In December last year, global recession seemed inevitable. The mood in the world economy has however brightened considerably since then. Stronger global growth prospects, falling inflation and less hawkish central banks are contributing to strong market developments. But is this too good to be true? Well, most likely. Inflation has become broad based and interest rates need to go higher than markets expect, especially in the U.S. This might trigger market repricing globally, bringing both risky assets and bond prices back down during this spring.
Year 2022 was the annus horribilis for portfolio investors, with both equity indices and bond indices having tumbled; global stocks were down by 20%, and bonds by around 15%. This is significant as stock prices and bond prices typically move in opposite directions, balancing the yield of a well-diversified investment portfolio. Such a dramatic and simultaneous fall in stocks and bonds has not been seen in decades.
The reason behind the market correction was the exceptionally strong interest rate shock. In 2022, central banks tightened their monetary policies to tame rampant inflation. In the U.S., the Fed increased the federal funds rate by a whopping 4.25 percentage points over a period spanning just nine months, representing the most aggressive Fed rate-hike cycle in more than 40 years. In the eurozone, the ECB raised the deposit rate by 2.5 percentage points in just 6 months.
Last year the main theme in the global economy was inflation and central banks. Towards the end of the year a new problem emerged. Economic growth slowed and fears of recession spread at the global level. In December, global recession seemed inevitable. Rapid interest hikes in the U.S., energy price shock in Europe, and tight Covid restrictions in China were steering the world economy into recession.
The mood in the world economy has brightened considerably since December. In the U.S., the economy, and the labour market in particular, has turned out to be more resilient to interest rate hikes than expected. In Europe, the fall of natural gas prices, a mild fall and winter, and measures to save energy have helped stabilize the economic environment. In addition, China’s decision to scrap its zero-Covid policy has boosted confidence at the global level and especially in Europe, which is heavily dependent on exports to China.
Last week the U.S. GDP figures for the fourth quarter of 2022 were stronger than expected displaying 0.7% growth from previous quarter. Looking under the hood, however, there are some signs of weakness. The main contributor to growth was inventories, which may provide some insight about weaknesses in demand. A rise in inventory investments typically projects weaker growth in the next quarter. This week the eurozone data from the fourth quarter of 2022 posted a surprise expansion; with only Germany and Italy, of the bigger countries, showing a minor decline in economic activity.
Just a few days ago, the IMF raised its GDP projection for the world economy in 2023 from 2.7% to 2.9%. According to their projection, the only major country with negative growth in 2023 is the U.K.
All of this is obviously good news. January was a strong month in the markets after the horrible year of 2022. European and Asian stock indices are up by 7-10%, S&P500 index in the US by 5%, and a broad global bond index by 3%. The buoyant mood in the financial markets has been bolstered not only by stronger growth prospects, but also due to easing inflation and less hawkish central banks.
Is this too good to be true? Major central banks continued to tighten monetary policy this week. The Fed raised its steering rate by 0.25 percentage points taking it to a range of 4.50-4.75%. The ECB and the Bank of England hiked rates by 0.50 percentage points. The main steering rate of the ECB is now at 2.5%, and the Bank of England base rate is at 4.0%.
Market participants are expecting the central banks to be approaching the terminal rates of this rate hike cycle. In the U.S., only one 0.25 percentage point rate hike is fully priced in. Furthermore, the Fed is expected to lower the policy rate already in the fall of 2023. The Fed policy makers have clearly communicated that the rate will land above 5%, and will stay there until next year. In short, the Fed seems to have a credibility problem, as the market participants don’t believe in what the Fed is saying.
In the eurozone, the rate hikes started later than in the U.S., and a major part of the impact of the past interest rate increases is yet to be seen. Markets are pricing in about 1.0 percentage points of more rate hikes before the summer. I, however, find it hard to believe that the ECB would dare to hike the interest rates so much. Many countries in the eurozone can tolerate higher interest rates, but not all.
And what about inflation? Well, inflation is still here, and central banks’ job is not done. The headline inflation figures have peaked and will continue to decline. In the U.S., December inflation was 6.5%, down from 9.0% in June. In the eurozone, January inflation was 8.5% after hitting 10.6% in October.
Moderating inflation is great news. The core inflation, which excludes volatile items such as energy and food prices, is however still elevated at 5.7% in the U.S., and at 5.2% in the eurozone. Core inflation is dominated by more slowly moving price categories, such as services, where wages comprise a sizeable part of the production costs. I’m afraid that getting inflation out of the system is a far more challenging task than currently understood.
The resilience of the economy towards rate hikes is obviously a good thing in terms of economic growth. At the same time, it means that the central banks need to push interest rates even higher in order to reduce aggregate demand and bring down price pressures.
And what are the implications across markets? In the near future, I would expect continued turbulence in the equity and bond markets. Global growth momentum is weakening, albeit the global recession narrative seems less likely than before. Provided that inflation is as sticky as I think it is, the Fed needs to go higher and stay there for longer than markets are expecting. This might trigger market repricing globally, bringing both risky assets and bond prices down again during this spring.