Complacent markets?
Resurgent markets are about to collide with central bank policy as the Fed and the ECB meet this week for the first time this year. It promises to be a sequel to the saga which unfolded a year ago, but with a discernible twist. A year ago, central banks, led by the Fed, sought to stamp their authority on markets as they took on then-raging inflation, embarking on one of the sharpest set of rate hikes in history. Most asset classes suffered. This year, central banks seem to be gaining the upper hand, with headline inflation peaking. As a result, some have started to call truce – the latest being the Bank of Canada, which signalled a pause after hiking rates 425bps since March.
We believe it’s too soon for the Fed and the ECB to declare victory as their job markets remain hot. The two central banks are worried about easing financial conditions too soon and letting underlying wage inflation pressures accelerate. Given this backdrop, it would be prudent to fade the rally in some asset classes where investor positioning particularly look stretched. We believe our SAFE portfolio, which has performed strongly since we issued our 2023 Outlook in mid-December, is still a good way to balance the risks with the emerging opportunities until we get further clarity on central bank policy.
In our view, three broad themes have driven the rally in some assets this year: a) Europe’s record warm winter removing the tail risk of an energy crisis; b) further signs of weakness in US economic activity and easing inflation, raising the odds of an early pause in Fed hikes; and c) China’s early lifting of mobility restrictions. However, our proprietary indicator shows investor positioning has become crowded in most assets that have led the rally, raising the odds of at least some consolidation. These assets include European and Asia ex-Japan equities, Asia local currency and Europe HY bonds, industrial metals, gold and the AUD. This week’s Fed and ECB policy meetings could be the catalysts for a near-term reversal, with expectations of a dovish shift in Fed policy raising the risk of a disappointment.
Markets have pared back expectations of the terminal Fed Funds rate by 10bps, expecting 25bps rate hikes in Feb and March before a pause. However, Fed officials have thus far remained resolutely hawkish until they see clearer signs of the job market and service sector wages easing. In Europe, the better-than-expected weather, which helped revive consumer and business confidence, raises the odds of a more hawkish ECB. A hawkish ECB, against the backdrop of stretched technicals, would challenge the Euro area equity rally.
There is a window for risk assets to continue rallying, after perhaps a near-term consolidation. Essentially, markets would need a confirmation that the US and Europe are heading for a soft-landing, followed by an economic revival, to justify the rally in risk assets so far. On this front, last week’s US Q4 GDP data (2.9% growth) was stronger than expected, boosted mainly by private inventory, although personal consumption slowed. A hot job market, seen in high job openings and near-record low jobless claims, point to a resilient services sector (Jan jobs data due on 3 Feb). However, contracting US PMIs and sustained negative reading of the leading index suggest activity is slowing significantly after a robust Q4 22. The contrast in the forward- and backward-looking data poses a quandary for the Fed. Meanwhile, Euro area’s outlook continued to improve, with services PMI returning to positive territory for the first time since July 22, providing further ammunition for hawkish ECB policymakers to propose a 50bps rate hike this week.
Investment implications: We would a) Refrain from chasing the rallies, given crowded positioning; b) Ensure portfolios are diversified and in line with your risk tolerance; c) Remain watchful for signs of the Fed preparing to cut rates before turning more constructive on risk assets (we expect the Fed to cut rates only in H2); d) Favour income: A diversified income portfolio remains a good way to play the current situation – earning income, while awaiting clarity on central bank policies.