Is good news bad news?
M.Sc. Barbara Gačnik, Head of Investment Management, Sava Infond doo
On Friday, the US published a labor market report that exceeded expectations. In January, 517,000 new jobs were added in the private sector, which is three times more than expected and the most since July 2022. The figure from December was also revised upwards. The majority of jobs would be created in the service sector. The unemployment rate is the lowest in the last 53 years and stands at 3.4 percent. This means that the Fed still has a lot of work to do to tame inflation. On the plus side, growth in average hourly wages has slowed, and that's the direction policymakers want to see. However, a resilient labor market encourages stronger consumption and thus supports earnings growth, which is good for equity markets. On the other hand, a strong labor market may in the long run trigger a second wave of inflation, forcing the Fed to raise interest rates even more aggressively, which in turn would trigger a deeper recession.
On Tuesday, February 1, as expected, the Fed raised the interest rate by 25 basis points, to between 4.5 and 4.75 percent. President Powell announced that the cycle of raising interest rates is not yet over, as inflation remains at elevated levels. The Fed pays special attention to the labor market. In order to reach our inflation target of two percent, economic growth will have to be lower than trend for some time, and the labor market much looser. Powell says that at this point, monetary policy is not yet restrictive enough. The demand for workers remains well above the supply and the latter will need to be balanced, as the strong labor market with its wage dynamics is strongly correlated with prices in the service sector. The prices of consumer goods and goods show an obvious negative trend, and prices for basic services (excluding rents) remain stickier, so it is far too early to declare that inflation has been defeated. Powell believes that at least two more rate hikes, followed by a pause, will be necessary. The Fed estimates that consumption will be strong enough to support US economic growth this year, and if the economy moves in line with their expectations, the committee does not expect to cut interest rates this year.
However, it appears that market participants hear the statements of the Fed chairman very selectively. Markets are in a good mood as inflation melts away and positive sentiment benefits both stocks and bonds. Even as investors are forced to push their interest rate cut expectations back further on the calendar, they still see a Fed reversal in the second half of 2023. Higher stock and bond prices are making millions of Americans richer and making it easier for companies to raise fresh capital for investments and new jobs. As long as inflation is enemy number one, anything that would further stimulate demand and influence prices to rise is undesirable for the Fed.
The key question is, will the sharp fall in inflation continue? If inflation continues to moderate at this pace, then a so-called soft landing is more likely and optimism on the stock market is justified. Conversely, price growth in the service sector may surprise. The last publication of the Service Purchasing Managers' Index far exceeded expectations, the service sector is booming. The prices of goods are indeed falling, but they cannot fall indefinitely, and the tools of monetary policy have less influence on service inflation.
The beginning of the year in the markets is quite positive, so caution will not be superfluous. Despite the growth, there are still opportunities to be found, just be selective. But for long-term returns, the most important thing is to stay invested.
Inflation may be coming down faster than it seems
Aleš Čačovič, senior manager of investment funds
Investors on stock markets are more optimistic than central bankers, who remain reserved in their statements.
With the entry into the new year, the flow and type of events did not change significantly. From the point of view of the media, which is a mirror of the daily events, the concerns of the individual are still connected with high inflation, the war in Ukraine and some other similar concern that is still lingering from last year.
But in the financial markets, which try to guess the direction of the economies from the movements of the curves, it is clear that optimism is returning. As usual, when many people do not know how to explain positive movements on the stock markets in times of bad conditions and vice versa, even now we can ask where the stock markets are rushing to, when the recession has not really hit yet, or where the bond growth is coming from, when the central banks are still they are always fighting inflation.
The divergences are not a surprise
Such inconsistencies are a constant for stock markets, as financial markets move on the wings of guesses, conclusions and expectations, which, economically speaking, are eventually realized.
If we focus on the debt or bond markets, which suffered historic losses last year due to the sharp rise in interest rate expectations, this year they have only begun to recover on expectations that inflation will decrease faster than the central banks expect.
This scenario, which has a significant probability, is becoming more and more relevant. The inflation expectations of the European Central Bank (ECB) and the American Central Bank (Fed) for the end of this year already seemed relatively high at the end of 2022, given the clear negative trend in the energy and raw materials market. Thus, it may turn out that the central banks will again be wrong in their expectations. The latter is nothing special and the markets are already used to it. After all, just as analysts keep changing their forecasts for either corporate profits or countries' gross domestic product, central banks keep changing their estimates for steering monetary policy.
Interest target level
In the last week, two key central banks, the British Bank of England and the Federal Reserve, met. The latter only confirmed with a slight increase in the interest rate (+ 0.25 percent) that it is reaching the target level for raising interest rates, while the Bank of England hinted at the last increase in the interest rate to four percent that it may have already arrived to the plateau.
This news made bond market players overjoyed as it was just one more piece in the puzzle of peak interest rates. The governors of the central banks do not yet share this optimism with the stock markets in their publicly expressed rhetoric and are more or less still somewhat restrained. They see the reason for the slow decline in inflation in the firm part of the market and the pressure on wages. However, the impact of wages usually has a very limited impact on inflation, especially if it does not contribute enough to the purchasing power of the consumer. Globally speaking, the latest surge in prices will remain more or less anchored and subject to the normalization of supply chains and recovery in commodity availability, the consumer will once again be saturated with supply, which will once again start to build deflationary pressures. Central banks don't see such a scenario on the horizon yet, but it could happen much faster than it currently seems.
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