Investors were bullish in January, seemingly convinced the inflation threat, and the central bank rate hikes that go with it, will soon be a thing of the past. Whether central bankers have the same optimism remains to be seen.
Despite the gloomy predictions that characterised the end of 2022, the first month of the new year has seen markets chalk up impressive gains – 4.9 percent for the NZX50 and 6 percent for the benchmark S&P500 index in the US.
Those who jumped in when the local market bottomed out in late October have already notched up a solid gain of 12 percent, while market technicians will be watching closely in the coming weeks to see if the index can push above its weekly 100 day moving average, a level it hasn’t eclipsed since February last year.
It seems investors have already decided inflation has peaked, further rate increases by central banks will be minimal and will eventually lead to cuts anyway, and that any recession, if there is one, will be mild and largely inconsequential.
There is plenty of evidence to support the bullish case, including labour markets that remain strong, and businesses seemingly weathering the onset of higher costs by increasing prices. Meanwhile consumers, while tightening their belts somewhat, continue to spend at levels hardly consistent with a slowing economy.
But is it possible markets are once again getting ahead of themselves as they have done previously when trying to second guess the outcome of central bank decisions.
Financial Times columnist Katie Martin recently posted a timely reminder to investors.
“Not for the first time, the current rally is being fuelled primarily by hopes that inflation appears to have come off the boil and that the US Federal Reserve might therefore be inclined to scale back, then stop, then even potentially reverse the interest rate rises that blasted into many fund managers’ returns last year. Futures markets show traders see a near-20 percent chance of rate cuts by the end of the year. Just because this narrative has been wrong on several occasions since the start of 2022, it is not necessarily wrong now.”
But as Martin points out “it was hard to find anyone at the recent World Economic Forum in Davos, Switzerland who was buying [the rate cut story]”.
Some analysts argue the current lull in inflation may well be temporary, particularly as China’s economy gets set to come roaring back after its Covid-enforced hiatuses.
With more than US$2 trillion in accumulated Covid savings ready to be unleashed in the world’s second largest economy, it’s entirely possible a second wave of inflation could be on the horizon, not to mention a potential resurgence in the price of oil if economic conditions continue to improve.
The world’s most recognised inflation indicator has also been steadily gaining ground in recent months. Gold has been somewhat missing in action in the last few years but since hitting a low of US$1615 in late October it has rebounded almost 20 percent, suggesting investors still see inflation remaining a problem for a while yet.
This week markets are set to face something of a reality check with the world’s most powerful central bank, the US Federal Reserve, set to make its first interest rate pronouncement for the year on Wednesday US time.
As Bloomberg writer John Arthurs points out, “the market is rallying as though it’s a clear day with a long straight road ahead and not a car in sight. And in doing so, it comes up against the paradox that has dogged every attempt at a rally over the last year. Central bankers want to slow down the economy, and hope to use tighter financial conditions to achieve it.”
As Arthur says: “this goes far beyond target overnight rates; ideally, we would see equity valuations fall and longer bond yields rise, while the liquidity available in the system dries up. The action of the last few weeks undoes such hopes.”
It’s well-known that the Fed under Jerome Powell is anxious not to repeat the mistake of his predecessors in the 1970s and declare victory over inflation prematurely by cutting rates too soon. The problem Powell, his NZ Reserve Bank counterpart Adrian Orr and other central bankers now face is the market seemingly has declared – prematurely? – victory on their behalf.
So what is a central banker to do? Reassert their authority in the war on inflation and potentially risk ushering in a recession that will inflict further economic pain on consumers already battling higher prices? Or ease off the accelerator hoping that interest rates at their current elevated levels will eventually begin slowing global economies?
Powell’s latest utterances will be scrutinised like never before, and ditto Orr’s three weeks later, on 22 February.
The latest RBNZ dilemma
Devastating floods in Auckland and surrounding regions since the weekend have caused major disruption and severe damage to the city’s infrastructure. The clean-up and repair job looks set to take months, not helped by the already acute labour shortage dogging the construction sector.
The extent of the flooding may well give Orr reason to pause or at least slow hiking the OCR, since increasing interest rates at the same time as the country’s largest city faces its biggest natural disaster in recent memory may well appear churlish. We’ll see – the governor certainly has plenty of data to mull over in the coming weeks, some of it contradictory.
Last week the first big domestic economic data release for 2023 showed that New Zealand’s inflation rate remains near 30-year highs. The annual rate remained unchanged at 7.2 percent in the final quarter of last year and the accompanying data painted a mixed picture.
Despite a sharp fall in petrol prices, imported (tradables) inflation surprised to the high side following a hefty 18 percent rise in international airfares. And core inflation, a key metric closely watched by the RBNZ, increased to 6.7 percent year-on-year.
There were, however, also pockets of good news including a downside surprise to the domestically generated (non-tradables) inflation. The annual non-tradables inflation rate was unchanged at 6.6 percent – well below the RBNZ’s forecast of 7 percent. Housing inflation has largely driven the spike in domestic inflation, but there were signs that even these price pressures are easing. The home ownership price index, which includes home construction, rose 2.1 percent in Q4 as wage rises and some increases in the price of materials were evident. The result was the smallest quarterly gain since the start of 2021.
Kiwibank chief economist Jarrod Kerr argues the evidence points to inflation “peaking”, and an improving outlook both offshore and onshore.
“Taken alongside weakening forward indicators of economic activity, the case for a smaller increase to the cash rate in February is building. We now expect the RBNZ to deliver a 50 basis point [0.5 percent] hike at the February Monetary Policy Statement, a step back from the outsized (catch-up style) 75bp signalled. We have seen more than enough to justify a reduction in the pace and extent of future rate rises. A move to 5.5 percent is likely to be a step too far. We expect a move to 5 percent.”
Kerr argues the good news is downside risks to domestic inflation are building. Wage inflation, a major component of domestic inflation is expected to peak soon. The December quarter labour market report due out tomorrow is widely expected to show the unemployment rate will post a third consecutive 3.3 reading, consistent with a labour market that is overly tight, but there are some early signs employment is beginning to slow as businesses go on the defensive in their attempt to cut costs.
“As January goes, so goes the year” is an old investing adage that certainly proved to be the case last year. After the January investors have just experienced, they will be hoping it holds for another year. Central bankers, however, will have the final say.