A relatively warm winter has also eased concerns over energy shortages in Europe. As a result, the S&P 500 is up 4% so far this year, China’s CSI 300 has risen 6.7%, and the Euro Stoxx 50 has climbed 10.2%. There has also been a rotation in favor of assets that benefit from an improving economic cycle, including US small caps and Eurozone, emerging market, and China equities. Consumer discretionary and communication services are the leading US sectors this year after being the biggest losers in 2022.
But it remains possible that the rally is a “head fake,” and that economic data will ultimately disappoint.
It remains too early to assume that the inflation threat has fully passed. While December headline inflation
data in both the US and Eurozone continued to point to a deceleration, core inflation has still remained well
above central bank targets. In the US, core inflation, excluding volatile food and energy prices, rose 0.3% for December on the month, up from 0.2% in November. On an annual basis, core inflation was down to 5.7%,
down from 6%, but still well above the Federal Reserve’s 2% target. In the Eurozone, core inflation actually increased in December on an annual basis to 6.9%from 6.6%. The possibility that core inflation is sticker than expected remains a risk for markets.
A soft landing will require a “Goldilocks” scenario for the labor market, with employment conditions neither too hot nor too cool. We think current demand for labor looks too strong to ensure wage growth slows—which will be essential to bring inflation lower. In December, the unemployment rate matched a 50-year low at 3.5%, while the three-month rolling average of wage rises was at 6.1% for December. Such strength is incompatible with meeting the Fed’s 2% inflation goal, in our view. However, a degree of resilience in the labor market should be critical in preventing an economic slowdown turning into a recession, which would be negative for markets.
The lagged effect of higher rates could represent a greater drag on growth than expected. A widely-held view is that the peak drag on the US economy due to the tightening financial conditions last year is occurring right now, and with conditions easing over the past two months, growth could recover by mid-year. But we think another plausible scenario is that the economic pain of higher policy rates will only really start to bite later this year as households and small businesses refinance at much higher interest rates. While the former scenario is consistent with a soft landing, the latter is much less so.
So, while the strong start to the year is welcome and we believe more risk-tolerant investors can start to anticipate an inflection point in 2023, we advise against complacency. Economic data remains noisy, making it hard to say for certain that the recent encouraging economic trends will continue. As a result, we continue to favor a selective stance, including a tilt toward defensive equity sectors, high grade and investment grade bonds.
Main contributors - Mark Haefele, Vincent Heaney, Patricia Lui, Jon Gordon, Jason Draho, Christopher Swann
Content is a product of the Chief Investment Office (CIO).
Original report - Is the current bounce in 2023 for real?, 18 January 2023.
