Mark Lister, 20 January 2023

The year has started well for financial markets, with most asset classes rebounding from the weakness of 2022.

This has been fuelled by signs of moderating inflation, a relaxation of restrictions in China and hopes of an end to the aggressive interest rate hikes we’ve seen from central banks.

These are all genuine reasons for optimism, although we aren't out of the woods just yet.

The most crucial development has been increasing evidence of slowing inflation.

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In the US, the headline consumer price index (CPI) posted its biggest monthly fall since April 2020 last month.

That saw the annual inflation rate slip to 6.5 per cent, the sixth consecutive monthly decline and well down from a 40-year high of 9.1 per cent back in June.

Much of this was due to lower energy prices, which meant the core inflation measure (which strips out food and energy) didn’t exhibit the same weakness on an annual basis.

Having said that, if we annualise the readings of the final three months of 2022 we get a core inflation rate of just 3.1 per cent.

Forward looking indicators are suggesting this trend will continue.

In December, the high-profile ISM survey in the US saw its supplier delivery times index fell to 45.1 (the lowest since 2009) while the prices paid index declined to 39.4 (the weakest since April 2020).

The latest US jobs report provided further evidence of slower price pressures, with wage growth falling to the lowest in 15 months.

Closer to home, we’ll get our CPI report this Wednesday. New Zealand’s inflation rate is sitting at 7.2 per cent, close to a 32-year high.

Reserve Bank forecasts suggest it’ll push higher this week, but I wouldn’t be surprised if we got a small decline.

The NZ dollar has been solid, oil prices are down and firms pricing intentions (in the ANZ Business Outlook survey) have fallen to the lowest since 2021, well below the peak.

This softer inflation points to a more cautious approach from central banks in the months ahead.

The US Federal Reserve has a policy interest rate of 4.50 per cent, and it has signalled an intention to raise this above five per cent during 2023.

Markets don’t believe the Fed will get there, and are calling its bluff. Instead, they see a pause coming very soon, and interest rate cuts before the end of this year.

I’m not sure we’ll see that from our Reserve Bank anytime soon, although it’s quite possible that – as with the US – the Official Cash Rate doesn’t quite reach the 5.50 per cent peak the Reserve Bank is projecting (it’s at 4.25 per cent currently).

As encouraging as that all is, there’s another side to the coin.

Inflation pressures are subsiding as supply chain pressures ease and commodity prices fall, but also because demand is taking a hit as cracks appear in the global economy.

In the US, leading indicators have slumped to the weakest since the recession of 2020, and before that the GFC.

The US services sector, which has been very resilient over the last 12 months, is also contracting for the first time in almost three years.

Here in New Zealand, business and consumer confidence have taken a similar turn for the worst, falling to record lows.

For those looking for a bright spot, one can point to unemployment, which is still extremely low.

That’s good, but it’s something we need to keep a close eye on. As one prominent US fund manager recently noted, a strong labour market was the "last man standing" in terms of economic indicators right now.

Inflation rates are headed down and central banks will soon call time on their interest rate hikes.

While that makes for a brighter outlook, it’ll come at the expense of economic activity (and therefore corporate profits).

This tug of war between falling inflation and a weaker economy will determine whether the January optimism prevails for the balance of 2023.