Key Takeaways:

• Slower inflation in late 2022 led markets to revise down interest rate expectations for 2023+ and rally through late 2022.
• However, recent data points to a resilient economy and persistent inflation. Such a scenario would mean prolonged tightening. This back-and-forth explains much of the volatility we have seen so far this year.
• With a high likelihood of a recession in mind, a protracted rate hike to rein in inflation would be bad for stocks in 2023.

The Fed does not want to crash the economy but is willing to engineer a (mild) recession to bring down inflation. As the pace of inflation started to slow in late 2022 (but still far from the 2% target), questions turned to whether the Fed had managed to engineer a decline in inflation without tanking the economy, a so-called soft landing. Indeed, after the release of relatively benign inflation data in October 2022, markets mounted a rally expecting that the Fed would begin cutting rates by the end of 2023, way ahead of schedule. More recently though, with the release of data showing a strong economy with a strong labor market and robust retail spending has dashed that sentiment. In other words, good news for the economy has meant bad news for financial markets.

Market participants are carefully parsing every macro data release—GDP growth, inflation, unemployment, etc—for signs of moderate economic growth and low(er) inflation, hoping that these would signal a reversal of the rate hikes that central banks began a year ago. How likely is such an outcome? Let’s examine the balance of risks moving forward.

For the volatile elements of the basket of items on which inflation is measured—energy and food—the outlook is somewhat mixed. For energy, global growth has begun slowing and will slow further with the continued tightening of monetary policy by central banks around the world. Slower growth implies less demand for oil and other energy sources which means lower prices. A mild winter in Europe and the shift towards other sources have also eased some of the strains from the Ukraine war. Some of this will likely be offset by China’s reopening. The war in Ukraine continues to weigh on food prices but the rate of increase is expected to slow which implies lower inflation.

On to core inflation, the pace of price increases for durable goods has slowed markedly as supply chain pressures have eased and households had pulled forward their purchases during the pandemic. However, the prices of services had been rising rapidly following a rotation from goods (cars and washing machines) to services spending (restaurants and air travel). Closely tied to services inflation is how fast wages and salaries are rising because labor, rather than machinery and tech, make up a larger share of the production process. So it’s useful to assess the strength of labor markets to form a view on the services inflation outlook. In fact, the labor market remains remarkably tight, with almost two jobs available for every unemployed person. This is partly because many working-age people left the labor force altogether during the pandemic. With this shortage of workers, sustained increases in prices across the board, and the expectation that prices will continue to rise in the near term, workers have increased their wage demands significantly. So far, wage growth has been less than inflation but there remains the risk that there will be second-round effects from wages to prices and this will spiral further.

With every data release, we are seeing markets swing wildly as investors adjust their bets on future interest rates. They are hoping for an economy that is just right—one where unemployment increases slightly, people spend slightly less, and inflation falls much faster. In our view, the odds favor higher interest rates at least through the first half of 2024 and a recession in the near term. 

As always, we remain focused on the long-term and bearing monetary policy & inflationary risks in mind. We have adjusted the risk tilt, overweighting resilience and value and remaining neutral on efficiency and growth. In our assessment, this best positions us for a prolonged high interest rate environment.