Markets cheer as recession and inflation risks abate

The new year kicked off with a strong rally in risky asset classes and EUR/USD. From an investor point of view, the latest news on the real economy could not have been much better. Headline inflation is coming down sharply in the US, while the euro area seems to have passed the peak. More importantly, it seems price pressures are waning without much damage to economic growth. Supported by China’s reopening, lower commodity prices and looser financial conditions, we now expect a turnaround in the global manufacturing cycle already in Q1, see Research Global – Global manufacturing PMI heading higher in H1, 25 January. Both the US and euro area are now set for milder and shorter recessions than previously expected. We have lifted our growth outlook both for the US and the euro area, and now longer expect a double dip recession in Europe.

While disinflationary pressures in the US already seem broad-based, in euro area, the convergence of headline and core inflation continues. Headline inflation in EA (excl. Germany whose data is missing) declined to 8.5% in January (from 9.2%). Meanwhile, core inflation kept at 5.2%. Wage pressures, based on job ads, seem to be levelling off, but same time, core goods inflation remains elevated as companies continue to pass on rising input costs to consumer prices. This year, inflation forecasting will be even cumbersome than normally as country-specific fiscal measures such as support for households’ energy bills distort consumer prices, see Euro inflation notes – January surprises, 25 January.

The more upbeat macroeconomic backdrop is a double-edged sword for central banks. US labour markets remain tight due to permanent damage to labour supply from the pandemic, and Europe continues to suffer from energy shortages as long as there is no permanent solution to replace energy imports from Russia. As supply side problems persist, both the Fed and the ECB have pursued demand destruction by hiking rates, hoping that cooling demand would eventually alleviate price pressures. Hence, while the improved economic outlook is positive news for businesses and households in short term, it jeopardizes central banks’ strategy to tame underlying price pressures for good. Without sufficient demand adjustment and financial tightening, there is a risk that the current disinflationary period proves temporary and inflation spikes again at some point.

Major central banks delivered no surprises in the first meetings of this year. The Fed hiked rates by 25bp as widely expected. In the press conference, Chairman Powell either failed to appear hawkish or intentionally delivered a more dovish message than before. We still expect the Fed to hike rates by 25bp both in March and in May, and then pause. Powell has emphasized that policy has to remain restrictive for some time, and hence, we think markets are premature in pricing cuts later this year. That being said, should the ongoing trend in rising short real interest rates continue, Fed might opt to lower rates in order to avoid an unnecessary tightening in financial conditions. The ECB hiked by 50bps in line with expectations, and intends to hike by 50bp also in March. Markets were expecting a hawkish Lagarde, even to the extent that her pursuit to be hawkish was probably doomed to fail. We think markets may still underestimate ECB’s determination, and risks remain tilted towards a peak policy rate closer to 4% rather than 3%.

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