MARKETS

The financial markets experienced a lack of direction as equities and bonds meandered aimlessly into the weekend following a series of inconclusive data releases from the U.S. economy.

For those seeking macroeconomic clarity, the situation remains pretty elusive. While there is a plausible argument that the U.S. labor market has effectively normalized, uncertainties persist in a market characterized by ongoing concerns about an indeterminate macroeconomic landscape amid the long wait for a recession that may or may not ever arrive.—hinting at the potential for a volatile year ahead.

Equity markets faced challenges last week as expectations of early 2024 rate cuts collided with the reality that these cuts are likely some time away. And to a degree, based on Friday’s NFP alone, they still are.

The S&P 500 declined 1.5% during the week, with technological and consumer discretionary sectors leading the falls.

The struggle intensified after the release of the minutes from the Federal Open Market Committee's (FOMC) December policy deliberations, reiterating that while rate cuts are a possibility in the coming year, the Fed will wait until it is confident in taking such action. Participants emphasized the need for policy to remain restrictive until inflation moves down sustainably toward the Committee's objective.

The December U.S. payrolls report showed a better-than-expected creation of 216,000 jobs, just slightly below the 225,000 average pace over the past twelve months. Wages continued their strong performance with a monthly gain of +0.4%, maintaining growth above 4% over the past 3- and 12-month periods. These factors did not align with the narrative supporting near-term rate cuts.

But providing some relief to the dovish bulls, the U.S. services ISM fell sharply to 50.6 in December, hovering just above expansion territory, with the employment component dropping to 43.3, the lowest level since July 2020.

With inflation falling and rate cuts widely expected, it is typically a good combination for equity bulls. However, the challenge lies in the higher bar set for 2024 than the previous year.

Amid the ongoing inflation downswing, the Fed's mechanical rate cut theory will be tested this week with the release of both the US CPI and PPI reports.

The good news is that underlying U.S. price pressures likely continued to recede in December, supporting the Federal Reserve's optimism about the path for inflation.

The consumer price index excluding food and fuel, considered by economists as a better indicator of underlying inflation, is expected to increase by 3.8% from a year earlier in December, according to the latest media poll and would represent the smallest annual advance since May 2021 and supporting the Fed's progress in curbing inflation. 

Theoretically, this should support risk assets and push back some bulls on the dollar.

WHY ALL THE UNCERTAINTY 

The current economic cycle exhibits unusual behaviour compared to past cycles, prompting questions about its unique characteristics. Traditional indicators that have historically signalled an impending recession are not aligning with the current economic landscape. According to these indicators, the U.S. "should" have entered a recession last year or be on the verge of one now.

Conventional expectations would include rising unemployment, declining earnings, and falling interest rates in a bearish manner. Investors would then typically seize opportunities to invest in high-quality assets at low price-to-earnings ratios.

Contrary to these expectations, there is currently a substantial $6 trillion pile of cash in the market. However, the process of identifying attractive investment opportunities is proving challenging. While it's not impossible, the yield from such searches is razor-thin.

OIL MARKETS

Increased tensions in the Middle East took center stage in the oil market last week. Notably, a U.S. drone strike in Baghdad on Thursday targeted and killed the commander of an Iranian-backed militia in Iraq. Additionally, twin explosions in central Iran on Wednesday, claimed by ISIS, resulted in the tragic loss of more than 80 civilian lives. Responding to these developments, the Iraqi government announced on Friday that it has initiated the process to remove the U.S.-led international military coalition present in the country since 2004. This decision, as stated by Prime Minister Mohammed Shia al-Sudani's office, raises concerns about further destabilization in a region already impacted by the Israel-Hamas conflict and attacks on commercial shipping by the Houthi militia.

Additionally, a supply disruption at Libya's largest oil field, El Sharara, caused by antigovernment protests halted operations across the Murzuq Basin.

Elevated geopolitical risks managed to counterbalance the bearish impact of a U.S. Energy Information Administration (EIA) inventory report released Thursday past.

NOW, THE BAD NEWS

The robust labor market performance observed in the previous year is not expected to be replicated. The economy is at the tail-end of a great aggregate supply and demand rebalance. The highly restrictive monetary policy from the Federal Reserve is beginning to take effect and will become more apparent for the labor market and economic activity as the year progresses. At the same time, downside risks loom for the global economy due to escalating geopolitical conflicts, past global monetary policy tightening, and the potential for further supply chain disruptions.

The December ISM Services index is very concerning for those looking for a canary. The headline composite index dropped to a near-stagnant 50.6 from 52.7 in November, and the service sector Employment Index plunged deeply into contraction territory to 43.3 from 50.7 in November. While this is just one month of data and not a definitive trend, it serves as a potential warning signal that requires confirmation from other economic indicators.

Still, the previous month's NFP revisions and the plunge in the services sector jobs index have sub-100k headline jobs numbers written all over it.

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