Navigating as market narratives shift

While 2022 was a difficult year for investors, the narrative was simple: Inflation was too high, and the Federal Reserve had to respond with aggressive rate hikes, hurting stocks and bonds and providing tailwinds for the US dollar.

So far, 2023 has been a much better year for asset class returns, with the S&P 500 up 7% year-to-date, but has been characterized by ever-changing market narratives. The potential remains for this data-dependent market to keep jumping from one narrative to another for the rest of the year. This will make it difficult for investors to navigate the coming months.

While banking stress has eased, credit conditions are tightening, boding ill for growth.

US and European regulators have acted quickly to ease the stress in the banking sector, thus averting a potential systemic banking crisis. As a result, deposit outflows have slowed, reliance on Fed liquidity has declined, and funding market stress indicators have remained contained.

However, there are indications that credit conditions have continued to tighten, which may weigh on medium-term growth. According to the Dallas Fed Banking Conditions Survey conducted 21–27 March, commercial and industrial (C&I) loans, real estate lending, and loan volumes fell while credit standards have continued to tighten. In our view, these developments do not bode well for growth later this year.

The recent cooling in US labor market data can be seen in both a positive or a negative light.

US data released last Friday showed that March nonfarm payrolls rose by 236,000, the smallest increase since December 2020. Average hourly earnings rose 0.3% m/m in March, vs. 0.2% in February, bringing the annual growth rate down to 4.2%, the lowest since June 2021. The labor force participation rate ticked up to 62.6%, the fourth consecutive monthly increase and the highest since the pandemic. Friday’s data was consistent with the February JOLTS data earlier last week, which showed that US job openings fell to 9.9 million, the lowest since May 2021, reducing the ratio of job openings to each unemployed US person to 1.67 from nearly two previously.

While the optimistic interpretation of this data is that the tightness in the labor market is easing as the balance of supply and demand of labor improves, the pessimists view it as the first cracks that will be followed by much greater deterioration in the coming months.

As inflation eases, growth may take over as the more dominant concern, perceived or otherwise.

US CPI data due on Wednesday will provide further evidence of whether inflation has remained sticky. Market consensus is forecasting headline March CPI to ease to 5.1% y/y from 6% in February. Indeed, favorable base effects could lead the headline CPI down to 3% by summer.

While the Fed (and the markets) still care more about core inflation, which remained stubbornly high at 5.5% in February, the optics of a decline in headline CPI to 3% may reinforce the view that growth, rather than inflation, will be driving Fed decisions and the market’s performance.

So, while navigating the fickle market narrative isn’t easy, it helps that rates are pricing in a more pessimistic view compared to equities, which are leaning toward a more optimistic outlook. In fact, this differentiation is a key factor for our preference for high-quality bonds over equities. We believe the latter have yet to price in the hit to earnings growth that would likely correspond with a Fed pivot later this year.

We hold a least preferred view on equities and recommend diversifying away from the US and growth stocks. We remain most preferred on bonds in our global strategy, and we prefer high grade (government), investment grade, and sustainable bonds relative to high yield bonds. We also like emerging market bonds.

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