Weekly market update – Runaway Bulls?

While the first week of 2024 saw a moderate pullback, overall sentiment remains bullish. So, what changed in the last two months? The answer, inflation came down faster than anticipated.

Investors, desperate for some good news after nearly two years of malaise jumped on the news and started pre-empting central bank rate cuts, ahead of the Fed’s December meeting. Just as most commentators, and possibly even traders, were expecting the Fed’s Chair to cut the party short and remind markets to be prudent, an anonymous internal survey (called the Dot Plot) suggested that the Fed wasn’t siding with caution, but with bullish traders. The Plot suggested three rate cuts for 2024, two more than it had three months before. Bond markets are now pricing in no less than six cuts for each of the major central banks and the S&P 500 is now trading back near all-time highs.

So, we enter 2024 considering whether we should run with the Bulls, wait on the sidelines, or bet against the market. While it is too early to answer that question, we need to think about the parameters that are going to help us determine the answer.

Question number 1: Will inflation fall below the 2% threshold and remain there, will it be volatile and trick us with a rebound, or will it slow down to 2.5%-3.5% and remain there?

We think inflation is indeed coming down but the way in which it comes down, and its volatility thereafter matter more than its present course.

The answer has vastly different policy indications. Only scenario A (a sustainable drop in inflation) would probably go some way towards justifying current market pricing. Scenario B (volatile inflation) would force data-dependent central banks, usually prone to err on the side of caution, to maintain higher rates. Scenario C (non-volatile but above-average inflation) would see moderate rate cuts, but still a rate cut pause above the r*, the natural rate of interest. Both B and C scenarios, which we presently favour, would cause some market correction from current prices.

Question number 2: Is the Fed inherently dovish?

Technically, the Fed is on the side of the economy. Until inflation, a tax on everyone is beaten, it has a high tolerance for risk asset volatility. However, in the decade following the global financial crisis, the US central bank has often prioritised volatility suppression over other economic goals, insofar as inflation would not become a problem. Traders and investors often jump on the slightest hint of a Fed Pivot away from a tight interest rate regime.

The experience from 2022 onwards suggests that the Fed is presently geared towards fighting inflation. If the Great Moderation (a long period of relatively stable macroeconomic readings) is indeed over, as we suggested this time last year, then we should expect two things: Central Banks more vigilant of inflation than of risk asset volatility, and the official end of forward guidance. In other words, this is not Greenspan’s, Bernanke’s or Yellen’s Fed. This is Volcker’s Fed.

What does it all mean for investors?

While we are positive that rates will come down this year, we presently do not share the market’s optimism that this will happen quickly and sustainably enough to produce double the rate cuts the Fed has suggested.

While we do attempt to answer the two key questions, we acknowledge that, in reality, we can’t be sure of the outcomes. The name of the game is still volatility. Following the pandemic, the world remains an unbalanced place. While a reasonable observer might argue that it has always been thus, we feel that the compounded effect of geopolitical conflicts, trade wars and the fact that this generation of supply chain decision-makers now knows inflation, creates a particularly volatile mix for the global economy. Thus, the range of potential outcomes is wide. 

To be sure, we don’t believe that 2024 holds a 2022-style retrenchment. Far from it. Bond prices have dropped significantly since then. Equity valuations, bar tech and telecoms are not that far from their mean. It is well within the realm of possibility that tech takes a break and allows other stocks to catch up.

But volatility is the enemy and risks abound. There are corners of the market, possibly still including some US banks, that could still suffer as a result of the steep rate hikes of last year. With central banks still somewhat hawkish, the safety net isn’t as wide and encompassing as in the past. Even if that wasn’t the case, Quantitative Tightening makes a sustainable equity rally very difficult.

George Lagarias, Chief Economist

Market update

The first week of 2024 saw global equities decline by -1.7% in GBP terms. Among developed markets, European equities suffered the most, falling by -1.9%. US equities also had a bad week, losing -1.5%. UK equities, however, performed relatively better, dropping by only -0.6% as services data was stronger than expected and mortgage rates decreased from previous peaks. Emerging market equities followed the global trend, decreasing by -2.1% in GBP terms, while Japanese equities fell by -1.1%.

Bond yields rose across the board as 10-year yields rose by 17 basis points, 23 basis points and 11 basis points across the US, UK and Germany respectively. 10-year yields now stand at 4.05% for the US, 3.83% for the UK and 2.13% for Germany.

The market reaction to the much anticipated jobs report on Friday was mixed, as US stocks and bonds moved sharply following the release, but showed almost flat returns over the trading day. Geopolitical events in the Red Sea appeared to affect market sentiment in many markets and saw oil rise by +3% over the week to $73.81 per barrel. Markets were closed on Monday in observance of New Year’s Day, while trading volumes were below average over much of the week.

Macro news

The US labour market was stronger than anticipated in December, with US employers adding 216k jobs to the economy. This was higher than the 170k jobs anticipated by economists, and market expectations for interest rate cuts by the Federal Reserve had been pushed back to May by the end of the week. However, the non-farm payrolls figure was only marginally above its six-month average of 192k jobs and this is by no means a clear signal that the US labour market will remain at the extremely tight levels we have seen over the last two years. Nevertheless, this stronger-than-expected data does also allow the Fed room to leave rates unchanged for longer in the event of continued economic resilience and/or a resurgence in inflation, highlighting the continued importance of data dependency when making rate decisions.

Meanwhile, more evidence of economic resilience could be found in the latest Global PMI data releases, with composite PMIs improving on a month-on-month basis, for both the US and UK economy. However, pockets of economic weakness remain clearly on display. The EU composite PMI remained unchanged, firmly in contraction territory at 47.6. The global manufacturing sector once again contracted in December, while services were somewhat more resilient. Critically, there are signs that economic weakness may be starting to bottom out in the manufacturing sector. Particularly in the hard-hit German economy, where new orders fell at the slowest rate since April 2023, although they remain firmly within contraction territory.

The week ahead

US consumer price inflation data for December will be released on Thursday this week. Market participants will be closely watching for evidence that the Federal Reserve, which adopted a more dovish tone in December, has room to accelerate its timeline for interest rate cuts. However, economists are currently anticipating a slight increase in headline inflation to 3.2%. Core inflation, which excludes movements in energy and food prices, is expected to have slowed slightly to 3.8%.