Inflation may well continue to moderate, but the move towards the Fed’s 2% target will be much stickier from hereon. This is due, in part, to the large component of services in the US economy — where workers are regaining bargaining power. Wages, while off the recent highs, are still growing faster than they have in two decades (see Chart 1). We believe inflation and, therefore, interest rates are unlikely to return to pre-pandemic lows anytime soon.
A marginally better-than-anticipated October inflation report, on the heels of a slew of weaker-than-expected economic data, fuelled market bets that not only have US interest rates peaked, but also that the Federal Reserve will start cutting in 2024, as early as at its March or May meeting. And that will help the economy avoid recession. In short, the market is all-in on the soft landing scenario. This, in turn, fed the stock and bond market rallies.
Last week, we discussed why we think the current optimism for stocks is unsustainable — earnings uncertainties remain heightened, and the risk-reward proposition is unattractive at prevailing historically expensive valuations. Yes, a quick Fed pivot will limit the damage of high interest rates on the economy and corporate earnings. But we also explained why we think such expectations — for an early and sharp cuts in interest rates (consensus now expects a cumulative 100-basis-point reduction by end-2024) — may not be realistic.
