The US economy has started 2023 on a much stronger-than-expected footing, adding confusion to markets as expectations reflected in stock and bond markets diverged further.
Despite the sharp interest rate hikes over the past one year — the federal funds rate (FFR) has risen from 0%-0.25% to the current 4.5%-4.75% — consumption, which makes up some 70% of economic activities, is holding up remarkably well.
We wrote about January’s huge jobs report last week — a net addition of 517,000 non-farm payrolls, far ahead of the expected 188,000, while the unemployment rate fell further to just 3.4%, the lowest since 1969. Businesses are raising wages to compete for employees, in order to meet consumer demand.
Last week, we got two more key reports, underscoring the rather unexpected resilience in the US economy. Retail sales for January grew 3% month on month, the strongest in nearly two years, and importantly reversing the declining trend in November-December 2022 (see Chart 1). In other words, instead of continuing to cut back, consumers resumed their spending, big time. There was strength across the board, including in big-ticket discretionary items such as cars, furniture and appliances.
This seems to suggest that consumers are growing more confident of their financial prospects as it becomes clearer that the job market is not about to buckle anytime soon.
It also makes things more confounding for investors. Should one buy stocks or bonds now? We presented the various possible scenarios in a matrix, and what we think should be the relative performances for both assets in each case (see Table 1).
Bonds will do better than stocks in a recession, as we have explained in previous articles. To be sure, one month’s data does not make a trend, but the probability of an imminent US recession, it appears, is falling. And the likelihood that the economy will stay resilient amid a tight labour market is rising.
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In this scenario (status quo), we foresee inflation becoming stickier even as it continues to decline. In other words, it is easier for inflation to fall from the peak of 9.1% (in June 2022) to 6.4% currently, than for it to fall further from hereon to 2%-4%. Case in point, the latest January inflation printed at the higher end of expectations — prices rose 6.4% year on year, down just marginally from the 6.5% in December and was, in fact, up 0.5% month on month (see Chart 2).
Recent disinflation has been driven, mostly, by lower inflation for goods with the continued unwinding of pandemic-driven supply chains snarls. China’s reopening was the last major disruption. But there is a limit to this deflationary drag — for instance, shipping costs have already fallen all the way back to pre-pandemic levels (see Chart 3).
Importantly, wages are extremely sticky — they hardly ever drop, except during major crisis times — and make up a material percentage of costs, especially in the services sector.
These will, we think, lead to more persistent inflation in the near-medium term — that may require the US Federal Reserve to raise interest rates higher than it currently expects, and most likely for longer than most investors currently expect.
Bonds investors have come around to this likelihood, as underscored by their expectations for a higher FFR as well as the upward reversal in bond yields — for example, for the 2-year and 10-year Treasuries over the past weeks (see Chart 4).
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Stock investors, on the other hand, are still holding out hopes for the “perfect landing” — where inflation falls rapidly to the 2% target, thereby allowing the Fed to halt interest rate hikes before damaging the economy (no recession). With inflation back down to its target levels, the Fed can subsequently ease interest rates, creating the textbook scenario for stocks to rally. Hence, the strong momentum for high-growth tech stocks we have seen so far this year (see Chart 5). Somehow, we doubt things can ever turn out so perfectly. Only time will tell.
The Global Portfolio fell 2.2% for the week ended Feb 16. All stocks in the portfolio lost ground, except for Grab Holdings, which gained 1.9%. The biggest losers were DBS Group Holdings (-5%), Oversea-Chinese Banking Corp (-3.8%) and Global X China Electric Vehicle and Battery ETF (-3.4%). Total portfolio returns since inception now stand at 28.5%, trailing the MSCI World Net Return Index’s 45.9% returns over the same period.
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