Executive summary
This week, we look at three important issues:
- The cost of the Fed’s pivoting early. While the FOMC is widely expected to keep rates steady next week, progress on inflation (despite the Red Sea tensions) has led some market participants to expect a pivot as early as March 2024, prompting an unusually large disconnect between the restrictive monetary stance of the Fed and easing financial conditions, particularly the buoyancy of the stock market. We estimate that a Fed rate cut in March could push up inflation by +0.5pp by the end of the year to 2.9%, potentially compromising the central bank’s credibility. Against this risk of premature monetary policy easing leading to renewed bouts of inflation, we still expect the Fed to pivot only in June.
- Red Sea 0 – 1 Inventory glut (except for the car sector). With demand on the decline since 2022, most manufacturing sectors are struggling with an inventory glut, especially in Europe and China. On the one hand, slower inventory liquidation in Europe could provide a buffer against any potential supply-chain disruptions that could arise from a prolonged Red Sea crisis. But the automotive sector may not be so lucky: With a very low inventory-to-sales ratio, the sector is very sensitive to supply shocks stemming from the Red Sea crisis, and companies do not seem to have learned from the recent supply crisis. On the other hand, higher inventories are already eating into pricing power for both European and US companies, especially in the textiles, furniture, metals, paper and chemicals sectors. Cost absorption should be the norm in 2024.
- The Eurozone is on track for its own soft-landing. While private consumption and investment remain subdued, the labor market continues to be exceptionally strong and real incomes are on the rise, finally improving the outlook for private consumption. The output gap is now significantly negative, which gives room for a mechanical catch-up with potential levels. In addition, January PMI indexes suggest a limited additional recession force as business activity in the manufacturing sector has improved to the highest reading in ten months – albeit at still low levels. Price indicators reveal little upside risk for Eurozone’s inflation outlook and with energy prices remaining stable, we continue to expect disinflation to gain traction and allow a first ECB rate cut in July. The latest ECB Bank Lending Survey shows that the most significant impact of the tightening has passed the peak.