Since late October, financial markets have made rapid upward moves as shares and bonds have rallied, while the US dollar (USD) has fallen. These positive market trends have been less obvious in Australia than in many other developed economies, but the momentum domestically is still positive. Driving them are expectations of a US Federal Reserve (Fed) pivot from raising rates to leaving them at current levels for a while, the USD coming off its peak, and hopes and expectations of a soft landing for the economy. While Australian markets have their own particular drivers (not addressed in this QB), it is still the case that the Australian Stock Exchange usually follows Wall Street, and that is likely to continue to be the case.
Source: Alpine Macro
The million-dollar question is, can the market recovery be sustained in a meaningful way into the new year? Events that have transpired in recent months suggest the answer is a resounding “Yes”.
The fiscal boost to the US economy has waned in recent months, while the labour market has been steadily drifting lower. If we examine the various sectors of the US economy, a year ago 85% of sectors were adding new jobs, whereas today it is down to around 50%. Meanwhile, the so-called “jobs quit rate” has returned to levels similar to 2018/2019. Importantly, the falling quit rate has coincided with falling wage growth, suggesting the labour market is regaining balance.
Importantly, the US forward markets, which assess the future path of monetary policy, have been quick to change their expectations, and now predict a downward move in rate projections. While forward markets are a useful indicator, of course, they can be wrong. Perhaps they are a tad overly optimistic.
Nevertheless, this is good news for markets: the softening of the labour market plus diminishing fiscal stimulus, means the natural tendency is for the US economy to weaken. This is positive news for asset prices because a softening economy eases the selling pressure in bonds, which in turn allows stocks to advance.
Of course, one has to temper enthusiasm with caution. The interplay among financial markets, the economy and central banks is like walking on a tightrope, with recession risks on one side and undesirable economic strength and inflation on the other. For central banks, the maneuvering room has diminished as rates have risen. Will higher rates lead to a gentle soft landing or a tough recession? Will inflation re-surge if rates are not quite restrictive enough?
What is a “soft landing” anyway? In simple terms, it is a non-recessionary growth deceleration, with inflation falling towards the target range of 2% in the US, or 2-3% in Australia. A soft landing does not preclude GDP growth from dipping into negative territory for a month or two, but a sustained contraction should be avoided. There are two key risks to a “soft landing” outcome. The first is that central banks overtighten, crushing the economy into a recession next year.
It could be argued that some interest rate-sensitive sectors are already in a recession – one simply has to think of those who have large variable rate mortgages and who purchased their homes recently at high prices. Generally, however, the consumer balance sheet is fairly robust, and the corporate sector seems okay with not too many negative shocks from the recent reporting season. Nevertheless, we all know that economic conditions can change suddenly, and there is no room for complacency.
The second key risk is the other side of the coin: persistent economic strength and sticky inflation. This could mean that central banks would have to resume rate hikes, which in turn would damage stocks and bonds. Yet remember that inflation has come way down and indicators suggest that demand will weaken once past rate rises take hold.
We suggest that how inflation behaves in coming months will hold the key: the faster inflation falls, the bigger the odds of a soft landing. We remain cautiously optimistic that inflation will surprise on the downside, and that a soft landing is the most probable outcome.
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