Investors should remain vigilant to the trajectory of corporate earnings and be wary of the lagged impacts of monetary policy.
What a difference a month makes. Just four weeks ago there were questions around the odds of a soft landing, Now, after a raft of stronger-than-expected data (here and offshore), several commentators have raised the prospect of a “no-landing” scenario.
What does a “no-landing” scenario for the world economy look like? More importantly, what could it mean for markets?
With a soft landing, markets and economies would skirt or even avoid an outright recession. The uplift in unemployment required to bring inflation back to most central banks’ 2-3 per cent inflation mandates would be tolerable, particularly given their current 50-year lows. It would also likely mean that equity market lows are already in for this cycle.
Under a no-landing scenario, economic growth and employment would remain resilient this year in the face of some of the sharpest ever increases in interest rates. But in contrast to a soft landing, the implications for markets are more difficult to discern.
Global equity markets have begun the year with a bang – the 7 per cent increase in the MSCI World Index in January was the second-strongest start to a year since 1987. The soft-landing narrative that powered that move was underscored by “recovery” sectors, such as housing, semiconductors, cyclicals and transport. On the surface, equities appear willing to embrace a “Goldilocks” soft-landing scenario.
Other indicators suggest investors should be more circumspect. First, the bond market, rather than embracing the soft-landing narrative, has been inching ever closer to the no-landing camp. Market pricing for the US cash rate peak is 5.3 per cent. A little over a month ago, it was 4.8 per cent. Investors have added almost two full rate hikes to their terminal rate in the US, and the same is true for Australia (now at 4.3 per cent from 3.6 per cent). In both countries, bond yields have retraced higher to prior peaks.
Second, the notion of a central banks’ pivot, or shift to near-term rate cuts, is being strongly challenged, with markets repricing future rate cuts from late 2023 into 2024, in line with our thinking. This “higher-for-longer” narrative seems more plausible today than at any point in this cycle.
For equities and portfolios more broadly, the implications are significant. A higher cost of capital or interest rate, all else equal, reduces the present value of corporate cash flows. This is what we saw last year, when the world price-earnings multiple (or valuation) corrected sharply (from about 22x to 14x).
However, there is also a second component to higher rates that is equally important. Monetary policy acts with a lag that is generally accepted to be at least a year. The US Fed only began hiking rates in March last year, the RBA in May and the European Central Bank in July. It is almost certain that the real economic impacts of those hikes are yet to be felt. This begs the question whether a no-landing scenario ultimately evolves in time to a hard-landing scenario, giving way to an equity correction that takes longer to emerge, but more destructive than currently expected.
For corporates, their earnings per share are already weakening. If economies were to remain resilient (particularly the jobs market), they risk persistently high interest rates and sticky wages pressure, not to mention higher refinancing costs. They would also likely see yield-seeking investors look to other asset classes (cash, credit, and government bonds), not equities, to generate income.
For now, equity markets are weathering the reporting seasons relatively well, particularly in the US, where a well-below-average upgrade cycle has not seen markets correct, but instead has challenged pre-pandemic valuation peaks. By contrast, in Australia, where about 50 per cent of corporates have reported, profit expectations have been marginally upgraded, despite reduced profit margins (largely as a result of rising wage bills) being a common feature. In Europe, the soft-landing thesis has supported a strong rally through January, given the strong cyclical bias in the European market.
Looking ahead, the irony for equity markets is that although no landing sounds like a better outcome than a soft or hard landing, this might not be the case if it delivers stickier inflation, or higher-for-longer interest rates.
Investors should remain vigilant to the trajectory of corporate earnings and be wary of the lagged impacts of monetary policy. Indeed, equity markets should be more welcoming of a deterioration in the current strong macro data, than if that data strength were to continue.
