Key Points
- The ‘Goldilocks’ soft-landing economic scenario was well entrenched in the first quarter of the year, driven by a disinflationary growth regime.
- Markets now appear to be focused on a more stubborn inflation story, with a measure of heightened geopolitical risk thrown in.
- For Goldilocks (not too hot, not too cold) to be the dominant market phase, we need a soft landing and more modest employment growth.
- We see potential for US bond yields to head back towards 5% to price in the higher-for-longer rate story, while equity markets could be volatile over the coming months.
- However, with strong economic signals coming from the US and many emerging countries, a more synchronized positive growth story could be the dominant narrative for a couple of quarters.
Changing expectations
Market expectations for 2024 appear to be moving on quite rapidly. The much-discussed ‘Goldilocks’ soft-landing economic scenario was well entrenched in the first quarter of the year, driven by a disinflationary growth regime, but now markets appear to be focused on a more stubborn inflation story, with a measure of heightened geopolitical risk thrown in.
Our view is that this phase could bring about considerable market volatility as investors start to worry about structurally higher inflation and the extent of central-bank activity and the interest-rate trajectory. The final phase, in which rate anxiety is followed by economic weakness, could be triggered quite quickly by markets.
Déjà Vu All Over Again
After 40 years in the investment management industry, I get the sense of déjà vu quite often. This time around, we only have to look back as far as last summer to see how markets respond to concerns of higher rates. Last May, we started to see rate expectations rise in the US on the back of a pickup in payroll numbers. While headline inflation was still on its way down from its previous energy price-induced highs, core inflation was still elevated (5.5% in April 2023), and markets started to wonder whether the US Federal Reserve (Fed) might have to raise rates even further to slow employment growth to help bring inflation down.
Sticky Inflation
Currently, while US core inflation had fallen to 3.5% by March 2024, it seems stuck at a level above the Fed’s desired 2% target. Meanwhile, US non-farm payroll employment numbers increased by 303,000 a month in March – the same level as in May 2023! For Goldilocks (not too hot, not too cold) to be the dominant market phase, we need a soft landing and more modest employment growth: too much growth and the Fed tries to cool the porridge by keeping monetary policy tight; too little, and fears of recession (hard landing) start to rise.
Volatile Market Reaction
The market reaction last year pushed 10-year US Treasury yields higher, from 3.30% to 4.99%, reflecting higher interest-rate and inflation expectations. Equity markets were volatile but able to rally, driven primarily by growth expectations around artificial intelligence companies. Additionally, the economic background was robust in the US, supported by strong fiscal spending, population growth and a consumer base insulated from rate increases owing to fixed-rate mortgages.
The sequel market phase in 2024 follows a similar playbook. Bond yields are once again moving to reflect the rising-rate story but, in this latest version, given the elevated levels of equity markets, we are seeing rising equity volatility and price declines.
Investment Implications
Recent moves in some key indicators point towards an inflationary growth regime. Commodities are on the rise, and both European and Chinese economic outlooks have improved from the more negative expectations in the first quarter. With strong economic signals coming from the US and many emerging countries, a more synchronized positive growth story could be the main narrative for a couple of quarters.
We see potential for US bond yields to head back towards 5% to price in the higher-for-longer rate story, while equity markets could find themselves kicked around over the coming months on investor sentiment that oscillates between focusing on good economic growth and anxiety over the added costs associated with higher-for-longer interest rates.
Authors
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