Under normal conditions, equity markets welcome the economy's good performance, which most often increases profits for listed companies. This logic is now being questioned in the United States: while economic indicators are pretty good, markets are worried about it. What the hell is going on?
The economy is still doing well
The unemployment rate is at an all-time low, at 3.4%, the labour market is in full swing with 517,000 jobs created in January, retail sales are up 3% in the same month, inflation is down sharply to 6.4% in January compared with 9.1% in June, the latest indicators from the United States are rather reassuring about the state of the economy.
Faced with such figures, the recession many feared does not seem imminent and should, in any case, be less profound than what one might fear. This is good news for the world’s leading economy.
The Fed’s increased room for manoeuvre worries
Unfortunately, more is needed for the equity markets. At this point, they are worried about the economy. Their reasoning is as follows: the more robust private demand and the economy will remain despite higher interest rates, the more room the US Federal Reserve will have to continue tightening its monetary policy, staying on an upward trend in key interest rates. And the higher they are, the greater the chances of a crash landing in the world’s largest economy. The current health of the economy increases the risks for the future.
Since December, the Federal Reserve has reported that its primary policy rate should be around 5.1% at the end of 2023 and that it would not fall rapidly after that: At the end of 2024 and end of 2025, it should still exceed 4.0% and 3.0% on average respectively.
On the other hand, investors wanted to believe that the pivot (the peak of crucial interest rates) would occur at a lower level earlier, significantly since key interest rates would fall rapidly after that. For this scenario to happen, it would take a struggling economy, where rising credit costs would cause a vacuum shift in private demand and precipitate a rapid decline in inflation. Such a threatened economy would force the central bank to help with growth, urgently lowering its key interest rates.
This would be a good thing for the markets because the chances of a crash landing on the American economy - the scenario everyone fears - would diminish. Second, because a Fed that would come back strong to lend a hand to the economy would be synonymous with a return to abundant and cheap credit that has pleased investors for a good decade, This would naturally be excellent news for equity markets.
Is a revision of the inflation target on the horizon?
Another essential point is that under pressure from a struggling economy, the Fed could live with permanently higher inflation and may only go some ways in searching for the inflation target of 2.0%.
This objective is not consensual and has only been explicitly mentioned among the Fed’s goals since 2012. Many economists describe this level as 2.0%, considering it too restrictive, and say that higher inflation, of the order of 3% or 4%, would be more than enough in a logic of price stability.
If the economy were to suffer when inflation was at such levels, the interest in pursuing the 2.0% target would be questioned, and this debate would take a back seat. But, on the other hand, there is no doubt that investors would find in the political world a powerful ally since a more lax inflation target, which would allow a more expansionary policy and a more favourable economic climate, is not likely to displease those in charge in search of a voice.
All financial assets are affected
This constant repositioning of investors to try to guess the exact trajectory of the cost of credit in the United States is fraught with implications for the prices of financial assets. At the beginning of February, when investors estimated that the Fed would soon have finished with the increase in key interest rates, interest rates in the United States fell, the ten years falling to 3.4% against 4.2% in the Autumn.
The U.S. dollar followed. While it had reached (also in the Autumn) peaks against a whole series of major currencies – including the euro, the Japanese yen, the Chinese yuan and the English pound – the greenback began to slide against all of these currencies to 1.10USD for 1€ in early February.
But since then, investors have changed their minds, thinking that the Fed will finally go further. From then on, the US 10-year rate is again close to 4.0%, and the US dollar has recovered - against the euro as against many others - to return to 1.06 USD for 1€. As a result, in US equity markets, volatility rebounds after a relatively calm start to the year.
How to face such uncertain markets?
The first thing to say is that while the latest mood swings in the financial markets were mainly caused by the Fed and its interest rate policy, staying away from US assets is not a recipe for avoiding volatility. Whether through currency and equity fluctuations, or interest rates, the reality is that developments on the US monetary policy front are impacting the entire financial planet.
We, therefore, remain investing in the United States, whose economy is proving, by its resilience at the beginning of the year, its ability to adapt and face new challenges. As a result, equities, sovereign bonds and high-yield bonds incorporate all of our portfolios.
Second important point: If all markets are impacted in one way or another, they are not necessarily affected similarly. Therefore, it is essential to remain well diversified and maintain exposure to different markets to achieve the best risk/reward balance.
Finally, given the movements that follow and do not resemble each other as the sessions unfold - large increases followed by significant decreases and vice versa - it is imperative to remain investments. Often unsuccessful in regular times, market timing attempts are even more difficult in times of high volatility.