Fynsa
Last week we discussed what a soft landing scenario means both in economic terms and in the performance of the different asset classes (see HERE) and that, although it is a pro-risk scenario, we believe that much of it is already incorporated in the current market valuation levels.
Our major apprehensions lie in a still expected upward trajectory in interest rates, still "hawkish" language from various members of the Federal Open Market Committee (FOMC) and reasonable doubt as to how quickly the ongoing "de-inflationary process" will evolve.
Fast forward to this week and the series of recent economic data and new interventions by FOMC members leave more doubts than certainties regarding the de-inflationary process.
This week's U.S. consumer price data, while continuing to show a moderation in year-over-year inflation readings, also hinted that the moderation may be slowing less rapidly than expected. The headline rate slowed to 6.4% in January, down from 6.5% in December, but higher than the 6.2% expected and core CPI, also slowed less than expected. Overall what we continue to see is disinflation still concentrated in the goods market, but with services inflation remaining strong, as we wait for rental inflation to begin to moderate later in the year.
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No one disputes that inflation will continue to show lower year-on-year variations in the coming months, favored by high bases of comparison, but let us understand that the logic of soft landing assumes a rapid convergence of inflation towards the central banks' targets and will not sustainably reach 2% inflation when there is such a tight labor market.
In addition to consumer price data, producer prices surprised to the upside, January retail sales were particularly strong, and labor market data remain solid. Simply put, economic data in recent weeks have mostly surprised to the upside, indicating an economy, and in particular demand, that remains quite resilient.
Of course, this has continued to put upward pressure on market rates (10-year treasury rates are already approaching 4% again) and expectations for the terminal fed funds rate are already trading near 5.5%, that's 50 bps higher than just a few weeks ago.
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A terminal rate at these levels should not come as much of a surprise, because it is basically what the Fed offered in its December projections, but for a market that was heavily out-priced and even incorporating rate cuts in the second half of this year, it explains the sharp upward adjustment in market rates in recent weeks.
Where then can things start to get more complicated? That stronger economic data and a less rapid moderation in inflation may end up tipping the balance to a more hawkish Fed. Remember that Chairman Powell himself has stressed on more than one occasion that the Fed is concerned about "the risk of doing too little," while "the risk of tightening too much" seems less of a concern, as they have tools that would work in that case. And that the peak in the federal funds rate could be higher, particularly if the labor market remains strong.
Well, two interventions by FOMC members drew attention this week, Federal Reserve Bank of Cleveland President Loretta Mester, who said she had seen a "compelling economic case" for deploying another 50 basis point hike in February, and St. Louis Fed President James Bullard, who said he did not rule out supporting a half percentage point hike at the March Fed meeting, rather than a quarter point.
Finally, given the remaining uncertainty about inflation and interest rates, in terms of strategy we continue to recommend overweighting less rate-sensitive assets, such as cash, value sectors, international equities and real assets.
In particular, increasing exposure to cash may be a good alternative. Risk-free rates on the short end of the sovereign curve have become particularly attractive and can bring not only yield (a 6m Treasury Bill is already approaching 5%), and diversification, but also less volatility to the portfolio, at a time when valuations are not particularly attractive in traditional assets.
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Sovereign rates at the short end of the curve have become "quite competitive" with the yields offered by both equities and bonds
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