Dear Investors,
Despite cautious central bank communication about the policy outlook, particularly in view of the persistent strength of labor markets, investors were expecting rate cuts in the second half of 2023 amid a fall in global inflation.
Yet, recent macroeconomic data has poured cold water on their quick disinflation sanguine view.
Will (and can) central banks tolerate stronger growth?
The February business confidence points to a return to growth, amid supply chains improvements and China’s reopening from COVID lockdowns.
Yet, while bottlenecks continue to fade, the output price sub-component in the manufacturing sector remains stuck at an elevated level, raising the risk of goods inflation becoming entrenched.
Meanwhile, tight labor markets risk feeding price pressures in the services sector.
Against this backdrop, investors were forced to revise upwards their terminal policy rate projections, while pushing out the timing of expected rate cuts.
500,000 Jobs created
More than 500,000 jobs were created in January and the unemployment rate fell to the lowest level since 1969(1).
Furthermore, initial jobless claims edged lower again in February.
The Conference Board consumer survey showed the percentage of households judging jobs are plentiful moved up for the fourth consecutive month in February, providing further evidence that the labor market still isn’t cooling.
Correspondingly, wage pressures are likely to remain robust.
Central Banks – what are the lessons from the 1970s?
The surge in consumer prices of the past two years has ignited the worry that the global economy could face a period of persistent high inflation.
The commodity price surge in the wake of Russia’s invasion of Ukraine has exacerbated already elevated inflationary pressures driven by the pandemic’s supply disruptions, both in the goods sector and labor market.
In that regard, the situation resembles the 1970s supply oil shocks.
Furthermore for Rothschild Asset Management, then and now, monetary and fiscal policies were accommodative in the run-up to these shocks.
However, the 1970s were a time of considerable structural economic rigidities, as collective bargaining covered four-fifths of employees on average OECD countries.
As such, general wage indexation was a powerful force in the wage-price spiral: when consumer prices rose by 1 per cent, wages automatically rose by 1 per cent, which increased firms’ costs in proportion to their wage bill, pushing up prices.
But in the 1980s, most countries decided to stop indexation clauses as these schemes involve the risk of upward shocks to inflation lasting longer.
Greater economic flexibility, with a less centralized wage setting, also allows a faster supply and demand response in sectors where prices are rising particularly rapidly.
Shift in monetary policy vs 1970s
Furthermore, there has been a paradigm shift in monetary policy frameworks since the 1970s.
During that period, central bank mandates incorporated multiple competing objectives, including for output and employment, and policymakers were inclined to attribute rising inflation to special factors, underestimating the pervasive and lasting impact of excess aggregate demand pressures.
In contrast, today’s central banks have clear mandates for price stability, expressed as an explicit inflation target, and have established a credible track record of achieving their targets.
As a result, inflation – in particular, core inflation – has become less sensitive to inflation shocks.
Overall, synchronous policy tightening around the world contributed to the global recession of 1982, with global inflation waning to around 5 per cent per year, on average, in the remainder of the 1980s, compared to more than 10 per cent a year on average between 1973-83.
Thus, a key lesson from the 1970s is that central banks need to act in a pre-emptive manner to avoid a loss of confidence in their commitment to maintaining low inflation, specified today in their inflation targets.
It is also critical to avoid inflation de-anchoring where households and businesses would base their wage and price expectations on their recent inflation experience, which would enhance the risk of wage-price spiral despite the absence of indexation clauses.
Highlights central banks Ahead
The Bank of Japan (BOJ) will be announcing its latest monetary policy decision during the Asian session today.
There are potential risks arising from BOJ’s yield curve control (YCC), and United Overseas Bank may see exiting BOJ Governor Kuroda tweaking YCC at this meeting.
Biggest US Bank failure since 2008
Market’s attention is likely to stay glued to the developments in the US financial industry. Following the biggest US bank failure since 2008, regulators shuttled another New York bank on Sun.
Subsequently, the Fed, US Treasury and FDIC issued a joint statement that depositors in both failed banks will have access to all of their money starting Mon (13 Mar).
Also, the Federal Reserve Board announced it will make available additional funding to eligible depository institutions to help assure banks have the ability to meet the needs of all their depositors.
US stocks fell on Fri on contagion concerns after a US bank collapsed in the biggest financial failure since 2008.
The S&P 500 fell 1.5% and came close to wiping out its 2023 gains. On the week, the index tumbled 4.6%, its worst week since last Sep.
The Dow Jones and Nasdaq Composite were also on the defensive, retreating 1.1% and 1.8% respectively on Fri.
“Growth” vs. “Value”
For Charles Schwab another defining characteristic of the market’s rally this year has been the outperformance of growth stocks relative to their value counterparts…or has it?
Even within different indexes, there can be a stark contrast in sector weights, which in turn distorts performance (and often leaves investors confused).
This has been prevalent recently when comparing the Russell family of indexes to the S&P family.
As shown in the chart above, Russell 1000 Growth has outpaced Russell 1000 Value by 6% this year, whereas S&P 500 Growth hasn’t had any edge over S&P 500 Value.
It’s quite a divergence, considering both ratios moved in lockstep with each other last year.
Accounting for the change is the difference in sector dominance within each index.
S&P does its annual index rebalancing in December, while Russell does theirs in June.
As shown in the pair of charts below, S&P 500 Growth now has a smaller share of Tech and larger share of Health Care compared to Russell 1000 Growth given December’s rebalancing.
Not only that, S&P 500 Value now has a much larger share of Tech; and in fact, the sector is the second-largest weight in the Value index, behind Financials. Yes, you read that correctly.