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  • Alex Haseldine

Fours Reasons To Be Thankful

And two to be cautious.

Reasons to be cheerful...

Rate Shift: over the past 4-6 weeks markets have shifted rapidly towards the idea that the major central banks (ex-Japan) have finished tightening, and that policy rates will fall significantly next year (100-125 basis points in the US and Eurozone, more like 80 bp in the UK). As a result, Risk Parity strategies have just had one of their best months ever. 30-year US and German bond yields are down roughly 80 and 65 basis points respectively from their 10th October highs while the S&P 500 and the Euro Stoxx 600 have rallied roughly 11 and 9% from their lows on the 27th October lows. Equity market leadership is also shifting away from big tech towards real estate, financials and small cap equities that are seen as having the most to gain from a peak in rates.

Inflation Pressures Have Subsided to the Pre-COVID Norm: the clearest way to see this is to track the composite PMI output prices indexes. (For simplicity, we use a 60-40 weighting scheme to combine services sector and manufacturing data). All the major economies are back in the zone that prevailed between the GFC and COVID - figure 1. That's not fully reflected yet in inflation momentum (6-mo/6-mo annualised growth) - figure 2 - but it's a strong indicator that on the ground inflation pressure is back where it needs to be. Further confirmation came out last week. The flash estimate for EZ inflation in November came in well below expectations at 2.4% yoy. Core inflation has been running at the same rate over the past 3 months. Final data will be released on December 9th but we expect it to be close to the flash estimate. In the US core PCE inflation was 3.5% yoy in October but only 2.2% per annum over the last 3 months, very similar to the Eurozone. Meanwhile, core inflation less shelter is running at 0.8% per annum over the past 3 months - figure 3. On the other hand service sector inflation less shelter - a measure the Fed likes to follow - has been picking up a bit over recent months - figure 4. The main culprit is the cost of car insurance, which is up 20% on the year, with big monthly gains since the summer. That's likely more of a one time bump to transportation costs related to the current issues around insuring and repairing electric vehicles rather than a sign of generalised inflation pressure.

US Growth is Cooling Down: according to our monthly US GDP tracker underlying US GDP growth accelerated from 0.3% to 3% per annum over the last 14 months. But recent data suggests this spurt of growth has already rolled over. Economic surprise measures have fallen sharply in recent weeks and the Atlanta Fed's GDP Now estimate for this quarter is 1.8% per annum. Some forecasters expect headline GDP to be negative this quarter as final demand cools and inventories changes switch from a big positive to a big drag - figures 5-6. That is exactly what the hawks on the FOMC need and want to see, as acknowledged by Governor Waller last week.

US consumers remains central to the global growth outlook. Since the GFC, real Consumption has been trending at an annual rate of 3.7% per annum, vs about 0.8% per annum in Europe - figure 7. Despite a huge shift in favour of goods expenditure vs in-person services ,and then back again during the course of the Pandemic, overall consumption quickly reverted to trend after COVID and has remained there ever since - figure 8. Older consumers with little or no mortgage debt left to pay down have never had it so good, while lower income wage earners have seen a big recovery in real wages over the past year, even as they spent the last of their stimulus checks. Looking out from here, it's clear that real income growth will slow down somewhat and that the labour market will continue to gradually ease, making it unlikely that consumption will remain on trend through 2024. (but unlikely that it will collapse either).

Re-converging: the pandemic led to a huge divergence in fortunes between goods and services and, for a while, much bigger than normal cross country dispersion in growth than normal. Last week's global PMIs confirm two things: that growth is stabilising across the G5, and that sector and country divergence has narrowed mightily over the last several months (more signs of mean reversion post-COVID). Our composite New Orders has held between 48.2 and 48.5 since August and during this time, manufacturing and services have come back into sync after a large divergence opened between them in the first half of this year - figures 9-11.

Reason to be cautious...

Have we got the energy? labour markets are still tight on most measures - see for example figure 12. That means central banks are wary of either hiking rates (overkill?) or cutting them. Ms Lagarde spoke for most central bankers last week as she warned last week against the possibility that unfavourable base effects and potential catch up in real wages would lead to a period in which inflation re-accelerates. (Something that should show up in the PMI output price numbers). In terms of the ability to get inflation all the way back to target and clear the way for rate cuts to happen, one of two things need to happen in our view. Either growth has to slow down more drastically, or energy prices (oil prices in the US, natural gas prices in Europe) need to remain stable or decline further. So long as headline inflation continues to fall, any remaining real wage adjustments can occur without putting upward pressure on nominal wages or overall inflation. What James Bullard once called "immaculate disinflation" - a fall in inflation that does not require either a major squeeze on non-oil margins or a big rise in unemployment - is what markets are currently betting on. It's seldom or even never happened before. And it almost certainly won't happen if there is another significant bump in energy costs - for whatever reason.

Optimistic Pricing: futures markets are already pricing in major rate cuts; equity analysts are already expecting significant growth in corporate earnings and free cash flow for 2024 and 2025, but especially for the largest US tech stocks that now account for a bigger share of the stock market than ever before. It is difficult to see much further downside in bond yields without a bigger slowdown in growth than most equity analysts expect... unless, as noted above, energy costs continue to decline. And it is difficult to imagine further big upward revisions to 5-year expected earnings growth for the major tech stocks, or to multiples. (Nvidia's price performance since announcing absolutely stellar results is a good indicator on that front).

In our opinion, that leaves many of the laggards in the past year's recovery in global equity market as the most plausible beneficiaries of immaculate disinflation. The recent shift in equity market leadership has room to run.


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