Markets and the Federal Reserve remain in a stand-off. Investors are focused on the scope for slowing inflation to lead to a turn in the interest rate cycle. Central banks, led by the Fed, continue to emphasise that inflation remains elevated and that the terminal rate is more likely to go up than down.
As expected, the Fed raised rates by 50bps at their December meeting and reiterated the need for ongoing increases. Seventeen of the nineteen members of the bank’s Open Market Committee now see the peak rate above 5%. The equity market sold off in response.
Despite the ongoing volatility in markets, we continue to believe that inflation has peaked and will come down steadily over the next twelve months. The uncertainty for investors is the associated level of economic pain and its impact on earnings. Lead economic indicators have slowed significantly and earnings forecasts have been revised lower. Nonetheless, employment is high and wage growth, while moderating, remains at level that makes central banks uncomfortable.
Expectations built into share prices, particularly for many domestic businesses, seem too pessimistic, such a significant decline in earnings looks unlikely to materialise. Indeed, with China re-opening and European gas prices falling, there may be some scope for economic growth to surprise pessimistic expectations. On many measures the expected recession is the most anticipated in recent economic history.
We are not complacent, however, as many headwinds remain, not least the impact of higher interest rates on consumers, but we believe current valuations create a positive set-up for the forthcoming year.