Only a few weeks back, bond investors were panicking over rate fears, as inflation was considered to be sticky and government supply oversized. This sent stocks down as well given the rate outlook and the economic prospects into 2024. A few weeks later, the traditional bond/equity blend (the infamous 60/40 portfolio most investors use as a benchmark for ‘the market portfolio’) recorded its third best month since 1993.
History tells us there is more to come, as strong returns are usually followed by more upside. Such moves are often rationalised by quoting fundamental changes. Yes, there have been some: inflation readings have kept undershooting, most recently even in Europe; the US labour market has definitely started to show some cracks after a stretch of super-strong readings beforehand; and even the masters of money, such as the chair of the US Federal Reserve, have had to admit that they are in restrictive territory by now. But then again, financial market moves cannot be fully explained by these changes. We assume that the extreme bearishness of investors has paved the way for the recent stampede.
US labour market cooling down
The extent of the slowdown in the US labour market will determine whether a weakening of growth could be followed by a recession. So far, the cooling of the labour market has been largely driven by fewer job openings and lower vacancy rates, without triggering a sizeable increase in unemployment.
Less employment weakens the spending power of consumers and increases the risk that the slowdown in demand, which is currently underway in the US, could negatively impact the economy. However, we expect the labour market cooling in the coming months to proceed gradually enough that a recessionary outcome can be avoided. So far, the vacancy rate in the US is still above the unemployment rate, which is hardly a sign of labour market tightness. A gradual cooling of the labour market argues against early and imminent rate cuts by the Fed, which are increasingly priced in by financial markets.
Euro: Signs of vulnerability
Last week, the eurozone’s November CPI inflation data surprised decisively to the downside with a lower reading due to falling energy prices and lower services prices. The data showed that inflation is now within reach of the European Central Bank’s (ECB) price stability target, although it should be kept in mind that the drop was largely due to notoriously volatile components.
Following the release of the data, we revised our eurozone inflation forecast for 2023 from 5.7% to 5.4% and for 2024 from 3.9% to 2.3%. Taking this into account, we expect no further rate hikes by the ECB, which will rather be forced to suppress talk of interest rate cuts as early as its next meeting on 14 December.
A repricing of ECB interest rate cut expectations has triggered a depreciation of the euro against most peer currencies, with declines of roughly 1.3% vs the US dollar and 2% vs the safe-haven Swiss franc since the release of the data. Markets are now pricing in kick-off of rate cuts in March and close to five cuts until the end of 2024. This depreciation of the euro confirms its vulnerability to the downside due to a weak economy, falling inflation, and the debate about when the ECB will cut rates. It also raises our confidence in forecasting a US dollar rebound vs the euro in the short term. With the heavy depreciation of the US dollar two weeks ago due to lower US inflation bringing forward Fed rate cut expectations, we believe that the lasting and even increasing interest rate advantage of the US dollar (due to the later take-off of the US Fed compared to the ECB) will trigger a correction in the euro.
What does this mean for investors?
So how should one navigate into year end? We suggest staying invested, of course. As inflation continues to cool with the ECB able to hit its target, the US rate-hiking cycle is over, and the US labour market is able to avoid a recessionary outcome, we are fairly optimistic going into 2024. History also tells us that there is more to come, as strong returns are usually followed by more upside, so we encourage investors to stay the course and enjoy the new season.