The economy and markets
Key points to know
Inflation has clearly peaked.
As backpackers know, the risk of injury is higher when hiking downhill than uphill. The same is true for inflation. Headline year-over-year U.S. consumer price inflation topped out at 9.1% in mid-2022 and has since moderated by almost 6%, to 3.2% in October. Comparable measures in Europe have dropped even faster, from 10.6% last year to 2.4% in the latest print. We always knew that headline prices would slide down from those summits. The question was whether stickier core prices would follow the same trail or take unpleasant detours back uphill.
We are more confident that core inflation is maintaining the downtrend in the U.S. Shelter inflation has decelerated for six straight months, and we anticipate further progress. Wage inflation remains elevated at an annual pace above 5%, but leading indicators point to a slowdown next year toward 4% (Figure 2). Overall, though inflation remains lofty relative to pre-Covid trends, it is set to continue its descent over the coming months and quarters.
Recession risks remain.
The upshot of the improved inflation outlook is that growth prospects have also deteriorated. U.S. unemployment has ticked up 0.5% from its recent low, and the pace of job creation has slowed from above 300,000 per month at the start of the year to less than 200,000.
Consumption and investment remain strong, but robust demand today may be simply pulling forward activity at the expense of next year’s growth. Consensus estimates for 2023 U.S. GDP growth are up +2.0% from earlier this year, but prospects for 2024 are down -1.4%. With next year’s economic performance looking increasingly tenuous, the risk is elevated for a dip into outright recession. New geopolitical risks could also weigh on activity, from Ukraine to the Middle East to East Asia. Amid this backdrop, we think a mild recession in late 2024 is more likely than not.
Eventually, as growth slows and the labor market continues to weaken later next year, we expect a pivot toward rate cuts in the U.S., likely around mid-year.
Central banks have finished tightening.
Over the last year and a half, major global central banks focused entirely on fighting inflation. The Federal Reserve, European Central Bank and Bank of England have each raised policy rates between 450 and 525 basis points, from near-zero to multidecade highs. With the inflation outlook now significantly improved, we anticipate an end to the overall hiking cycle. A few outliers may emerge, such as high odds of a rate hike from the Bank of Japan and Australia and/or Sweden following suit.
But for the Fed and most other central banks, attention will now shift. Instead of focusing on “how high” rates need to climb, the question will be “how long” they stay at current levels. With material runway before inflation returns comfortably to the Fed’s 2% target, we think policy rates will remain at current levels for the next several quarters. Eventually, as growth slows and the labor market continues to weaken later next year, we expect a pivot toward rate cuts, likely around mid-year.
What does this mean for rates and markets?
Our macro outlook hinges on three key variables. Inflation has peaked, economic growth will peak soon and central bank policy rates are peaking now. Historically, these dynamics have tended to coincide with a peak in rates broadly, as well as with a re-steepening of the yield curve. We expect Treasury yields to gradually move lower from their current levels over the coming quarters, as high inflation risks ebb, downside growth risks escalate and central banks start to signal eventual rate cuts.
A few variables certainly push against our base case. If growth remains healthy, the Fed may not need to cut rates at all next year, and Treasuries accordingly would not rally. Persistent and outsized fiscal deficits should offset upward pressure on rates. Non-U.S. demand for U.S. fixed income remains pressured by high currency hedging costs. We are cognizant of these risks, but increasingly believe that the case for overweighting fixed income is becoming progressively more persuasive.
All market and economic data from Bloomberg, FactSet and Morningstar.
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