As we turn the page on 2022 and look with cautious optimism at 2023 for some respite in markets, investors are appraising the investment landscape with an understandable degree of trepidation. Indeed, following the macroeconomic and geopolitical events of 2022, losses in fixed income markets were on par with those in equities making it one of the worst years on record for balanced portfolios. Conflating this with the prospects of a global recession, the amplitude of which is yet to be fully appreciated, pessimism in markets has led investors to position themselves incredibly bearishly at the end of 2022. This was demonstrated by recent spikes in the Chicago Board Options Exchange Put/Call Ratio which went haywire in November before spiking to its highest level on record in December. This normally contrarian indicator might therefore be pointing to a significant regime shift and things might in fact not all be doom and gloom.
Let’s start with the good news. It seems, inflation has likely peaked and is expected to fall materially this year. Looking at the data in the US, the contribution to headline Consumer Price Index from prices of goods has come right off, as the supply and demand shocks from the global pandemic recovery have dissipated. In addition, commodity prices have fallen significantly from their peaks in 2022, some to pre-invasion levels. The one thorn in the side is core inflation, which strips out food and energy prices, and is expected to remain sticky, in part due to a resilient labour market (low unemployment and unwavering wage growth) coupled with a robust consumer.
Turning to monetary policy the US Federal Reserve (Fed) has already hiked rates to a range between 4.25% and 4.5% with expectations for terminal rates at around 5%, so arguably, the majority of hikes have already been priced in1. Monetary policy operates with a lag, with services, jobs, and inflation being in general the last to respond to policy impulses. However, the early effects of last year’s tightening on activity and inflation are clear. Growth in the US is cooling as illustrated by a raft of economic data. In fact, the latest flash Purchasing Managers Index’s for January, while showing a slight improvement from December, still indicated a seventh consecutive month of contraction in the private sector. The one outlier is the strong US labour market, but even there we are seeing signs of weakness starting to materialise. High frequency indicators are flashing recessionary signals as evidenced by the growth over the last six months of weekly jobless claims. Additionally, looking at the rate of change of the (admittedly high) job openings over the last six months reveals a clear contractionary trend. Qualifying all of this with the decline in hiring intentions, as suggested by the National Federation of Independent Businesses survey data, one can only expect an imminent cooling in the labour market. This would vindicate the market pricing of a Fed pivot as illustrated by the Fed Funds futures and the Fed dot plots. However, risks remain as the Fed will absolutely want to regain credibility after previously beating the ‘transitory-inflation’ drum for so long and in doing so, will tolerate an economic slowdown and higher unemployment to bring inflation down to its 2% target.
So, how have markets reacted? Focusing on valuations, these have rerated substantially last year with equity markets having returned closer to their long-term averages and bond markets now offering attractive yields without the need to take on significant interest rate or credit risk. Interestingly, strongly inverted yield curves are signalling an imminent recession, but credit spreads aren’t pricing this in at all. What the higher yield levels do afford is a greater degree of reassurance as investor bearishness has been baked-in to prices, effectively discounting a substantial level of downside potential. Similarly, whilst equities aren’t yet discounting a significant earnings recession, we can perhaps take comfort in the realisation that last year’s equity market drawdown was exclusively driven by multiple contraction resulting from higher interest rates, whilst earnings growth remained positive. Given markets imply we are about 50bps from peak rates in the US, we can therefore reasonably expect a mild earnings recession to have a less dramatic effect on markets, especially if the outlook is more positive for 2024. Finally, if we consider a best-case scenario where fixed income markets are right and we do see a true Fed pivot this year, we could then reasonably expect a reversal of the multiple contraction seen last year.
Wishful thinking? Perhaps, but investors should turn away from the glass-half-empty approach and instead take solace in the fact we are entering a new regime where government bonds are offering positive ‘risk-free’ rates once again. Whilst a mild recession seems the widely expected outcome this year, markets have repriced closer to fair value (with some cheap valuations in areas) hence, we are starting the year from a more attractive base to generate long-term returns. Something positive to look forward to, then, amongst all the doom and gloom?
Source: 1Federal Reserve 14 December 2022. Unless stated, all data from Bloomberg Finance L.P.