did not meet the standard definition of a recession, but that does not change the fact that during this period, economic growth was very weak.
Profit margins for S&P 500 companies declined sharply during the period, with a total contraction exceeding 11%. Historically, EPS margins usually decline by about 10-15% during recessions, so by this standard, the margin compression between 2022 and 2023 fits the typical profile of a recession. We also experienced a 30% correction in the S&P 500 Index in 2022, which is consistent with a typical correction during a recession. The only unusual thing is that unemployment did not rise during this period. So, perhaps we do not need to see much higher unemployment before we see lower inflation. The pace of U.S. disinflation will shape the macro landscape in 2024. As growth slows because of higher interest rates and less fiscal spending, inflation may undershoot, pushing rates lower than expected. Higher productivity and robust household balance sheets cushion the risk of another significant recession.
Inflation is Key
At the February FOMC Meeting the Fed decided to keep policy unchanged. The changes to the Fed Statement generally indicate that the Fed is preparing to move towards easing monetary policy. Specifically, the statement notes that “risks to achieving employment and inflation goals are moving into better balance.” Moreover, the reference to “any additional policy firming” was removed. Instead, the Fed reaffirmed its data-dependent approach, noting that incoming data, the evolving outlook, and the balance of risks will guide future adjustments to the policy rate.
Jerome Powell underscored that FOMC members are seeking greater confidence that inflation will sustainably reach the 2% target. Powell acknowledged that the inflation data has been “good,” but that more of this “good” data is needed to reassure policymakers that the job is complete. In other words, it is unlikely we will see a rate cut at the March 20th meeting, but we will likely get a rate cut at the May 1st meeting.
A potential surprise could be that the Fed waits until the back half of this year to start cutting rates, limiting near-term upside in Treasury prices and interest rate-sensitive equities, without changing the bullish endpoint. All in all, we remain positive on the outlook for risk assets, despite uncertainties.
We anticipate a growth slowdown this year, but we think it doesn’t necessarily have to trigger a severe recession because the Fed has a lot of room to ease policy. U.S. household and bank balance sheets are also healthy enough to withstand a period of income weakness without triggering a deflationary deleveraging cycle.
The global economy could benefit from two other factors. First, the economic sentiment and consumer confidence in China seems to have gotten so negative, that the government almost has no choice but to step up efforts to stimulate. Secondly, we have elections around the world this year, and politicians typically can’t help themselves but to either stimulate their domestic economy or promise additional stimulus if elected.
What Will This Mean for Financial Markets?
We remain positive on risk assets, and we think equity markets can move higher. However, we are likely to see several short-term corrections along the way. Geopolitical tensions can flare up at any moment. Even more likely are fears about renewed inflation pressure will cause corrections from time to time.
Although we believe central banks will cut rates, the surprise could be that this could happen later than the market now expects. Last month, the European Central Bank (ECB) poured a bucket of cold water on the idea of aggressive ECB rate cuts this year and indicated that it is premature to say when the ECB will cut rates. This was followed by Fed Governor Christopher Waller who said that any Fed easing “will be carefully calibrated and not rushed.” These comments caused bonds to stumble.
However, do not focus too much on what central bankers say, as this can change quickly as demonstrated by the rapid shift from Powell’s “higher for longer” stance to policy easing in merely six months. From a big-picture viewpoint, does it matter if the Fed cuts rates three or five times? Not really. In the end, both the stock and bond markets are anticipatory in nature, and prices will adjust ahead of policy actions. Therefore, a persistent drop in inflation is a far more important factor for financial markets than what policymakers are saying.
If the Fed starts to cut rates this year when there is no major financial crisis, but a robust labor market and strong consumer spending, it will be a truly exceptional event that could reduce, not increase, the odds of a recession.
Of course, there is no guarantee that the Fed will get it right, as it could misjudge the situation and hold rates too high for too long, which could inflict undue damage on the economy and increase the next recession risk.
Equity Market Support
Considering that the U.S. is likely to avoid a significant recession owing to robust household balance sheets, stocks can outperform cash and fixed income even amid a growth slowdown or even a shallow downturn. If, as we expect, inflation continues to decline quickly, Fed easing will pull bond yields lower. It will be critical that nominal GDP growth maintain some spread over interest rates as is currently the case. This will offer equities some protection even as nominal earnings growth comes under pressure.
