Diverging World – Strong Labour Markets May Force The Fed To Hike Rates Further

The macro environment is, for the first time since this rate hiking cycle begun, characterized by sharp divergences between asset classes, and also across different readings of the business cycle.

For instance, many lead indicators (ISM, Philly Fed survey) have dropped precipitously in the past two months to levels typically associated with a recession, though within those indicators, the service sector appears far more healthy than the manufacturing one. At the same time, consumer centric indicators like retail sales have been strong, and lagging economic indicators like employment are very strong across the Western economies.

No Landing

This dissonance allows commentators with ‘soft landing’ views to feel justified, as much as those with ‘hard landing views. And, there is also a ‘no landing’ school of thought which holds that we dont see a dip in growth and that central banks need to then fight inflation aggressively.

This divergence of opinion is also evident across markets.

It seems first, that the bond market is taking a pessimistic view of the outlook. The yield curve (essentially the difference between long-term and short-term bond yields) is inverted (short term yields higher than long term), a phenomenon that has usually prefigured a recession.

Meanwhile, both equities and the credit markets have rallied in recent weeks, with signs of complacency creeping in (reflecting this our risk appetite index hit its highest level since November 2021).

The issue now is how these divergences are resolved. Our view is that much depends on the stickiness of inflation – if inflation takes hold of the services sector and wages then central banks will have to lean more heavily against the robust labour market. While there may also be some relief from falling commodity prices (i.e. gas) and the effective end of supply chain blockages, recent data suggest that inflation is more sticky than many thought.

In this context, it will pay to stay cautious on stocks – which could well gravitate towards the 3600 level for the S&P 500 index.

In addition, cash is not at all a bad ‘allocation’ move, especially if volatility picks up.

Source: https://www.forbes.com/sites/mikeosullivan/2023/02/22/diverging-worldstrong-labour-markets-may-force-the-fed-to-hike-rates-further/