Fine line for investors amid economic fog

The ‘Goldilocks’ outcome for the US economy is in the balance as pressure grows for more interest rate rises. How should investors be positioned? 

Investors have been braced for “episodes of high volatility” as sentiment pivots between hopes of a soft landing and concerns that rate rises will tip the US economy into recession.

The warning by UBS Global Wealth Management comes after Wall Street expectations over the eventual peak for US interest rates rose again yesterday on the back of inflation data showing prices coming down less swiftly than previously thought.

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The developments cast doubt on whether the US can achieve a “Goldilocks” outcome where inflation falls and a healthy labour market ensures no abrupt decline in consumer spending.

Until strong employment data released on 3 February, updates had pointed to an outcome neither too hot nor too cold as global equities rallied 9.5% in the year to that date.

The blockbuster payrolls report, which showed the jobless rate falling to a 53-year low, reminded markets the Federal Reserve has more work to do in order to bring inflation down toward its 2% target. The rate stood at 6.4% in January.

UBS’s chief investment officer Mark Haefele said the anticipated inflection points in inflation, monetary policy and growth have not yet been reached.

He said: “We continue to see near-term headwinds for markets with the potential for episodes of high volatility until investors have greater clarity about the economic outlook.”

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Haefele adds that technical support for a smooth rise in markets has faded, with bad economic news now likely to have more impact. 

He explained: “Investors started 2023 with a light positioning in risk assets, reflecting concerns in prior months over the growth outlook for China and worries over the potential for energy shortages in Europe.

“The speed of the rally at the start of the year was partly due to a shift in positioning, as hedge funds covered shorts and added new longs. With investor positioning now more balanced, markets are more likely to be impacted by any bad economic news.”

Haefele recommends investors consider strategies that provide exposure to equity market upside while also adding downside protection.

This favours defensive stocks such as consumer staples and healthcare, alongside value and income opportunities that should outperform in a high inflation, slowing growth environment. In addition, investors should consider cyclicals with the potential to perform well as and when markets start to anticipate the inflections.

In today’s session, the S&P 500 opened 0.5% lower after retail sales highlighted strength in the US economy with a 3% month-on-month jump in January. This was the biggest increase since March 2021 and above market forecasts for a 1.8% rise.

Futures markets last night pointed to a high for interest rates of 5.27% in the summer and 5.07% in December, both fresh peaks for the cycle and significantly higher than the respective forecasts of 4.80% and 4.30% seen just two weeks ago. The current Fed funds rate is in the range of 4.5%-4.75%, but with policymakers expected to hike by another 0.25% next month.