Financial markets have started the new year in a buoyant mood, bolstered by an elusive alignment of stronger global growth prospects, falling inflation and less hawkish central banks. The broad-based rally in asset prices and the resulting loosening of financial conditions have opened the way for issuers to tap the capital markets for funding at quite attractive levels relative to those in 2022.
The sustainability of this encouraging configuration is not yet assured, however. Four issues in particular require close monitoring by investors.
The rally in stocks and bonds has been breathtaking so far this year. In just the first two weeks, the more volatile Nasdaq Composite Index has gained 5.9% while the S&P 500 Index and the Dow Jones Industrial Average have risen 4.2% and 3.5% respectively. The prices of U.S. government bonds have continued to defy their long-term negative correlation with stocks, with the 10-year Treasury gaining 3% so far this year. The Bloomberg Treasury index is up 2.3%, and the broader aggregate bond index is up 2.7%, both with relatively shorter duration.
The rally has not been limited to stocks and bonds. The price of Bitcoin is up some 25% so far this year thanks to looser financial conditions and larger risk appetites.
Three market beliefs have driven this pronounced and broad-based improvement in financial markets:
• Global growth prospects have been enhanced as China has pivoted away from its Covid Zero policy much faster than most people deemed likely; a warm winter has eased the energy price headwinds to European economic activity; and a strong service sector and solid labor markets have contributed to upside growth surprises in the U.K. and the U.S.
• Moderating inflation on the back of lower energy prices and better functioning supply chains is on its way to meeting central bank targets.
• The Federal Reserve will not deliver on its often reiterated forward policy guidance of keeping rates higher for longer. Instead, investors are pricing in interest rate cuts later this year.
The resulting market perception of more favorable global growth, inflation and policy outlooks lowers investors’ concerns about the trifecta of risks related to interest rates, credit and earnings, and market functioning. With that, financial conditions loosen significantly, risk appetites increase, price gains extend far and wide and trading and issuance activity accelerate.
Seasonality is also playing a role. The new year is often characterized by more buoyant markets as institutional risk limits are reset, new money in put to work, and issuers get an early start on meeting their annual funding goals.
Having said all this, durability is not guaranteed. Four main factors warrant particularly close monitoring.
First, while China’s pivot away from its Covid Zero policy has paved the way for higher supply and demand, this is being attempted without the favorable resolution of the trade-off between lives and livelihoods that widespread effective vaccination enables. Despite the worrisome lack of official data, sufficient partial indicators suggest that China’s health system is under greater pressure from a Covid outbreak and that the death toll may be significant. In addition to raising questions about the sustainability of the current policy approach, this also increases the risk of new mutations of the virus spreading from China.
Second, the improvement in U.S. growth prospects is being accompanied by a depletion of savings, which had benefited from the considerable fiscal transfers to households during the pandemic, and an increase in indebtedness. The offset of a strong labor market is relevant as long as the supply side can meet the high job vacancies through an increase in labor force participation and better skill-matching.
Third, while headline inflation will continue to fall in the months ahead, the prospects for significantly lower core inflation are less assuring, especially in the second half of the year. Recent data confirm that inflationary pressures have transitioned to the service sector after being concentrated in two products—energy and food—and subsequently in the goods sector as a whole. This transition is particularly noteworthy because inflationary pressures are now less sensitive to central bank policy action, as is mounting wage pressure. The result could well be more sticky inflation at around double the level of central banks’ current inflation target.
Finally, this inflation picture, combined with central banks’ twin and linked desires of avoiding the policy mistake of the 1970s and restoring their damaged inflation-fighting credibility, suggests that markets may be too quick in assuming that more dovish forward policy guidance will soon accompany the improved inflation and growth prospects. If central banks do indeed cut rates later this year, the driving force would be recession concerns, something that would also pressure households and corporates. In the interim, I doubt that the Fed is as excited as markets are about this year’s considerable loosening in financial conditions.
While investors should indeed welcome what has been a wonderful start to the year for financial markets, especially after such a brutal 2022, they would be well advised to be cautious when it comes to extrapolating the favorable driving forces. There is still plenty of uncertainty about the world’s growth, inflation and policy prospects.
Mohamed A. El-Erian is a Bloomberg Opinion columnist. A former chief executive officer of Pimco, he is president of Queens’ College, Cambridge; chief economic adviser at Allianz SE; and chair of Gramercy Fund Management. He is author of The Only Game in Town.