After the worst year for multi-asset investing in decades, the first month of 2023 witnessed a strong move higher in both equity and bond prices, rising by 7.2% and 2.3% respectively.
The primary driver of this recent rally is a positive shift in sentiment towards global growth. Consensus expectations have turned a corner from inevitable US recession to a higher likelihood of a ‘soft landing’ – the scenario in which the US economy slows as inflation falls but avoids a ‘broad-based weakening’.
The likelihood of this outcome has increased and financial conditions have eased, driven not only by the gains in equities and bonds but also by a weaker US dollar and tighter credit spreads.
Recession in the US remains illusive
We have been anticipating a normalisation of the US economy, as opposed to a more severe downturn, since the strong post-lockdown recovery of 2021. Recently, several economic indicators have shifted more clearly in this direction.
In particular, inflation is now more convincingly trending lower. Core Personal Consumption Expenditures (PCE) inflation was reported at 3.9% in the fourth quarter (annualised), having peaked at 6.0% in mid-2021.
Meanwhile, the evidence points to a robust labour market, supporting consumer spending. Initial claims for unemployment benefits recently fell to the lowest level since April last year.
However, there remains widespread expectation that the strength of the economy will buckle. We are seeing an interesting divergence between very weak ‘soft’ data – consumer and business sentiment, typically acquired through relatively narrow surveys – and resilient ‘hard’ data, such as consumer spending, employment, and other quantitative readings of economic activity.
Some of the more pessimistic forecasters point to the current weakness in purchasing managers index readings and manufacturing sentiment surveys, some of which are at near record lows.
Importantly, our research highlights that, while soft data can be a useful guide to the direction of travel, they tend to exaggerate extremities. Economic survey data is typically less useful when expectations are euphoric, or as they have been in the past six months, very depressed.
When we analyse signals of real economic activity, the message is quite clear: the US economy is holding up better than expected. As financial conditions have eased in the past three months, mortgage rates have also retreated, supporting the housing market. Most of the negative impact from higher interest rates is likely to be behind us. Real GDP growth for the fourth quarter was 2.9%, which beat expectations.
While much of this strength relates to technical factors around inventories that will not repeat in early 2023, the meagre expectations of 0.1% for the first quarter suggests room for further positive surprises.
Peter McLean is a portfolio manager at Stonehage Fleming. The views expressed above should not be taken as investment advice.