Can central banks engineer a soft landing?

Despite the fears surrounding a potential global recession, high inflation and rising interest rates, investment markets performed reasonably well over the first half of 2023.

Both global equity and bond markets produced positive returns, with the former producing especially solid gains. And that’s despite a brief global banking panic and concerns over a potential US debt default.

The MSCI All-Country Equity Index returned 14.0% in local currency terms, and a higher 16.1% in unhedged Australian dollar terms (reflecting some weakness in the $A against global currencies).

Among major regions, Japanese stocks performed very well, returning 28.6%, while US stocks were not far behind with a 16.9% return. The first half of the year also saw an ongoing solid rebound in technology and growth stocks relative to more value-orientated exposures such as energy and financials. As a result, the Australian market was somewhat of a laggard, returning only 4.5% over the period.

Supporting equity market returns was the ongoing resilience of global economic growth to central bank interest rate increases since early last year. Contrary to widespread fears, consumer spending continued to hold up reasonably well, with households using income buffers built up during COVID lockdowns to satisfy pent-up demand for a range of goods and services. To meet this demand, businesses have continued to add staff where they can find them. And the launch of consumer-friendly artificial intelligence services has added extra allure to the global technology sector.

Although still too high, declines in headline inflation – due to falling energy and food prices –helped to both bolster consumer purchasing power, and raise hopes that inflation will fall back to comfortable levels without the need for a crushing recession.

In bond markets, although central banks continued to raise interest rates over the first half of the year, the size and speed of rate increases slowed. The US Federal Reserve raised interest rates by 0.25% in each of its first three meetings of the year, then paused in June. The Reserve Bank of Australia raised rates at four of its five meetings, with a mid-way pause in April.

With markets concluding that the end of the global monetary tightening cycle is getting close, long-term bond yields broadly moved sideways over the period, thereby supporting modest positive gains from fixed-rate bond returns. The Bloomberg Global Aggregate Bond Index returned 2.1% in $A hedged terms, while the Bloomberg AusBond Composite 0+ Yr Index returned 1.5%.

Looking ahead

Despite the encouraging performance of investment markets over the first half of the year, challenges remain. For starters, most of the recovery in equity markets has been through higher valuations – earnings growth has been muted following downgrades over 2022. Accordingly, equity markets are counting on a soft landing for the global economy and a speedy rebound in earnings – and certainly not a recession.

Yet with tight labour markets and sticky rates of service sector inflation in much of the developed world, it’s still far from clear that a recession won’t ultimately be needed to sustainably bring down inflation. The great lingering fear among central banks is that the longer it takes to bring down inflation, the greater the risk of it becoming entrenched through a lift in second-round wage and price claims – especially in today’s environment of cyclically strong wage and price bargaining power. The Reserve Bank of Australia, for example, has noted a degree of price indexation has started to creep into some recent local wage and price setting claims.

Ideally, central banks desire only a modest slowing in economic growth to ease lingering tightness in labour and product markets. Yet history suggests engineering such a perfect soft landing is not easy. Indeed, every time the US unemployment rate has risen by more than half a per cent or so, it has tended to rise a lot more and the economy has tipped into recession.

In Australia, signs of a slowing in economic growth have been somewhat clearer – especially among consumers. But it’s also true that local inflation has proven somewhat stickier, not helped by significant ongoing cost increases in the home rental and electricity markets.

All up, central banks seem likely to raise interest rates modestly further in coming months – though with economic growth starting to slow, not by enough to seriously damage bond market returns to the degree evident last year. Indeed, there’s even the possibility both the US Federal Reserve and the Reserve Bank of Australia may decide they don’t need to raise rates again if further convincing evidence of a growth slowdown emerges.

With regard to the equity market, the risk of at least a correction in prices over the second half of the year appears high – if only because central banks are likely to insist on a decent growth slowdown to ensure some easing in sticky core inflation.

Whether this slowdown develops into a full-blown recession remains to be seen – as it depends on the sensitivity of both global economic growth to higher interest rates and inflation to weaker economic growth. One hopeful sign is that global competitive pressures and ongoing technological disruption appear greater than in earlier periods of high inflation such as the 1970s. As a result, a modest slowing in global economic growth could quickly translate into lower inflationary pressure.