A decline in the discount rate for corporate earnings can be a more powerful driver for equity prices than changes in earnings expectations. Most importantly, the earnings outlook is improving. Operating margins for the S&P 500 companies appear to be bottoming. In the past two quarters, earnings have been surprising to the upside.
Margins could come under some downward pressure as the economy slows this year. However, the downside for margins and profits is limited by strong productivity growth. And while pricing power has generally declined, costs have eased even more for many companies. As long as earnings growth remains positive as the Fed cuts rates, then there is a chance that investors will be able to “look beyond” the higher interest costs.
China’s Post-Covid Slump
While the U.S. market is hitting new highs, the Chinese equity market remains depressed with the CSI 300 Index falling another 6.3% in January. A weak export backdrop and persistently suppressed domestic consumption continue to constrain China’s post-Covid recovery. Depressed consumer and business confidence are visible in weak loan demand and capital investment. Unlike the U.S., China’s fiscal policy has tightened just when it needs to ease to revive the “animal spirits” required to reboot overall growth. Declining capital investment relative to available savings remains China’s most pressing and problematic economic imbalance. Weak aggregate credit growth is a major pain point for the overall economy with no money supply expansion in sight. Domestic conditions remain deflationary such that China is effectively exporting deflationary pressure globally.
Although China’s real estate sector suffers, the manufacturing sector remains an important domestic growth locomotive. The country’s continued capital deepening in manufacturing has kept the sector exceptionally competitive thanks to persistent cost advantages and relentless innovation.
The weak stock market has also caught the attention of the top leadership with China’s prime minister Li Qiang recently ordering authorities to attract long-term capital to stabilize the stock market. The State Council, as China’s cabinet is called, was briefed on the operations of the country’s capital markets, according to a report by Xinhua news agency. The meeting emphasized the need to improve the basic system of the capital market, improve the quality and investment value of listed companies, Xinhua said. Unfortunately, this is easier said than done. For equity market confidence to return, we would need to see looser monetary policy combined with a significant increase in fiscal spending.
And Beijing has taken some actions to prop up the economy and financial markets. The central bank’s balance sheet expansion is accelerating, while both the policy rate and reserve requirement ratios (RRR) have been cut. These measures are necessary, but not yet large enough to turn the economy around and reverse the badly damaged investor confidence.
This likely means that China will continue to be a source of global goods price deflation, which would be a positive for international bond and equity markets. Large cap Chinese tech companies seem attractive at current valuations, but the broad Chinese equity market is still trapped in a bear market, unless more forceful policy reflation is put in place.
Fixed Income is Attractive
Throughout the last decade, excess savings from Europe and China suppressed Treasury yields, probably by around 0.2-0.3%, if not more. Going forward, excess savings from Europe and China will only grow, given that Europe is in stagnation and China is trapped in a deflationary environment. Assuming inflation at 2% being the steady-state, this means that steady-state 10-year yields should be 3%, plus some term premium. We expect 10-year yields to fall back towards 3.5%. Of course, if we get a recession, bond yields could easily melt towards 2.5% or even below 2%. No matter how you cut it, investors should continue to overweight duration.
Despite the Fed’s cautious tone, falling inflation and a softening labor market should force the Fed eventually to cut rates, perhaps by more than what the market expects. Therefore, we like longer dated government bonds in global fixed income portfolios.
Rising Floor for Oil Prices
Counterintuitively, lower U.S. inflation supports oil demand by raising real income. China’s demand has now recovered to its pre-Covid trend. Looking ahead, low inventories and oil companies’ shareholders’ preference for cash flow over capital investment are supply constraints that put a floor under oil prices just as geopolitical conflict raises the risk of a supply shock.
We kept our portfolio tilts to the NASDAQ and Japanese equities going into the new year. As we do foresee that there could be a rotation in market favorites this year, we foresee that we will rebalance the portfolios in the near term. In fixed-income portfolios, we are currently neutral on duration, but we would use any corrections in the bond market to extend duration.
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