09 Jan 2024
In previous guidance, Powell had focussed on the possibilities of further rate hikes, but whilst the Fed were meeting, the release of core CPI and PPI numbers clearly surprised them on the downside and Powell openly referred to Fed members revising their Summary of Economic Projections (SEP) numbers on the back of this. In the SEP, growth forecasts were upgraded, and core inflation forecasts declined evidence of supply side improvements. This is in line with a recent interview given to the FT by economist Claudia Sahm of the eponymous Sahm rule who believes a soft landing is ‘in the bag.’ The inference at the press conference was that the Fed also believes this to be the case and the Chair emphasised that it was now future rate cuts that were the focus of debate. The Fed also seem comfortable with the loosening of financial conditions which have occurred looking at the bond, equity, and currency markets. This should present a more favourable backdrop for investors as we enter 2024 with the headwinds of recent years dissipating for now at least. One word of caution is that the soft-landing scenario has now been priced in by markets to some degree, so if there is any adverse news, the market reaction could be unfavourable, especially with the S&P relative strength indicator at extended levels and the deviation from the 200 moving day average at +10%. The January employment data may also have an impact on markets.
Seasonal factors can continue to favour markets in the first quarter and there has been a strong pattern in recent years of markets moving earlier to discount economic and interest rate moves. In other words, markets are looking further ahead than in the cycles before the pandemic. This was seen in the first week in November as the markets quickly discounted peak interest rates and moves in yields, which had historically taken six months, occurred in a week. Equity markets had front run changes in Fed policy in November and December and may continue to do so unless and until there are disappointments on either the interest rate or earnings front. Markets are now pricing in a soft landing. Often in markets it is better to travel than arrive and this may be the case in 2024.
Markets are already discounting future monetary easing at an unusually early stage in the cycle and pricing in more rate cuts than the Fed dot plot chart in the SEP indicates as likely, which a soft landing would allow based on the Fed’s favoured indicator - the Taylor rule. In addition, markets are still factoring healthy profits growth, with consensus estimates for the S&P500 earnings at around plus 11% for 2024. The motivation or reasons for the rate cut(s) will therefore be important – at present the market is focussed on the driver being a decline in core inflation with the Fed not wanting to make policy more restrictive, as it does not want to tighten in real terms. This is a positive scenario for equities. If, however, rates are cut because the economy weakens, materially the outlook for equities (but not bonds) would be less positive. In the latter scenario for equities to remain relatively unscathed, there would need to be rapid rate cuts on a global basis but this would in all likelihood usher in a more challenging period for equity markets, especially in the context of the gains seen since the start of November.
All in all, the fall which has occurred in several inflation measures, with the latest PPI, CPI and PCE numbers all lower than expected, leaves the Fed in a less constrained position. The latest core PCE number released just before Christmas showed over the past six months the core PCE at 1.9% annualised, hitting the Fed’s inflation target. During the summer, the markets had feared policy would have to remain tight due to elevated inflation (higher for longer), driving the equity market sell off as both nominal and real yields rose. The December Fed meeting demonstrated this was off the table, at least for now, with the change in language and emphasis by Fed Chair Powell at the press conference very explicitly in favour of the soft-landing outcome.
The ECB met shortly after the Fed and the language here was far more hawkish. The markets have taken the view that the Fed will act before the ECB with the delta of change in expected rate moves now driving currency markets. Given the relative strength of the US economy versus Europe, this may not prove to be the case, although the ECB do have a history of over tightening with subsequent damage to the economy and, unlike the Fed, do not have a dual mandate including employment.
On the broad geopolitical front, the US election in November will become a focus of market attention as the year progresses, and the highly unusual circumstances surrounding both the Democrat incumbent (age and health) and Republican contender (legal battles) make the consequences impossible to predict with certainty.
Both Ukraine and the Middle East are caught in conflicts with no certainty as to how things will end. In Ukraine, Zelenskyy’s domestic popularity has dropped and there have been reports through diplomatic back channels that Putin is willing to consider a ceasefire. Once again, the US election is likely to be material to the outcomes and solutions to both conflicts.
On balance, markets are likely to start 2024 on a relatively optimistic note with investors pricing in a soft landing for the US and global economy, but for sustained progress throughout the year, there will need to be a continued fall in core inflation numbers without a material deterioration in the profits outlook. Any concerns on either of these could see investors taking some degree of profit taking after the strong gains of recent months, but for longer-term investors the outlook remains reasonably positive as the worst fears for both inflation and interest rates do not look likely to occur.
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