Q4 Update: Powell Pivot Postponed

Central banks haven't finished tightening and the U.S. Treasury yield curve remains inverted. We believe that slowing core inflation should allow the U.S. Federal Reserve (Fed) to go on hold in early 2023, and that oversold equity-market sentiment means a lot of bad news is already priced in.

Key market themes

Markets had stabilized somewhat over the past three months, but it remains an annus horribilis for investors, with equities and government bonds posting negative returns so far this year. Investors remain worried about high inflation, slowing growth and the potential for an aggressive Fed to cause a recession.

It's hard to find much good news at present, but one source of comfort is that investor sentiment is very negative. Our composite sentiment index, which measures investor sentiment for the S&P 500® Index via a range of technical, positioning and survey indicators, is near two standard-deviations oversold. We believe this provides some reassurance that markets have accounted for the bad news so far.

While it's too early to predict that a recession is the most likely outcome for the U.S. economy during 2023, we believe the probability is rising. The main warning comes from the inverted Treasury yield curve, where the spread between the 10-year yield and the 2-year yield is the most negative in 40 years. Some of the leading indicators for the U.S. economy, such as the Institute for Supply Management's index for new orders, have softened. The indicators that the Fed is focused on, such as payrolls and wages, remain overheated. These labor-market trends tend to lag the broader economy. This creates the risk that the Fed will continue to tighten while the economy weakens. We're still in the soft/softish landing camp for the U.S., and expect that strong household and corporate finances can limit the downturn to, at worst, a mild recession.

In Europe, a challenging winter lies ahead. High energy costs will depress consumer spending and industrial production, while persistently high inflation will likely lead to continued tightening from the European Central Bank (ECB). The Russia-Ukraine war is no closer to being resolved, and with measures of industrial production beginning to decline in response to high energy prices, it's difficult to see the region avoiding at least a mild recession.