Nearly two months in…
The economy has been on a fairly solid footing since the start of the year. However, the Federal Reserve Bank and other leading western central banks are still deciding what their next move should be regarding further monetary tightening, as the picture remains decidedly nuanced. January saw some unexpectedly healthy consumer figures and a tight labour market in the US. Inflation, however, remains stubbornly high.
The US economy is now looking stronger than initially thought. Retail sales are good, last month’s jobs report was much stronger than expected and we are currently seeing a robust rebound in homebuilder sentiment. Hardly the kind of economic backdrop that one associates with impending recession and ongoing inflationary pressures.
But in actual fact, the Fed’s aggressive tightening measures over recent months have done very little to tame inflation or even slow it down. So does it need to do more?
The bond market seems to think so (although some market pundits take the opposite view). There is every reason to believe that Fed Chair Jerome Powell is set to announce harsher measures. In the interim period, however, equities seem to be unfazed.
US retail sales are the real surprise – they have soared impressively, well ahead of market expectations. The advance was led by a rise in auto sales (the global automotive and parts sector is up 25% this year), together with strong spending in restaurants and furniture outlets (both sectors which have recovered very well in 2023).
Further gains were seen across a broader range of categories. This would suggest that consumers are back in force, unleashing the savings they accumulated during the pandemic following a period of more tempered behaviour in the final quarter of 2022.
Might we just escape recession?
Consumer spending accounts for some 70% of GDP. So where the consumer goes… the economy follows. With consumption accelerating and the labour market unusually resilient, recession fears seem to be fading. But how justified is this positivity? There is still the potential for more bad news out there, and the sceptics are never silent for long.
Some market commentators have sketched out a third possible economic scenario. While the debate rages on about how hard or soft the landing will be when the recession comes, some even envisage a third “no landing” scenario, whereby the economy avoids recession altogether.
This would involve the economy simply powering on without slowing down, disregarding the Fed’s forceful interest rate hikes. A resilient economy is obviously the most desired of all outcomes. But with the Fed tightening its monetary policy so aggressively, at some point it will generate a spike in unemployment, slowing down the consumer and business demand.
Last year, global equity markets were highly sensitive to rising rates. This year, however, they appear to have ignored the February data and the rebound in US Treasury bond yields. Indeed, growth-style investments and the more speculative parts of the market have begun to outperform those defensive areas which started to rise towards the end of 2022. Are we caught in a bear market trap? Or is this the beginning of a new bull market (which started when the markets bottomed out on 12 October 2022)?
Further volatility is almost a given
As the year gets underway, a more forceful Fed committed to raising interest rates even higher remains entirely plausible. This could catalyse renewed volatility, begging the question… should a more defensive investment approach be adopted? Until there is more clarity about how far the Fed and other western central banks are prepared to go to beat inflation, the bullishness of the equity markets squaring off against the central banks’ determination could result in a rollercoaster ride.
It is worth remembering at this point that the US actually saw a protracted period of disinflation in the 1970s during which global financial conditions eased and the stock markets rallied.
This was followed by a second wave of inflation in the 1980s, followed by a prolonged period of high real interest rates under the harsh supervision of then-Fed Chair Paul Volcker. To his admirers, Volcker was the most successful Fed Chair in history – a bold policymaker who was willing to go to any lengths to defeat inflation. To his detractors, his monetary policy made him hugely unpopular.
Despite embedded inflation, the markets are very resilient
Currently, inflation has seeped into the service sector, we have a tight jobs market, we’re seeing rising wages and tightening monetary policy, a war is raging in Europe and relations between the world’s two remaining superpowers are worsening. And yet… and yet, the markets appear curiously resilient.
Average growth of weekly earnings in the UK compared with the CPI inflation rate from March 2001 to January 2023
In the UK, the FTSE 100 Index broke through the 8000-point level for the first time, helped by inflation falling to a five-month low of 10.1% year-on-year in January. The current level of core inflation (which does not include volatile food, energy, alcohol and tobacco prices) fell to 5.8% (down from 6.3% the previous month). More surprisingly, the UK retail sales figures recovered last month, increasing by 0.5% month-on-month following a 1.2% decline in December.
The recent fall in inflation would appear to have fuelled expectations that the Bank of England might soon consider pausing its interest rate tightening cycle – Andrew Bailey even recently made some statements to that effect.
Geopolitically, Washington’s recent downing of a Chinese balloon off the coast of South Carolina has worsened the rift between the US and China. Indeed, China has imposed sanctions on two US defence manufacturers over arms sales to Taiwan. And the possibility that China might even supply Russia with weapons and ammunition for the Ukraine war is likely to exacerbate matters.
US Navy sailors pulled the downed Chinese balloon out of the sea
Leverage those pullbacks!
There is still enough in the way of uncertainty out there to derail the current market recovery. However, we believe that inflation is set to fall further, central banks will pause their interest rate hikes and the markets will continue on an upwards trajectory. That does not mean that the road ahead will not be bumpy over the coming months.
Now is therefore a good time to take advantage of any pullbacks in the markets, using them as buying opportunities. The longer-term trends remain intact, so pound-cost averaging will offset any short-term volatility.
Nevertheless, inflation continues to erode our spending power. And a raft of forthcoming stealth tax rises means that now is an excellent time to take a fresh look at your financial plan and make the most of any allowances and tax wrappers at your disposal. As the current tax year draws to a close, ISA and pension fund contributions should be your priority.