Weekly market update – "This is a Good (US) Economy"

On the other hand, late last year, one of our senior analysts, James Hunter-Jones, insisted on adding a 'Dream' scenario to our forecasts. One where the economy would perform well, and still inflation would drop. We did and assigned an outlier probability to it.

Let’s see how James fared versus the world.

Last week the IMF increased its forecast for 2024, from 2.9% to 3.1%, mostly due to strength in the US and China, stating that the global economy is “surprisingly resilient”.

Let’s focus on the US, as it is the economy which leads the interest rate cycle and affects global growth and inflation.

On Wednesday, Fed Chair Jay Powell said: “The labour market is strong ... We've got six good months of inflation data and an expectation that there's more to come … Let's be honest, this is a good economy”.

On the back of that resilience, US non-farm payrolls, one of the key indicators for US interest rates, literally blew past expectations in January, suggesting that the US economy added more than 300 thousand jobs in the month.

PMIs also suggest that the manufacturing sector may have bottomed out, with all countries bar Russia improving in January.

As expected, year-end bond-market rate expectations for the US Federal Reserve moved closer to earth, from 6.5 cuts to 4.7 cuts as investors realised that the US economy is probably going from 'soft landing' to 'no landing' at all.

Economic strength, we could argue, would undermine rate cuts as inflation may rise. However, this may not necessarily be the case, for various reasons:

I)                 Headline inflation was strong in the first few months of last year. So, if inflation pressures remain benign, the number would still continue to drop due to base effects.

II)               Indeed, average inflation in the past six months has been benign.

III)              Meanwhile, core inflation, the Fed’s preferred gauge, is still dropping.

So this is indeed a good US economy. Not necessarily a healthy one, as we will show, but a good one. Inflation is receding at a healthy pace, growth is close to long-term averages and the labour market is strong.

The Fed didn’t manage a soft landing. It managed a perfect, Sully Sullenberger, landing.

What did most of the analysis world get wrong (bar James that is)?

Well, the answer is surprisingly simple. Debt. The Treasury of the world’s biggest economy didn’t want to enter an election year in a recession. So it ran a high deficit and boosted the economy, in hopes that consumers would not go on a spending binge and stoke inflation. After all, incentivising new factories in the Rust Belt to boost growth may not have the same effect as sending cheques across the nation.

Meanwhile, acting quickly, the Fed avoided 'he inflation mindset', i.e. the secular increase of consumer expectations for inflation, which can become inflationary by itself. Consumer expectations for inflation are indeed coming down.

So, in this environment, the Fed is now saying it will perform three cuts this year, and qualifies this statement by intoning that the fight against inflation can’t be considered won yet.

What does it all mean for investors?

For one, we will not be fighting the Fed, whose 2024 policies are becoming clearer by the day. If they say ‘three cuts’ we are likely to believe them. We also stick to our guns that cuts might come later in the year, as the Fed is wary of cutting “too soon” according to its chair. Additionally, we are now looking hard at the debt world once more. This may be a good economy, but it was likely purchased at the expense of a future economy. To be sure, some of the debt incurred is 'good debt', the kind that fosters higher growth. But at these high levels, any debt is precarious and has implications for long-term investors, even if it is in the world’s reserve currency. At this point, we should add that neither presidential candidate in the US is too excited about fiscal discipline. It is, thus, not outside the realm of possibility that credit agencies might once again warn investors about rising US debt. According to the IMF, the number could be as high as 137% of GDP in four years, higher than the 133% at the height of the pandemic, a time when GDP collapsed.

Debt to GDP is a very difficult number to bring down. In the last fifty years, only President Clinton managed to reduce it, by less than 10% in the five years from 1996 to 2001 (last year was technically George W. Bush’s year, but it’s safe to say that it was Clinton’s policies which were still affecting the economy).

As a result we stand by our earlier predictions, that investors should not be strategically piling over each other to obtain higher yields. At these debt levels, and given the Fed’s determination not to return to the zero-rate world and avoid secular yield suppression, we would expect long-term yields to remain well above the zero-rates we saw last decade.

As for equities, we are still cognisant of the fact that the bond market continues to price in two more cuts than the Fed has said it will perform and that US large-caps are trading 27% above their 30-year average, led by a very narrow band of stocks.

This may be a good economy, and possibly a good market, but neither seems balanced. Market expectations are still manifestly ahead of economic realities. And this is the key for investors going forward. Lack of balance means that risks abound. For inflation, this is more the case, as geopolitical tensions continue to disrupt global trade and threaten a third wave of price hikes, which would probably delay rate cuts. And let us not forget that the economy in Europe and the UK is much weaker.

To be sure, investors need not wait for the world to balance. It will probably not, and that’s not a bad thing for portfolios. Lack of balance exacerbates differences in world views, and that in turn creates opportunities and markets. Instead, investors need to make sure their advisers understand this world, and how to turn risk into opportunity and generate 'alpha' for their portfolios.

George Lagarias – Chief Economist

Market update

Last week, global stocks rose by +1.3%, with mostly positive results across regions. US stocks rose by +1.9% in spite of fading hopes for swift rate cuts, as tech giants Apple, Amazon and Meta reported strong results. Japanese stocks also performed well with a return of +2.1% on the back of strong corporate earnings, while European and UK stocks underperformed, returning +0.4% and -0.3% respectively. Emerging market equities improved by +0.8%.

The US 10-year treasury yield decreased significantly over most of the week as markets weighted guidance provided by the Fed and the US Treasury, but rebounded partially following a much stronger than expected jobs report. Overall, yields decreased across regions as the US 10-year yield closed at 4.15%, down 12 basis points, the UK 10-year gilt yield fell by 7 basis points to 3.98% and the German 10-year bund yield fell by 3 basis points to close at 2.24%.

Oil retreated by -6.9% over the week as concerns over supply disruptions in the Middle East eased. Ongoing concerns over China’s economic recovery also weighed on demand.  

Macro news

The latest non-farm payroll jobs report indicated that 353k new jobs were added to the US economy in January, blowing past expectations of a more modest 180k jobs, as labour markets remain tight by historical standards. The latest jobs report was good news for US President Joe Biden, who seized the opportunity to promote the resilient labour market as evidence that “America’s economy is the strongest in the world”. While the strength of the jobs report may be good news for the incumbent President, who is attempting to strengthen his popularity with US voters on the economy, the defiance of an expected slowdown in the jobs market has stoked fears of a resurgence in demand-led inflation.

Central bankers continue to adopt a somewhat cautious tone to rate cuts. Notably Jerome Powell, Chair of the US Federal Reserve, pushed back on the possibility of March rate cuts last week, sacrificing policy flexibility in favour of delivering a strong message. However, rate cuts remain firmly on the table for this year, with Powell highlighting the significant majority of the members of the Federal Open Market Committee expect three rate cuts by the end of the year, in an interview with CBS.

The week ahead

Markets will be looking for further indicators of US economic resilience this week via the ISM Services PMI data, which will provide further information on the current demand and inflationary pressures impacting the US services sector. Meanwhile, the OECD will be publishing their biannual report on the global economic outlook, indicating their views on global economic growth for 2024, as well as significant risks for the economy moving forward.