As markets approach Christmas, it’s typical to see activity slow down and market trading volumes drop off a cliff...
As markets approach Christmas, it’s typical to see activity slow down and market trading volumes drop off a cliff. Last night’s US inflation reading therefore marked what was likely to be the final driver of short-term performance. Last month’s inflation reading was the first of the year to come in below expectations, and the hope was that the one-off reading would turn into a trend. Fortunately, that is exactly what occurred as core inflation (the market’s preferred data) rose just 0.2% in November, the smallest monthly advance since August 2021.
Within the reading, there was a lot of evidence to suggest that peak inflation is now behind us and that the lag impact of rate rises will continue to put a handbrake on economic activity. What is perhaps a wonder is that we are seeing inflation slow down while employment continues to surprise to the upside, and the possibility of a ‘soft landing’ in the US is now becoming more likely when the pathway was looking very narrow just a few months ago.
Coming into 2023, there were several paths we thought the macro picture could go down. The worst would be a period of stagflation whereby inflation remained stubbornly high while economic growth slowed considerably. In this scenario, monetary policy would need to remain tight and corporate earnings would likely suffer. Such periods have usually resulted in difficult periods for equities, not surprisingly. The second scenario would be that central bankers overshoot the tightening cycle and that economies contract harder than necessary before inflation cools down. In this scenario, we would see long-term bond yields contract (good for valuations) but at the cost of near-term corporate revenues, margins and profits.
The final outcome is what has become more likely overnight; that is, that previous interest rate rises have done much of the work cooling demand-pull inflation and that economies don’t need to slow down considerably. In this scenario, we may see long-term interest rates reduce (once again, good for valuations) while corporate margins and profits do not suffer. To use the well-known valuation methodology of the price/earnings ratio, the multiple would increase with lower interest/discount rates while the ‘earnings’ side of the equation remains little changed.
So, while we didn’t see a huge rally overnight, the ingredients are there to see a better outlook for 2023 than what seemed likely only a couple of months ago.
