Central Banks Tighten, Markets Loosen

By Erik L. Knutzen

While some pessimism has lifted from central bank messaging, we still think the market may be hearing only what it wants to hear.

There is growing divergence between the hawkish policy outlooks of central banks and the dovish outlook being priced in the markets. The policymakers insist they will “stay the course.” The markets assume they will “pivot.”

Our view has long been that this divergence will resolve in favor of the central banks: Inflation and policy rates will stay higher for longer than the market expects, even as the economy weakens.

Last week, however, the U.S. Federal Reserve, the European Central Bank and the Bank of England all delivered their latest policy positions—and the market took it as an overwhelming vindication of its view.

Here is why we don’t share the runaway optimism.

‘Disinflation Is Underway’

The BoE hiked rates by 50 basis points, but hinted that this might be the end of the cycle. That was dovish, but not entirely unexpected, given the fragility of the U.K. economy.

Faced with stubbornly high core inflation, the ECB was sterner. It hiked rates by 50 basis points, promised to “stay the course” with another 50 in March, and set out its plans for quantitative tightening. Hawkish, but not unexpectedly so: The euro weakened and yields declined.

It was the Fed the day before—or rather, Chair Jerome Powell’s comments to the press—that really moved the needle.

As expected, the central bank shifted to 25 basis points with its latest hike, while signaling “ongoing increases.” That initially soured the market mood. By the time Powell had finished talking, however, the S&P 500 Index was up 2% and the two-year Treasury yield was down 15 basis points.

He said that a “disinflationary process” was “underway.” He thinks that 2% inflation is achievable “without a really big increase in unemployment.” While financial conditions indices are at their loosest since last April, he said policymakers did not focus on “short-term moves” and noted that “conditions have tightened significantly over the past year.” And he is “not particularly concerned” about the divergence of the Fed and the market, because it reflects different views on the path of inflation rather than different views on the Fed’s reaction functions.

Threat of Stagflation

We think that, along with volatility-amplifying technical dynamics such as short-covering and cash coming in from the sidelines, there may be some confirmation bias in the market’s enthusiastic response. To take that last example, investors appear to be hearing, “We agree with you.” What Powell really said was more like, “You may be right—let’s hope so, but not assume so.”

In their most recent CIO Weekly posts, Joe wrote about how bad leading economic indicators look, and Brad warned that services ex-shelter inflation remains sticky.

Powell agrees. Disinflation appears to be underway in goods and on the horizon in housing, he said, but not in core non-housing services. A “really significant economic decline” and high unemployment may not be necessary to return inflation to target, but the labor market remains “extremely tight” and “out of balance.”

He could have pointed to data from earlier that day to illustrate the threat of stagflation and the difficulty of the Fed’s task.

The Institute for Supply Management’s (ISM) latest U.S. Manufacturing Purchasing Managers’ Index (PMI) data suggests that prices paid rose more than expected just as new orders collapsed to recession-like levels. Meanwhile, the Job Openings and Labor Turnover Survey (JOLTS) for December showed job openings at a five-month high, a rise in the ratio of vacancies to unemployed workers and no sign of a downturn in the quit rate.

That labor market tightness was confirmed by an extraordinary nonfarm payrolls report on Friday. The U.S. added half a million jobs in January, when economists had been forecasting just 190,000. The unemployment rate declined even as more people entered the jobs market, and wage growth remained strong and steady. The ISM’s Services PMI also surged strongly back into expansion territory on Friday.

Tighter Policy

Friday’s data took some of the wind out of investors’ sails, effectively taking markets back to their pre-Powell levels.

Nonetheless, Bitcoin is up more than 40% and Goldman Sachs’ Non-Profitable Technology Index is up more than 20%, year-to-date. The STOXX Europe 600 Index is up more than 7% and the Russell 2000 Index is up almost 14%, while the S&P 500 Index lags at a mere 9%. The Bloomberg Global Aggregate Index has returned just over 4%.

That recent environment has not been kind to our current fundamental outlook. For multi-asset portfolios, we continue to favor fixed income over equities, and within equities, we prefer value, quality and dividends to growth, and a generally defensive stance. While we have become more optimistic on emerging markets since the start of the year—due to China’s reopening and the weakening dollar—even that presents a further inflation challenge for the developed economies.

We have not wavered because we think investors should believe central bankers when they say they are serious about defeating inflation, and be wary of reading too much into additional commentary.

As Robert Dishner, my colleague in the Fixed Income team, puts it, Powell’s softer tone suggests he is less fearful that defeating inflation will require a major recession, but he is also clear it’s a difficult job that is far from done, and that he still thinks rates will need to stay higher for longer than the market expects.

Some of the extreme downside risk may have dampened, but the economic data continue to suggest that the range of potential outcomes is wide, in our view, and still biased toward tighter policy and downside in risky assets.

In Case You Missed It

• Eurozone Q4 GDP: +0.1% quarter-over-quarter
• S&P Case-Shiller Home Price Index: November home prices decreased 0.5% month-over-month (SA) and increased 6.8% year-over-year (NSA)
• U.S. Consumer Confidence: -1.9 to 107.1 in January
• China Manufacturing Purchasing Managers’ Index: +0.2 to 49.2 in January
• Eurozone Consumer Price Index: +8.5% year-over-year in January
• U.S. ISM Manufacturing Index: -1.0 to 47.4 in January
• February FOMC Meeting: The Federal Reserve raised interest rates by 25bps
• U.S. Employment Report: Nonfarm payrolls increased 517k and the unemployment rate decreased to 3.4% in January
• U.S. ISM Services Index: +6.0 to 55.2 in January

What to Watch For

• • Thursday, February 9:
    • China Consumer Price Index
    • China Producer Price Index
  • Friday, February 10:
    • University of Michigan Consumer Sentiment

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