Market Musings: Reality check, phase two
In a past Market Musings, we flagged how we thought complacency had crept in and that optimistic markets were vulnerable to a ‘reality check’ from central banks around how long restrictive policy settings may need to be in place, and too optimistic in assuming inflation may effortlessly fade away and/or that the worst of the economic fallout had passed (see Are markets too complacent?, 31 January 2023).
Over recent weeks some markets have repriced, as per our thinking, but others continue to look at things through rose-tinted glasses. Bond yields have jumped up, particularly in the US, and the USD has recovered some lost ground. The still robust US labour market has challenged expectations inflation could seamlessly decelerate back down to the Fed’s 2%pa target. And in our mind, the detail within the January US CPI report confirms the increasingly services-driven inflation problem won’t go away any time soon. Unlike some risk markets, global policymakers are under no illusion about the challenges that exist. The US Fed and the ECB have lasered in on the need for ‘restrictive’ settings to remain for some time given the ‘long fight’ against inflation, while others like the RBA have hiked rates again and flagged the need to do more.
In our view, recent gyrations may be a taste of things to come over future months, with economies and markets set to enter choppy waters. While some markets (i.e. US interest rate expectations and the USD) have adjusted, we think there could be further to run given signs underlying inflation may be stickier than predicted, and with central banks looking to err on the side of doing too much rather than not enough given the longer term damage high inflation can cause. Indeed, the US Fed is a student of history, and based on its comments it wants to avoid repeating the mistakes of the 1970s when victory against inflation was declared too soon and policy was eased too quickly to support growth, enabling inflation to come roaring back. US 10-year yields tend to peak around the time and near the level the Fed funds rate tops out. With the US Fed set to hike rates further it looks too early to assume US yields have hit a ceiling, and that the USD rebound could peter-out .
Elsewhere, markets like equities and credit, which we believe have thus far underreacted to the renewed upswing in interest rates, could also face other macro pressures. In addition to factoring in a higher interest environment, over coming months we see rising odds asset markets may need to navigate a ‘negative growth shock’ as effects of the rapid-fire policy tightening delivered over the past year gain traction in areas like consumer spending, business investment and jobs, and this feeds into views about corporate earnings and solvency risks.
For financial markets what happens in the US is especially important. This is where we have focused our analysis, and signs US growth could slow materially over Q1 and Q2 are piling up. A range of forward indicators with long track records of picking major US turning points have deteriorated. The US Conference Board Leading Index is at its lowest level in nearly two years, a range of US yield curves are deeply inverted, and importantly the flow of credit is starting to dry up. Credit is the lifeblood of an economy. The latest US lending survey shows that standards (an indicator of future loan supply) have tightened substantially, and this has typically preceded a downturn.
We think the rubber could soon start to hit the road, with the view economies like the US will experience a ‘soft landing’ coming under real threat. Outcomes relative to expectations drive financial markets. In our judgement, the risks appear skewed to the US, and global, activity data hitting an air pocket and disappointing over late-Q1/Q2 as cost-of-living pressures and tighter monetary conditions take their toll. This would be inline with the usual seasonal pattern of the US/global economic data underwhelming consensus expectations over the middle of the year.
This supports our view that volatility could reignite as optimistic markets begin to crash up against the harsher economic reality. This is a backdrop that tends to weigh on risk sentiment, favours the USD, and creates headwinds for ‘high-beta’ currencies like the AUD and NZD. This time could be no different. Our analysis finds that the AUD’s and NZD’s positive correlation with US equities remains quite high.
Currency Strategist - APAC