The lost plot

While the Fed is now predicting two more hikes, despite leaving rates unchanged in its June meeting, the market is not buying the Fed’s story.

AS we will soon be turning the chapter into the second half of 2023, it is perhaps an opportune time to gaze at the crystal ball again and see what lies ahead over the next six months for global markets and Malaysia. For this week, an analysis of the global economy will be made while in the next column, the focus will be on Malaysia and what lies ahead.

Mixed forecast

While the World Bank was more upbeat in its June 2023 assessment of the global economy whereby it raised the gross domestic product (GDP) forecast to 2.1% from 1.7%, the International Monetary Fund (IMF) in its April 2023 update, lowered its estimate by 10 basis points (bps) to 2.8% from 2.9% that it made in January.

Perhaps the assessment of the two world bodies is a reflection of over-optimism at the beginning of the year on IMF’s part and too conservative on World Bank’s part as we now see the gap between the two forecasts narrowed to 0.7 percentage points (pps) from 1.2 pps earlier.

Nevertheless, it is estimated that the IMF may likely revise its outlook to a lower growth in its next review when it releases the World Economic Outlook July 2023 Update within the next two weeks.

For the World Bank, the key concerns that were flagged early this year remain very much in view with inflation still showing its ugly head, central banks (except for Vietnam and China) are still raising rates despite selective financial markets entering the bull market phase.

The rise in interest rates is not only dampening consumption and investment but also intensifying the risk of a financial crisis, according to the World Bank.

Failed dot plot

Last week, although the US Federal Reserve (Fed) left key rates unchanged at between 5% and 5.25%, it surprised the market with an assessment that the US Fed Fund Rate (FFR) is seen to average at 5.6% this year from 5.1% forecast as early as three months ago.

This is after it raised the core personal consumption expenditures (PCE) forecast to increase by 3.9% this year from the earlier estimate of 3.6% made in March.

While one cannot blame the Fed for raising the PCE estimates, especially since it has been stubbornly high at between 4.6% and 4.7% over the past six months, the resultant increase in the FFR was seen as an overkill.

This, by the way, is not the first time that the Fed is seen to have lost the plot as far as predicting where key economic indicators are heading as it has been behind the curve at the onslaught of inflationary pressure when it increasingly became evident that the inflation trajectory was not “transitory”.

The Fed only started to raise the FFR exactly a year after the core PCE crossed the acceptable 2% mark in March 2021.

By the time the Fed raised its first 25 bps in March 2022, the core PCE had already surpassed the 5% mark.

The Fed was then clearly behind the curve and its expected FFR trajectory too was, at best, second-guessing.

Fast forward to June 2023, and while the Fed is now predicting two more hikes, despite leaving rates unchanged in its June meeting, the market is not buying the Fed’s story.

Based on FFR futures, the market is only pricing in one rate hike next month and leaving the rate unchanged for the rest of the year, while a rate cut is only envisaged next year, with the first 25-bps cut as early as January 2024, followed by four 25-bps cuts each in May, June and July, followed by a 25-bps cut each in November and December 2024.

This will take the FFR to finish the year 2024 at 3.75% to 4%, a 150-bps reduction from the estimated FFR of 5.25% to 5.5% at the end of this year.

It seems like the Fed’s latest dot plot on where FFR will be is a lost plot.

Uneven expectations

With almost half a year gone, we have seen central banks around the world behaving rather inconsistently, faced with persistently high inflationary pressure, especially with core inflation prints.

One sore point is while headline inflation has eased, core inflation remains sticky and stubborn.

Among the aggressive central banks has been the Reserve Bank of New Zealand, which has raised rates as much as 125 bps this year alone to hit 5.5% – the highest in 14 years.

The Reserve Bank of Australia and Bank of Canada too surprised the market with the latest 25 bps hike each to 4.1% and 4.75% respectively, while the Bank of England took an upsize option with a 50-bps hike to 5% on Thursday, marking its 13th rate hike in a row and highest since 2008.

The United Kingdom too is grappling with inflationary pressure, which has remained persistently high with the latest core inflation rate at 7.1% year-on-year in May 2023 – the highest level since March 1992. Not to be outdone, Norway and Switzerland too were in the news as the central banks raised rates by 50 bps and 25 bps respectively on Thursday.

However, the biggest surprise was definitely from Turkiye as the central bank took the bazooka out with an unprecedented 650-bps hike to 15% to fight runaway inflation and the spiralling downfall of the lira.

On the other hand, some central banks are already seeing early signs of success in their battle against inflation and have been on hold in raising rates any further and this includes the Bank Indonesia, the Reserve Bank of India, the Bank of Korea, and Bangko Sentral ng Pilipinas.

Rising recession risk

The relentless hike in rates will see a dampening impact on economic growth.

We are already seeing the impact as New Zealand entered into a technical recession when it announced a 0.1% quarter-on-quarter (q-o-q) contraction in the first quarter of financial year 2023 (1Q23) GDP data, which follows the 0.7% q-o-q contraction in the preceding quarter.

Of course, New Zealand is not the only country already in recession, at least technically speaking, as the eurozone too slipped into recession with a 0.1% q-o-q contraction in the recent revised 1Q23 and 4Q22 data points.

Yet, the European Central Bank (ECB) is not done raising rates just yet as it is up against relatively stubborn core inflation, which came in at 5.3% for May 2023.

The ECB, which raised the benchmark rate by 25 bps last week, is expected to at least raise its benchmark rate by another 25 bps next month.

For the United States, the odds of a recession are growing by the day. With the inverted yield curve, which was last seen at minus 100 bps, which is the spread between the 10-year and the two-year US treasury, and widest since the early 1980s, the United States is toying with recession but it may only be a mild one.

A quick rebound is envisaged as the economic key indicators are still relatively strong, led by the robust US jobs market and resilient consumer demand, as seen in strong retail sales.

However, the housing market may pose a threat due to higher borrowing costs, joining the fragile commercial real estate market, while the risk of further collapse of regional or small US banks cannot be discounted, especially with persistently high-interest rates.

Markets are ahead

Hence, despite the economic headwinds, most global markets are seeing strong traction with some markets already in a bull market phase.

The tech-heavy Nasdaq is up 30.2% year-to-date while the S&P 500, which has some 26% weighting from the technology sector, is higher by 14.1% this year.

Nevertheless, the double-digit gain on the index is mainly led by the “Magnificent Seven” stocks – Apple, Microsoft, Nvidia, Google, Tesla, Meta and Amazon, making the index returns very much skewed towards the tech-heavy stocks, especially Nvidia, Meta and Tesla.

Certain Asian markets too have been buoyant, led by a 27.5% gain on the Nikkei 225, which has surpassed the 33,000 points mark – the first time in 33 years, while the Bombay Stock Exchange’s Sensex Index recently hit a fresh all-time high.

Other North Asian markets too are doing well, led by a 21.7% gain on Taiwan’s Weighted Index and a 16% rise in South Korea’s Kospi.

Surprisingly, despite being an oasis of global economic growth in 2023, the South-East Asian markets have not been performing well and most of them are down for the year with losses ranging from 0.9% on Singapore’s Straits Times Index to 9.5% on Stock Exchange of Thailand Index.

In summary, while economic fundamentals are challenging, given the elevated inflation prints and persistent rise in interest rates, most major markets are completely ignoring these headwinds and are in the bullish camp.

The reason for this is that the market, which normally trades six months ahead, believes that the economic outlook will turn sooner or later and the clue will be when central banks start to cut rates, as early as late this year or in early 2024 onwards.

Pankaj C. Kumar is a long-time investment analyst. The views expressed here are the writer’s own.