Coupled with an unexpected rebound in service sector activity, the data caused markets to price a more hawkish trajectory for US monetary policy. Fed funds futures moved to price a peak in rates of close to 5% by June, 10 basis points more than at the start of the day.
The news came after markets rallied earlier in the week on hopes that the Fed is getting ready to stop tightening. At its meeting last week, the Fed slowed the pace of rate hikes to 25 basis points, down from 50bps in December and 75bps in the prior four meetings. At the following press conference, Fed Chair Jerome Powell chose not to explicitly push back against easier financial conditions and referred to a “couple more” rate hikes, giving the impression that the cycle is drawing closer to the end. That less hawkish tone was echoed later in the week by the European Central Bank and the Bank of England. ECB President Christine Lagarde said the risks to the economic outlook were dual-sided. The Bank of England, meanwhile, signaled that rate hikes were unlikely to continue much longer.
But optimism over the potential for easier monetary policy was partially offset by lackluster corporate earnings, including weakness in high-profile tech companies. Apple reported a steeper-than-expected sales decline, Amazon projected weak revenue in the current quarter, and Alphabet's results narrowly missed analyst expectations. With the US reporting season close to three-quarters complete, aggregate earnings are missing forecasts by close to 1 percentage point, and earnings per share are on track to decline by 3.4%.
What do we expect?
Central bankers did sound less hawkish last week. But they will remain data-dependent, only ending rate hikes when economic data provide compelling evidence that inflation is returning to target. In our view, markets have moved too quickly to price in this pivot.
In the case of the Fed, inflation data continues to moderate. The central bank’s favorite measure, the core personal consumption expenditures index, rose by 4.4% in December, its smallest increase since October 2021. However, employment data remains too strong to justify an end to the tightening cycle, in our view. Although wage growth appears to be moderating, with the Atlanta Fed’s three-month moving average falling to 6.1% for December from a peak of 6.7% in August, the pace of pay rises remains too high and inconsistent with the Fed hitting its 2% inflation target. Earlier in the week, the JOLTS data pointed to rising job vacancies with 1.9 openings for every unemployed person in December.
In addition, the market may have paid insufficient attention to hawkish elements in the statements of top policymakers last week. Powell reiterated that it was premature to declare victory, while ECB President Christine Lagarde said there was “still ground to cover” and that it was important to “stay the course.”
Equally, the lackluster fourth-quarter US reporting season reinforces our view that an earnings recession is coming, with profits now on track to contract in the fourth quarter. We continue to see macroeconomic headwinds mounting. The tech sector results underlined that even high-growth areas, such as cloud services, have been slowed by reduced business spending. Pressures on consumer spending also appear to be impacting the sector, as we forecast.
How do we invest?
In our view, the speed of the recent US equity rally has been partly due to technical rather than fundamental factors. Many investors started 2023 lightly positioned in risk assets in response to worries over a global recession and a potential energy crisis in Europe. That made the market susceptible to a swift rally. But we continue to believe that the US market is vulnerable to a reversal in the near term, before a more sustained inflection later in the year.
Against this backdrop, we like strategies that provide exposure to equity market upside while adding downside protection. We incorporate a combination of defensive (consumer staples and healthcare), value, and income opportunities that should outperform in a high-inflation, slowing-growth environment, alongside select cyclicals that should perform well as and when markets start to anticipate the inflections.
In equities, we maintain a least preferred stance on US stocks and the technology sector. Instead, we prefer emerging markets including China, as well as German equities, which we expect to be among the main early beneficiaries of China’s reopening and an inflection point in global growth in 2023.
In fixed income, we maintain a preference for high grade and investment grade bonds, given continued near-term threats to global growth along with attractive all-in yields. We also like emerging market bonds, which we expect to benefit from China's reopening and the recent downshift in the pace of US rate hikes.
Main contributors - Mark Haefele, Christopher Swann, Brian Rose, Jon Gordon
Content is a product of the Chief Investment Office (CIO).
Original report - Jobs data dampens hopes of dovish pivot by the Fed, 6 February 2023.