‘Bad news is good news’ narrative for markets may not last

With the first month of the year now complete, both bonds and equities have performed well in expectation of a collective pause from central bankers and growth outcomes have waned. Picture: NCA NewsWire/Damian Shaw

“Bad news is good news” for markets again, as economic decay fosters a change in communication from central bankers which has bolstered asset markets. Economic data is declining quickly offshore, as tighter financial conditions, higher interest rates and higher prices – plus a drawdown of pandemic savings – are finally generating significant caution among global consumers.

With the first month of the year now complete, both bonds and equities have performed well in expectation of a collective pause from central bankers and growth outcomes have waned. It is unlikely that 2023 is quite that simple and investors should consider several differing elements that make up market pricing – not least the macroeconomic backdrop and medium-term inflation outlook.

Seemingly last year there was uniform agreement among most central bankers, the developed world over, to move rates quickly to restrictive territory. An acknowledgment that much has been achieved in moving policy, combined with significant caution around the outlooks towards growth, are the flavour of most speeches from this community so far in 2023. This is helping markets perform as we open the year, as the elusive “pivot” in monetary policy should encourage market participants that the moment of peak restrictive policy is now complete and things can improve under the assumption of rates cuts in the future. With the Reserve Bank due to meet this week, we also expect it to acknowledge the bulk of its work is complete in raising rates, as it moves to a “pause and assess” moment in monitoring the decay of growth, due to higher mortgage rates (and the fixed rate mortgage cliff) biting into discretionary spending.

Looking at US data (as the dynamic leading economy for markets), over January alone we have had a string of decaying economic data prints. Institute of Supply Management (ISM) manufacturing came in at 48.4, ISM services at 49.6 (below 50 in contractionary), New York Fed business activity index at -21.4, Richmond Fed business conditions -10, Philadelphia Fed business outlook at -8.9, Dallas Fed manufacturing activity -15, (below zero is contractionary), industrial production -0.7 per cent, manufacturing production -1.3 per cent, housing starts -1.4 per cent and a large decline in retail sales at -1.1 per cent. This is an economy losing velocity rapidly and looks set to continue as policy settings are now restrictive (rather than accommodative as they have been for most of the GFC period). Across the pond in the UK a similar picture is developing. Negative industrial production, manufacturing production and weak retail sales also point to further slowdowns ahead. Germany is also showing lower retails sales and manufacturing activities.

Australia has had little data over January due to our summer break, but our own December retail sales collapsed by -3.9 per cent: the largest ever decline outside of the pandemic and introduction of the GST. With mortgage interest charges already more than 60 per cent higher over the year, it is little wonder that a sharp slowing of discretionary spending is widely expected and should mirror outcomes in other developed economies. Combined with higher prices (we all noticed the cost of BBQ goods this summer), the drain on households spending remains acute.

Thankfully, domestic and global inflation should continue to fall towards the middle of the year as a powerful base effect in the collection and averaging of 12-month data series will drive down headline levels. This decline is helping central bankers gain comfort that a pause to policy tightening is warranted after final rate hikes in the first quarter.

Looking again at the US economy, inflation velocity has collapsed. The last six months of incoming data has reflected falling oil prices and the normalisation of goods prices, while services (especially rent) has remained elevated. Prices do not need to fall for inflation to become zero – they just need to stabilise. However, it is worth noting the amplitude of this base effect in the data works in both directions. The process is still at work, dropping the previous higher data reading from 12 months ago and replacing it with lower current inflation outcomes – thereby lowering the average number. This is why year-on-year inflation in the US has fallen from 9.1 per cent to 6.4 per cent over recent months. This process is likely to continue until the middle of this year, at which time the headline can start to accelerate again (amplitude), as the legacy lower 12-month-old data drops out of the calculations – if the incoming monthly numbers are higher at that time than the prior 12 months data which is discarded, then inflation starts to accelerate again.

With China reopening and President Biden having already played his strategic petroleum reserve card, drawing heavily on US oil stocks to “pump” prime his midterm election chances, it is possible oil and energy prices could be higher, adding some renewed inflation uplift just as markets are hoping for rate cuts to address the slowdowns from the first half of the year.

While markets are enjoying the “bad news is good news” narrative so far in 2023, bad news may not be countered with the good news of policy accommodation (further supporting asset prices) if inflation does not stay well behaved into the back half of the year. This complication would see interest rates stay at elevated levels for a longer period, which will foster more delinquency in the credit system driven by both the high price of money, and a longer length of time at high prices. Northern Hemisphere markets have long used the adage of “sell in May and go away”. If we continue to have a strong run in markets through the first half under a policy pivot assumption, it may be worth considering this adage as we look to the second half of 2023.

Charlie Jamieson is chief investment officer at Jamieson Coote Bonds.