Soft, Hard or No Landing

Last week was a busy one on the data front. But while government bond yields continued their recent upward move, rising another 0.1% or so, global equities ended the week little changed.

Until recently, the market debate was all about soft-landing or hard-landing, recession or no recession. However, the real world is now not playing ball, prompting investors to come up with the idea of ‘no-landing’ at all.

We are talking here about the US economy and this new concept has been prompted by much stronger than expected data for January. Following hard on the heels of a surge in employment and rise in business confidence, last week saw news of a 3% jump in retail sales.

This leaves US growth starting the year on a firm note and casts doubt on the notion that the economy is headed into recession, as the inversion of the yield curve has been proclaiming for a few months now. The unusually warm weather may well be partly behind some of this unexpected strength but even so, an imminent dive into recession now looks unlikely.

Meanwhile US inflation fell less than expected in January, with the headline and core rates both down only slightly at 6.4% and 5.6% respectively. The former is well down from a high of 9% but these numbers suggest the retreat of inflation is unlikely to be as fast or as smooth as markets had come to expect. Core inflation looks likely to end the year around 3% or higher, well above the Fed’s 2% target.

All this has led to a U-turn by the bond market which is now pricing in an outlook for interest rates much more in keeping with the Fed’s forecasts and rhetoric. Expectations that rates would be cut later this year and be back below current levels by end year have been abandoned. Instead, the market is now anticipating another two or three 0.25% rises over the next few months with rates still up at 5.1% at year-end versus 4.5-4.75% now. This looks much more plausible.

This new concept of ‘no-landing’ is not really that helpful, not least because, as any airline pilot will testify, there is ultimately either a soft or hard landing. Arguably, the day of reckoning has just been postponed until the second half of the year with any US recession now looking more likely to occur then, if one occurs at all.

No such quandaries seem to be bothering equity markets. Retail investors have been a major force behind the rebound and appear firmly in the soft-landing camp. The market rally may have paused in the last couple of weeks but global equities remain some 14% up from their October low.

Current valuations give little weight to the considerable uncertainties still surrounding the outlook. The global price/earnings ratio is now 15.6x, up from a low of 13.2x in October and back in line with the 10-year average. Furthermore, equities are now looking somewhat expensive versus bonds.

Markets could therefore well unwind some of their gains. Even if they don’t, the upside over the coming year from current levels now looks limited, with the best prospects lying outside the US where valuations are significantly cheaper.

There is no need for any new-fangled terminology to describe the outlook for the UK, with stagflation looking a pretty accurate description. Inflation fell back a bit more than anticipated in January with the headline rate dropping to 10.1% and the core rate to 5.8%.

Both, however, are still unacceptably high and the labour market remains robust and a source of underlying inflationary pressure. The unemployment rate was unchanged in December at a lowly 3.7% while regular wage growth picked up further to 6.7%.

On the growth front, retail sales surprised on the upside in January, rising 0.5% and reversing some of their decline in December. With the squeeze on real incomes beginning now to moderate, a period of stagnation or mild recession now seems on the cards for the UK over the coming year, rather than the more severe downturn feared a few months ago.

Rupert Thompson – Chief Economist