Financial markets got off to a flying start in 2023. Stocks, bonds, and even bitcoin rallied in January. Emerging markets, shunned during the pandemic, also saw large inflows. Risk appetite was based on expectations of a “soft landing” in the United States: rapid disinflation, without recession. Investors were brought down to earth on Friday as the United States reported strong jobs numbers, raising the possibility of inflation being more rigid than expected and the Federal Reserve pushing interest rates upward for longer. Investors are puzzled. Until a clear narrative emerges on how the economy will behave, markets will continue to seesaw.
Markets were initially supported by signs of easing price pressures in the United States: headline inflation fell from its highs since the summer and Fed rate hikes began to calm interest rate sensitive sectors of the economy. Investors did not buy into the Fed’s narrative that monetary policy needed to try harder before price growth was brought under control. They had forecast a lower terminal rate and cuts later this year – even after the Fed hiked rates 25 basis points last week and warned that more were to come.
After jobs figures showed the US gained 517,000 jobs in January, far more than expected, with unemployment at a 53-year low, markets edged closer to the line. Fed and have sold. After all, solid job growth points to a still hot labor market that will keep price pressures up. But markets are still digesting what that means for the US economic outlook, with a hard, soft and even “no-landing” scenario on the table that has varying implications for investors and their positioning.
For some, the “soft landing” narrative remains intact. The number of stable jobs, coupled with a slowdown in annual income growth – which hit a 17-month low of 4.4% – suggests that disinflation could be achieved without a noticeable increase in unemployment. The employment cost index, which is closely correlated to core services inflation – a measure the Fed monitors – has also softened recently. In this scenario, the Fed does not need to raise rates much more and may even cut them before the end of the year. But there is also unease that the exceptional job growth and resilience of the services sector could signal a “no landing” in which the economy does not slow down and inflation and interest rates interest are reaching new heights.
Others are more alert to a “hard landing”. Indeed, economic activity is weakening more broadly: forward-looking indicators for the US manufacturing sector suggest it may already be in recession, while recent data on the housing market and retail trade show fragility. If wage growth does not subside, the Fed may have to push the cost of credit even higher, making an accelerated slowdown in the US economy even more likely. But similarly, the weak economy and the faster pass-through of previous rate hikes could lower both growth and inflation faster.
Financial markets find it difficult to assess all these risks. Conflicting views mean asset prices will be particularly sensitive to new data and comments from Fed officials. For investors, the startling jobs numbers highlight the risks of taking aggressive positions when uncertainty remains high — and picking data to fit a narrative. Making sense of the US economy after recent shocks requires some humility. The Fed, meanwhile, must remain firm in its aim to bring inflation back to target and ensure its communications are clear, while remaining mindful of the risks to financial stability as markets swing and reassess positions. . Whether the landing for the US economy is soft or hard, there will be plenty of turbulence along the way.
