Market Musings: Are markets too complacent?
The more upbeat mood in markets over recent months has reflected China’s faster than expected COVID-reopening, resilient activity data that has raised hopes downturns in the US and other major economies may not be as bad as feared, and an assumption that the topping out in inflation could see central bankers morph from rate hiking inflation fighters to growth supporting rate cutters later this year. These forces have weighed on the USD and helped propel the AUD higher. As shown above, consensus growth forecasts for 2023 for a range of nations have stopped being downgraded, with views for some, like China, slightly upgraded.
In its latest World Economic Outlook Update the IMF followed suit. Largely on the back of upward revisions to China the IMF nudged up its forecasts for world GDP growth. While upgrades are welcome, 'less bad' shouldn’t equate to being viewed as 'good'. China’s reopening can help cushion the blow, but relatively tough macro conditions still look to be on the cards in several countries, particularly over H1 2023. Indeed, at 2.9% and 3.1% the IMF is itself still projecting world activity to be well below average over 2023 and 2024 (note, between 2000 and 2019 world growth averaged ~3.8%pa). And although ‘adverse risks have moderated’ the balance of probabilities around the global outlook remains tilted to the downside, with the world economy still navigating a tricky narrow path.
In our view, short-sighted markets have become overly focused on the pace of interest rate hikes and peak inflation over the past few months. As such, we think markets could be: (a) somewhat vulnerable to a ‘reality check’ from central banks around how long high/restrictive interest rate settings could be needed to definitively squash inflation, particularly in places like the US where tight labour market conditions is underpinning ‘sticky’ services inflation; and/or (b) too optimistic in assuming inflation may seamlessly decelerate back down to target and that the worst of the economic fallout has already passed. Monetary policy changes work with ‘long and variable lags’. The impacts from the rapid-fire policy tightening cycles that have been unfolding over the past year (and have yet to finish) haven't fully shown up.
As the chart below shows, volatility in various asset classes (equities, bonds, and FX) has eased back down to respective long run averages. As the macro tensions discussed play out over coming months we think financial market volatility could re-ignite. History shows that volatility tends to lift as US/world economic downturns crystallise. In FX, higher volatility and more cautious risk sentiment tends to be a headwind for the AUD, while the USD also typically garners some support in this type of environment.
Currency Strategist - APAC