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As someone who grew up in America in the 1970s and 1980s, my school friends and I often laugh about our childhoods and how oblivious we were to the dangers around us. We marvel at how we survived not being required to wear seatbelts in cars or helmets on bicycles. One close friend of mine actually fell out of her mom’s car – with a cat on her lap – while we were driving down the road. I’m happy to report both were unharmed. But being footloose and fancy free didn’t always work out. There was the time my mom – who was so blissful because she had gotten a new car with a moon roof – forgot to get an oil change or even just put motor oil in her car for about a year. She was enjoying a sunny day out when the engine seized and the car ceased to operate. All the fun quickly came to an end as we watched the car towed away on a flatbed truck.
I share these anecdotes because I wonder if policymakers are becoming oblivious to the risks around us – or at least complacent. Yes, economic data has largely been what we hoped for. But there is a significant risk created by the kind of aggressive, rapid tightening we have seen in the past year; we haven’t seen all the effects yet because of the time lag between policy implementation and real economy impact. My base case remains that we will avoid serious damage and end up like my friend and her cat, a bit shaken up but with just a few scrapes. However, we have to consider the risks and follow them closely so that we don’t end up like my mother’s car on the flatbed truck.
The end of March brought with it a slew of data indicating a jump in demand for services in Europe and China, and a cooling economy in the U.S. that appears to be tamping down inflation. Will the U.S. Federal Reserve (Fed) and other central banks be satisfied with this progress in its fight against inflation? Let’s dig into the details.
S&P Global’s Purchasing Managers’ Indexes (PMI) for the eurozone indicate an increasingly strong economic environment, with the services PMI hitting a 10-month high in March.1 Similarly, while China’s Caixin PMI surveys showed a tepid manufacturing environment, the services PMIs are robust, climbing significantly since China’s economic re-opening began in late 2022. The Caixin Services PMI rose from 55 in February to 57.8 in March, and the New Orders sub-index is at a 28-month high.2 As I have said before, “revenge living” is underway as a high level of pent-up demand is starting to be acted upon.
Last week we also got more signs the U.S. economy is slowing:
So the U.S. economy is cooling, but arguably that’s a good thing if it’s in moderation and inflation is cooling along with it. That appears to be the case so far. Let’s focus on services inflation – the category of inflation that Fed Chair Jay Powell worries will be very sticky. While the U.S. ISM Services Prices Paid sub-index is still high, it has eased significantly in the last year, dropping to 59.5 in March 2023 from a sky-high 83.80 one year ago.6 Clearly, prices have been moving in the right direction – and that movement has picked up speed recently.
In addition, the very tight U.S. labour market – a major driver of services inflation – is showing signs of normalizing. My key takeaway from the March jobs report is that it shows significant progress on the path to normal.7
Simply put, the U.S. economy seems to be in a relatively good place right now, clearly on the path to a more normal, pre-pandemic environment. However, we have to worry about the lagged effects of monetary policy and what will happen when the full impact of the Fed’s tightening finally hits the economy.
The question for the Fed and investors is whether the central bank believes it has done enough to control inflation and, perhaps more importantly now, whether it has done too much to avoid a recession.
In addition, we still have to worry about a flare-up in banking industry issues.
First of all, when banking issues erupted last month, one of the risks we worried about was the tightening of credit conditions. As I mentioned in a previous blog, some tightening of financial conditions could be positive if the Fed decides it doesn’t need to tighten policy anymore. But if financial conditions tightened too much, that could plunge economies into recession. And so it’s important that we monitor credit conditions closely.
A tightening of credit conditions could create substantial headwinds. For example, there are whispers about a few U.S. banks that are potentially withdrawing lending to specific entities such as auto dealers. If lending conditions were to tighten too much and affect many industries, it seems likely a substantial recession could ensue. And so we will need to follow this measure closely.
Second, banks could still face headwinds. We believe the probability of a serious banking crisis is low, but there is still a risk that confidence could be undermined so much that there may be a “run” on another bank. This seems unlikely, especially given that there are policy tools available to prevent that and given that policymakers are hyper-focused on preventing another crisis, but we still want to be vigilant.
What seems more likely is that banks remain in a challenging operating environment in the near term. They have to worry about depositors pulling their money out of banks and putting it into money market funds and other higher-yielding destinations. Banks may need to increase deposit rates in order to be more competitive in attracting deposits, which could in turn compress margins. Of course, we will want to follow this industry closely, which means paying close attention to what is being said on bank earnings calls this season.
I will be very focused on insights to be gleaned from earnings season, especially bank earnings. I will also be looking forward to eurozone retail sales, to see if we get confirmation of the strength of the eurozone economy, and to the U.S. Consumer Price Index, in the hopes that this inflation print helps convince the Fed to hit the pause button and stop hiking rates.
We’ll get more insights into the Fed’s thinking with the release of March Federal Open Market Committee meeting minutes – I’m hoping to see signs that the Fed is increasingly satisfied with its progress in fighting inflation. In addition, I’m hopeful the minutes will show a Fed that is thoughtful and sensitive to the lagged effects that its aggressive tightening cycle over the past year will have on the U.S. economy.
I believe the prudent approach going forward is to remain defensively positioned tactically. Within equities, I favour the technology, health care, consumer staples, and utilities sectors, and the quality and low volatility factors. Within fixed income, I favour investment grade credit.
In terms of strategic positioning, I continue to advocate broad diversification both within and across the three major asset classes, with adequate exposure to assets with capital appreciation potential and income-generating assets.
Kristina Hooper is Global Market Strategist at Invesco. With contributions from Andras Vig.
Notes
Disclaimer
© 2023 by Invesco Canada. Reprinted with permission.
This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.
The opinions referenced above are those of the author as of April 10, 2023. These comments should not be construed as recommendations, but as an illustration of broader themes. This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.
Forward-looking statements are not guarantees of future results. They involve risks, uncertainties, and assumptions; there can be no assurance that actual results will not differ materially from expectations. Diversification does not guarantee a profit or eliminate the risk of loss. All investing involves risk, including the risk of loss.
Diversification does not guarantee a profit or eliminate the risk of loss.
All figures are in U.S. dollars.
This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.
All investing involves risk, including the risk of loss.
Past performance is not a guarantee of future results.
In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.
Commissions, trailing commissions, management fees and expenses may all be associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Please read the simplified prospectus before investing. Copies are available from your advisor or from Invesco Canada Ltd.
Investment funds are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that any fund or security will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently and past performance may not be repeated. No guarantee of performance is made or implied. The foregoing is for general information purposes only. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.
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