According to its latest median dot plot projection, the Fed is set to deliver one more 25bps increase this year before pausing for the rest of 2023.
But irrespective of whether the Fed delivers a further rate increase, we see reasons to be cautious about the outlook for the US economy and corporate earnings.
US inflation remains sticky and well above target. US inflation has remained stubbornly high despite the 475bps of cumulative rate hikes. March CPI data due later today will provide evidence on whether US inflation remains sticky. According to a Reuters poll, the consensus forecast is for headline CPI to ease to 5.1% year-over-year from 6% in February. However, the more important core inflation measure is expected to have increased 0.4% m/m in March from 0.3% in February, bringing annual core CPI up to 5.6% y/y from 5.5% previously.
Even if the Fed opts to pause next month, with US inflation still running well above its 2% target, the central bank will want to see the hikes delivered thus far having the desired effect of bringing inflation down closer to that target before it can consider any rate cuts (i.e., a pivot).
The real US economy is starting to hurt from the impact of tightening to date. US recession risks are rising, as evidenced by the latest March ISM manufacturing PMI falling to 46.3, its lowest level since May 2020 and the fifth consecutive month in contraction territory. The US labor market is also starting to cool, with March nonfarm payrolls and JOLTS data showing slower wage growth and lower job openings.
Credit conditions are tightening as banking sector turmoil adds to the pain from rate hikes. According to the Dallas Fed Banking Conditions Survey conducted 21–27 March, commercial and industrial loans, real estate lending, and loan volumes have fallen while credit standards have continued to tighten. This concern was also highlighted by Chicago Fed Chief Austan Goolsbee, who said yesterday that the US central bank should exercise “prudence and patience” in raising rates as it needs to assess how much credit conditions have tightened following the banking turmoil. Historically, tighter credit conditions have been correlated with weaker corporate earnings.
So, with the US economy cooling and a Fed pivot not imminent, we believe the environment for equities will remain challenging in the coming months. We are least preferred on global equities, including the US, where we expect earnings to contract 4.5% this year. We prefer bonds to equities, and we like high grade (government), investment grade, and sustainable bonds relative to high yield bonds. Apart from the potential tailwinds from an eventual Fed pivot, we think that high-quality bonds can offer defensive traits to a portfolio in the event of a sharper economic downturn.
Main contributors - Mark Haefele, Patricia Lui, Vincent Heaney, Jon Gordon
Content is a product of the Chief Investment Office (CIO).
Original report - Pause or hike, caution is still warranted, 12 April 2023.