Analysis Suggests That Markets Usually Trough Around The Same Time As The Macroeconomic Data
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Is the growth pause discounted already?
The current economic environment is shaped by the experiences and actions of the past year (or three). It was ever thus, but that doesn’t lessen the importance of this observation. The outlook for growth, as foretold by leading indicators of activity, remains downbeat (see Exhibit 1). This reflects the cumulative tightening of monetary policy that the leading central banks have already made, and the further hikes that undoubtedly will be delivered in the early part of 2023. It also incorporates the hit to consumers’ confidence from costofliving effects — a result of wage gains, large though they have been in many economies, failing to keep up with the surge in inflation seen in 2022. All of this is further complicated by the lingering economic effects of COVID 19 and the very real consequences of China moving away from its zero-- COVID policy. But is the likely pause in developed market growth already discounted by financial markets?
The signs of a slowdown have been building for a while, as we have discussed in Allocation Views in recent months. This has resulted in us continuing to anticipate a high probability that many developed economies will experience a recession in the coming year. In some, such as the United Kingdom, they may already be in recession, according to our analysis. Indeed, certain market commentators are describing this as “the most highly anticipated recession in history.” However, in the case of the United States in particular, where more lagging measures of activity remain robust, it doesn’t feel like recession. Indeed, corporate earnings expectations do not seem to fully reflect an impending recession. It is important to note that this is mainly because the US economy is not yet in recession. The lagging indicator in data from The Conference Board shown above reflects the ongoing strength of the labor market, which remains a focus of the US Federal Reserve (Fed) and continues to support the policy response which will see further rate hikes. But history suggests the cumulative effect of tighter policy will be felt in the end and see coincident measures (a proxy for reported gross domestic product growth) weaken further. Eventually, even the lagging indicators should confirm that a recession has happened.
This is important for our outlook for risk assets, as our analysis suggests that markets usually trough around the same time as the macroeconomic data — within a few months of each other. Markets can and do recover before the end of a recession, but it seems unlikely that they would trough before its onset.
Inflation has peaked
Part of the reason that financial markets have fared better in recent weeks, and led some market participants to anticipate an end to the Fed’s hiking cycle, is that it is seems increasingly clear that inflation has passed its peak. This statement may require a few caveats. Clearly, in the case of the United States, it is only six months since annual measures of Consumer Price Index inflation reached the highest level seen in many decades. Given the lopsidedness of that “decades to months” comparison, it is too early to say that any form of secular peak has been reached. As we discussed in last month’s Allocation Views, we anticipate ongoing inflation will remain above its previous trend level during the next business cycle. However, the postpandemic phase is likely to allow more of the imbalances that drove inflation to its 2022 high to be reversed. We continue to see silver linings to the supplychain bottleneck clouds that were dominating the discussion a year ago (see Exhibit 2).
With labor markets tight — especially in the United States, but also in the United Kingdom — wage pressures remain the dominant concern of policymakers. So long as job openings remain elevated and employers struggle to fill vacancies with appropriately skilled applicants, broad measures of inflation will be slow to normalize. These pressures are particularly acute in the service sector, where productivity gains can be harder to come by and automation is more problematic. As a result, central bankers continue to have a laser focus on developments in employment and the labor force. Even as we become more certain that inflation has peaked, it is too early to sound the “all clear” from a policymaker’s perspective.
With labor markets tight — especially in the United States, but also in the United Kingdom — wage pressures remain the dominant concern of policymakers. So long as job openings remain elevated and employers struggle to fill vacancies with appropriately skilled applicants, broad measures of inflation will be slow to normalize. These pressures are particularly acute in the service sector, where productivity gains can be harder to come by and automation is more problematic. As a result, central bankers continue to have a laser focus on developments in employment and the labor force. Even as we become more certain that inflation has peaked, it is too early to sound the “all clear” from a policymaker’s perspective.
Policy remains a headwind
Developed market central banks’ policy objectives remain clear. Their resolve to keep inflation expectations anchored appears to have been stiffened by the period of uncomfortably high inflation during the last two years. We have talked about a singular focus on fighting inflation and a willingness to accept the collateral damage caused by higherthananticipated interest rates, in the form of slower growth and potentially higher unemployment, in the years ahead. However, in the past month, the last outlier has started to move in the same direction as its peers. The Bank of Japan (BoJ) surprised the markets by recalibrating its yield curve control policy, widening the range within which the benchmark 10 year government bond yield would be constrained. Although this is not directly a precursor to rate hikes, it has been taken as an indication of the direction of travel. If wage pressures in Japan rate policy. continue to build, the BoJ may eventually move away from its zero
Despite what we view as a clear restatement of policy imperative by central banks, markets continue to discount a pivot toward easier monetary policy in the year ahead, by the Fed and others. This has fueled a bear-- market rally in stocks and the riskier parts of the bond market. With the Western central banks all confirming that they are indeed likely to slow the pace of future rate hikes (though they protest that this is not in any way the same as confirming the market view that easing is just around the corner), government bonds have also joined the “feel good” party.
Taken together with the prospects for a slimming of central bank balance sheets, expected central bank hikes will moderate negative real rates and sustain restrictive conditions. Although fiscal policy is responding to energy costs in some countries, especially in Europe, it will be slow to sway dovish in others, leaving it more differentiated across economies. However, the anticipated shift in global policy is still quite hawkish. Overall, this sees our final theme complete a set of three unambiguously negative drivers for markets, even as it evolves to downplay the pace of hikes but emphasize “Policy to Remain Restrictive” we move through 2023.
Equity valuations have moderated (the multiples of earnings at which stocks trade have fallen considerably), but the levels of anticipated earnings per share remain close to their peak. This appears to underplay ongoing concerns around economic growth, inflation, and likely policy responses that continue to weigh on investor sentiment and to support us remaining more cautious in our view of stocks, rather than becoming bolder.
We moved to trim our toplevel allocation preference for equities early last year and took advantage of the ebbs and flows of sentiment that occurred to progressively temper our view. We enter 2023 with an allocation preference away from stocks, which we have retained in recent months as we do not see a sustained rally at this stage. Over the next few quarters, we anticipate that a nimble investment management style will continue to be required, and we look for assets that offer some protection if a less favorable scenario were to be realized. We are more attracted to the yields available in highquality government bonds. Although we still see attractive longerterm return potential for stocks and believe they should earn their equity risk premium over time (see Exhibit 3), we struggle to find a strong argument supporting an equity preference at this time.
