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Happy New Year! After a torrid year last year, I’m sure many will be hoping for a less turbulent time in financial markets over the coming 12 months.
2022 was one characterised by high inflation and aggressive central banks, resulting in a severe shock to markets, negatively affecting bonds, equities and, latterly, property prices. As we know, this meant an extremely difficult year in terms of portfolio returns.
To try and put the magnitude of the shock to the system into context, the chart below shows that so far, the US Federal Reserve’s (Fed’s) interest rate hiking cycle has been the most aggressive since the 1980’s:
The Fed “front loaded” interest rate rises to try and tame inflation and avert a stagflationary environment of runaway inflation and slow economic growth. The Bank of England (BOE), European Central Bank (ECB), and others around the world have followed a similar path. As we know, this environment was toxic for bonds resulting in more cautious portfolios suffering higher drawdowns than higher risk ones with a higher equity content.
The good news is that we believe that most of the pain has now been inflicted by central banks. We can see that the red line in the chart above, showing the current tightening cycle in the US, is beginning to flatten off, as the Fed raises interest rates by a smaller amount at each meeting. Whilst it is likely that there are further interest rate rises to come in the US, UK and Europe, they are expected to be smaller, and the market believes that we are close to peak interest rates in many regions. The chart below shows the rates rises seen so far in various developed countries in the solid lines and the rises expected by the market in the dotted lines:
Victory over inflation?
So, have central banks been successful in their war on inflation? Well, it might be too early to say for sure and it depends on which region you look at, but early signs are promising. Supply chain pressures continue to ease and wholesale energy prices have fallen, resulting in lower headline inflation in the US. The issue is that food price inflation and services inflation remain high and are yet to show signs of abating, either in the US or the UK. Europe has a greater inflation problem and so the ECB is expected to deliver more interest rate rises (proportionately to the current position).
The big questions on investors’ minds are “will wages rise sharply, potentially creating a second round of inflation” and “will central banks cause a recession”? Well, there is no doubt that economic activity is slowing, and Europe is arguably already in recession. The following chart shows the Manufacturing and Services Purchase Managers Indices (PMIs). These are widely used as leading economic indicators and a reading below 50 is generally accepted to be an indicator of recession:
We can see that readings are well down from their 2021 highs and below 50 in most cases. According to the International Monetary Fund, global GDP growth is also slowing:
As I have discussed before, the bond market is also indicating a recession in the major developed economies.
We believe that recession in the UK and Europe is inevitable as the effects of higher interest rates are felt in the housing market, particularly in the UK. However, a recession is not a foregone conclusion on the US. The jobs market is very strong and consumers in the US are estimated to have a huge amount of excess savings, which should help bolster consumption. That being said, the housing market in the US also looks fragile and the full effect of the interest rate rises last year are yet to be felt in the real economy.
China to save the day?
The other key area of note this year is China. At the back end of last year, the markets got quite excited over rumours that China would start to wind down it’s Zero Covid policy which was prolonging global supply chain issues. Indeed, China did announce plans to wind down the policy and fully re-open it’s economy. This had a profound effect on markets with virtually all asset classes delivering gains in the last quarter. Those with greater economic exposure to China enjoyed the biggest gains with Europe being a stand-out performer.
The question is how the Chinese healthcare system will cope with Covid now running free in a largely unvaccinated population with little immunity. Time will tell but, for now, there is a risk that, because China is the world’s biggest consumer of many commodities, reopening results in higher commodity prices and stickier inflation in the West. This could mean that interest rates must stay higher for longer than the market currently expects.
A brighter outlook (timing TBC)
2023 has started on a reasonably positive note although the immediate term outlook is somewhat murky. Our central view is that we might see more market volatility as the final interest rate rises are announced and whether the US enters recession or not becomes clearer.
Historically, bonds do relatively well in recessions and equity markets tend to bottom just before the end of the recession. Therefore, whilst the timing is uncertain, we are confident of brighter days ahead for portfolio returns.
Until next time, stay well.
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