What happened?

US stocks rose on Friday as signs of moderation in wage growth allayed fears over the extent of further Federal Reserve tightening. A sharp drop in service sector activity added to investor perceptions that the Fed’s hiking cycle may be drawing nearer to a close.

The S&P 500 rose 2.3% in a broad-based advance that lifted all sectors, while the tech-heavy Nasdaq gained 2.6%.

With the economy showing signs of weakening, bond yields retreated. The yield on 10-year US Treasuries fell 16 basis points to 3.56%, and the 2-year yield declined by 20bps to 4.26%. Federal funds futures markets reflected lower expectations for the Fed’s terminal rate, with the peak in the federal funds rate seen at 4.96% in June, compared with 5.04% in morning trade on Friday.

The US dollar also fell, with the DXY dollar index depreciating by 1.1% to 103.91.

The US labor report for December showed nonfarm payrolls increasing by 223,000, above consensus expectations of 203,000 but still the slowest job growth since December 2020. Average hourly earnings were up a moderate 0.3% month-over-month, and there were downward revisions to previous months, bringing the year-over-year increase to 4.6%, down from 5.1% last month.

The US ISM Services PMI fell to 49.6 in December, down from 56.5 in November, far below consensus expectations of 55 and the lowest reading since May 2020. Details of the report were mostly weak, with new orders falling and inventories rising. Prices paid continued to trend higher but at a slower rate.

What do we expect?

Fed officials may be encouraged by the slowdown in growth in average hourly earnings in the monthly employment report. Wage growth of 3.5% is about the maximum that would be compatible with the Fed's 2% inflation target, and this month's data brings us closer to that mark.

However, with the other data indicating that the labor market is tight, the Fed will need to see more evidence that wage growth is slowing before it considers pausing the rate-hiking cycle.

The unemployment rate, which fell from 3.6% to 3.5%, now matches a 50-year low. The JOLTS survey data showed job openings dropped by just 54,000 month-over-month in November to 10.46 million. There are 1.74 vacancies for every unemployed person. Importantly, the quit rate remains high, which is associated with strong wage growth. The Atlanta Fed’s wage growth tracker shows that job switchers are achieving wage growth of 8%.

Investors also took comfort from evidence that the US services sector contracted for the first time in more than two-and-a-half years in December. Excluding the fall during the pandemic, this was the weakest reading for the nonmanufacturing ISM since 2009. The survey could also help reassure the Fed that price pressures are abating in the service sector, a key concern. The prices paid component fell to the lowest level since January 2021, a sign that bottlenecks continue to clear.

How do we invest?

We expect markets to remain volatile and still do not think the macroeconomic conditions for a sustained equity rally are in place yet. The earlier part of the week was characterized by falling US equities amid strong labor market data and an apparent realization that it will take more than just softer US consumer price data to prompt the Fed to pivot policy. Today’s slower wage growth is a step in that direction but is just one data point.

Against this backdrop, we maintain equity exposure but prefer strategies that add downside protection. Within equities, we continue to favor more defensive sectors like consumer staples and healthcare, and more value-oriented markets like the UK compared with the more tech-heavy US market. In fixed income, we prefer high-quality bonds while remaining more cautious on riskier credits.

That said, we do expect this year to bring inflection points in inflation, interest rates, and economic growth; and as these come into view later in the year, it will be appropriate to consider tilting toward a riskier stance overall.

For more risk-tolerant equity investors looking to identify parts of the market that could rally most strongly when the inflection arrives, we see select opportunities in early-cycle markets, like Germany; “deep value” stocks; parts of the semiconductor sector; and the likely beneficiaries of China’s reopening.

In currency markets, in December we moved the US dollar to neutral from most preferred, as we believe the peak for the greenback has already been seen.