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A strong, positive start for markets 2023. The S&P 500 is up by over 2.5% YTD, and the positive sentiment has reverberated around broader markets and commodities. Copper is up by almost 9% too.
We highlighted the metal as one to watch here at the end of last year.
One big driving factor has been China’s reopening. The faster than expected end to Covid Zero alongside multiple promises of stimulus and support, even for the beleaguered property sector has pleased markets.
The ‘three red lines’ will be eased to allow systemically important developers to shore up their balance sheets and encourage mergers and acquisitions in the industry as well. Two big China risks 'addressed' in one hit.
The worst case scenario of an EU gas crisis has been avoided too. The surprisingly mild European winter has seen gas prices fall dramatically. Goldman Sachs upgraded their forecasts for the European economy and no longer see a 2023 recession as the most likely scenario.
Instead, the bank predicts that the Euro area economy will grow by 0.6% in 2023.
“...we look for weaker growth in Germany and Italy than France and Spain. The most important reason is that Germany and Italy were more reliant on Russian gas imports, while France and Spain have more diversified energy sources and are relatively more service-sector intensive.
“This is especially the case for Spain, which still has room to rebound from the covid crisis. As a result, we see Germany and Italy on the edge of recession but expect continued growth in France and Spain.”
Weak growth rather than recession is a long way from the predictions of European doom last year. Will the optimism last?
Well, a lot still depends on the US. The role of the global end consumer is key. To quickly recap, one of the concerns towards the end of 2022 was the impact of inflation on wages. On aggregate, households were slightly worse off after adjusting their earnings for inflation, but a big pile of pandemic savings was helping maintain spending and consumption.
As that pile of savings is getting smaller, the personal saving rate is/was falling at the same time. The future potential of consumption looked weak:
However, inflation is falling rapidly. Thursday’s CPI report was perfectly in line with expectations. A negative headline inflation print on the month due to a large drop in energy prices, although core inflation remains sticky, especially in the services sector.
Core goods prices are falling though, led by the drop in used car prices (-2.6% month on month). This Bank of America chart highlights the stickiness of the core services measure vs goods inflation.
This continued slowing of inflation has brought more optimism to the market. Talk of soft landings and Goldilocks conditions is rampant. Central banks are unlikely to facilitate such a landing. We’re heading in the right direction but many of the factors that central banks want to see resolved in order to cut rates are likely to persist.
Fears are that sticky core inflation will stay above the 2% target. Labour shortages will ensure that wage growth persists, especially in the service industry. Or so the narrative goes.
Nevertheless, the latest jobs report saw the Goldilocks chatter ramp up. Hopes are rising that maybe the ‘soft landing’ is possible after all. As the economy moves away from running ‘too hot’ it can stay resilient enough to flourish above the kind of ‘too cold’ levels that would signify recession.
Beyond the headline of 223,000 new jobs being added, there were two encouraging signs that the labour market is balancing out. Firstly, the participation rate increased by 0.2%, indicating that workers are returning to the labour force, pushing back slightly against the structural labour shortage claims.
Wages are also not rising as fast as feared. ING’s James Knightley explains:
The annual rate of wage inflation (average hourly earnings) is now 'just' 4.6% whereas the market had been looking for 5%. Last month’s 0.6% month-on-month initial print has been revised down to 0.4% while December's MoM rate came in at 0.3% versus 0.4% expected. So we have a weaker trend materialising it seems.
That weaker trend is precisely the response that the Federal Reserve is looking to induce. The revision of last month’s 0.6% to 0.4% was encouraging too, calming market fears that labour market tightness could cause wages to continue running hot.
A clear trend of slower wage growth is emerging, as this chart from the Atlanta Fed shows:
However, economists have also highlighted the weakening trends under the surface. Temporary help has fallen for five consecutive months now. Temporary workers are the easiest (or least costly) workers to let go. These cuts aren’t really indicative of a red hot jobs market…
Wage growth falling is also a double-edged sword. On one hand, it reduces the potential for future inflation (and increases the potential for interest rates to be cut). On the other, slower wage growth reduces potential future consumption.
It’s worth remembering all of the things that need to be true if this story is going to have a happy ending.
Right now, the Fed fund rate sits at 4.5%. Fed officials are communicating that it’s time to slow the pace of hikes to 0.25% per meeting and that they’re likely to pause in the region of 5% and hold rates there for some time. So, a couple more hikes and done?
Given recent trends, the shallow recession/soft landing narrative is roughly dependent on the Fed nailing the turn. We covered Goldman’s take on this here. As inflation slows, real wage growth is likely to turn positive. Inflation will no longer exert the same drag on purchasing power. The economy could pick up again.
Can economic growth rise significantly without prompting another round of inflation?
Can inflation be tamed without causing too much economic weakness?
That’s the tightrope the market is walking.
Miracles are possible, but not probable.