Financial markets have not gone exactly as expected so far this year.
To the uproar of big fund managers, January brought gains in the value of risky assets – a vote of confidence in the soft landing narrative. At the same time, government debt markets maintained their warnings of a severe recession ahead with strong demand for long-term bonds that crowded their yields below short-term debt – the dreaded yield curve. reverse yield that has been the harbinger of so many downturns.
“Something is wrong with me,” Greg Peters, co-chief investment officer at PGIM Fixed Income, told me earlier this week. “You can’t have a strongly inverted curve, with rate cuts presumably priced in because the recession is looming and risk assets don’t really price in those results. All of these things cannot be true.
He was right. After data released on Friday showed the US economy added more than 500,000 jobs in January, a step ahead of the 185,000 expected, it seems the recession bet is simply wrong.
This is great news for the average human. This is less good news for economists and fund managers, who had almost unanimously spoken of an economic slowdown, judging by the annual exercise of the investment house Natixis to browse the thousands of pages of prospects for the coming year for major banks and asset managers. (Thank you for your service, Natixis.)
His analysis shows that the market’s so-called big brains were, on the whole, neutral on US equities and downright negative on Europe. It has worked very poorly so far. By early February, stocks in both regions had risen about 6%.
But the seemingly poor health of the US job market suggests that a pessimistic view on equities may turn out to be right, for all the wrong reasons. This completely resets the main risk for the markets for the rest of this year.
Now, said Mike Bell, global market strategist at JPMorgan Asset Management, “the big risk for markets this year is not a recession but a labor market that remains robust. That would mean the Fed can’t offer the rate cuts that the market takes into account.”
Namely, when stocks opened an hour after the jobs data, the US S&P 500 index fell a hefty 1% before regaining some balance.
Alan Ruskin, strategist at Deutsche Bank, pointed out that the numbers were a bit off. “There is a feeling that the labor market is simply not matching several other weak growth signals,” he said in a note to clients. “That is true.”
Yet, he added, “at a minimum, the data adds to perceptions of a unique cycle, requiring a unique policy response.” It also tears up many investors’ game plans for the year precisely because it presents the Federal Reserve with a golden opportunity to raise interest rates much higher than market participants had previously expected.
Even before the nonfarm payrolls data, some investors feared the rally in equities, underway since October, was eating away, generating excess exuberance and, by extension, more inflation. But the bulls were willing to stick with it, in part because U.S. interest rate policymakers didn’t tell them they were wrong.
This week, the Fed announced a reduced increase of a quarter point in interest rates. President Jay Powell told reporters “we have a long way to go” to bring inflation under control. But at the same time, he noted the emergence of disinflationary forces and, importantly, passed up the opportunity to say that the frothy markets had taken the lead.
And now? This is certainly vindication for those who thought the rally in risky assets, particularly in the US, had gone too far.
Among them is Iain Cunningham, co-head of multi-asset growth at asset manager Ninety One. He is of the view that the full force of the ultra-aggressive monetary tightening of 2022 has not yet properly passed through to asset valuations. “What the Fed and the ECB have done – that degree of tightening is definitely going to bite,” he says.
He watched the rise and rise in stocks at the start of this year in disbelief, convinced that the risks of recession were simply not being properly priced in. Again, he may be right about the market and wrong about the recession, but the result is the same: the moment the market cries out for interest rate cuts and the Fed jumps the other way is when “risky assets really don’t like it,” he says.
Investors now need to go back to the drawing board and sort out their thinking on what will really drive the markets this year. Like the Fed, they will struggle to make meaningful guesses about the future and will instead need to be flexible from one data release to the next.
“It’s pretty clear that the market has been taken ‘offside’ when it comes to favorite deals of the year,” Deutsche’s Ruskin said. “At a minimum, this data will require traders to pull back and regroup.” They may also have to accept being wrong.
