Thought Leadership

Our year of inflections continues to confound

Wall Street and the City are divided. After a strong start to the year for the stock market, will gains continue or is the rally set to fizzle out in the second half of 2023?

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Wall Street and the City are divided. After a strong start to the year for the stock market, will gains continue or is the rally set to fizzle out in the second half of 2023?    

The S&P 500 has surged 16% so far this year, while the Nasdaq 100 is up an astounding 32%. The gains are polar opposite to the losses experienced in 2022, with growing excitement for artificial intelligence stocks helping to power the recent rally.

But there is also fundamental progress that can help explain why stocks are performing better today than they were in 2022. For one, inflation continues to show signs of easing, which should give the Federal Reserve (Fed) some breathing room in its monetary tightening policy. Additionally, the US job market remains resilient and corporate earnings were better than feared.

Now the question is whether these trends in the US markets will continue or dissipate in the second half of the year.

Closer to home, in the UK, the Bank of England’s Governor, Andrew Bailey, has recently hinted that interest rates may stay high for longer than expected amid stubbornly high inflation.  Speaking at the recent annual conference of the European Central Bank he said, “it was clear financial markets expected several more interest rate rises.”  The consensus suggests a UK interest rate peak of 6.25% from the current 5%, making it the highest since 1999.

In Europe, the Central Bank increased rates by another 0.25% in June, taking the total to 3.5%. This was despite signs of both headline and core inflation decreasing.

With markets braced for more tightening from Central Banks in response to sustained inflation, the yield on the two-year US Treasury hit 4.79% - its highest level since the collapse of Silicon Valley Bank.  The equity markets meanwhile are surprisingly resilient with the implied volatility, as indicated by the VIX index, which is at its lowest since the onset of the pandemic.

Is this the calm before the storm or the end of the worst recession that never was?

According to UBS, there are three narratives an investor would need to believe in for equities to rally further:

1. The Fed will not increase rates after the two hikes implied by the latest ‘dot plot’

2. The widely predicted US recession is no more

3. The AI rally was justified

These narratives do not coexist comfortably.   If consumer spending, the labour market, or the stock market proves too resilient then investors could start to worry that the Fed will need to make further interest rate hikes, and a subsequent shift in equity market sentiment could quickly play out.

Investors, therefore, face a balancing act.  There is a path higher for equities, but it is a narrow one.  After a long run, the upside now appears limited.  To guard against the risk of more persistent inflation, we think that allocations to real assets could provide some protection for portfolios as well as reviewing bond allocations.  Cash is also now paying you a decent return in the short term as well.

Reasons to be optimistic

While there are still reasons to be optimistic, we might not see their impact until late in 2023 or possibly even 2024.

Economic recovery: The global economy has been recovering from a slowdown. The second half of 2023 might see continued improvement in economic indicators, such as GDP growth, employment rates, and consumer spending. Increased economic activity generally bodes well for financial markets.

Corporate earnings: Q1 2023 corporate sales increased, but earnings contracted, meaning that profit margins are being compressed. In this environment, companies with strong pricing power performed strongly in the first half of the year and should continue to do so. Household consumption, which represents two-thirds of US GDP, should continue to be supported by strong labour markets and solid household balance sheets.

Low interest rates: Major central banks have announced that they would maintain restrictive monetary policies for longer in the face of sticky inflation figures. With inflation falling faster than headline numbers are suggesting, markets are betting on central banks removing some of their monetary tightening as soon as Q1/Q2 of next year in order to support economic growth.

Reasons to be cautious

Economic downturn - Economic growth is slowing fast enough to add to the disinflationary momentum, but without suggesting any imminent recession.  This is contrary to my statement in the economic recovery above (reasons to be optimistic) and it really is in the balance.

Geopolitics – The backdrop remains challenging, with no end in sight to the war in Ukraine and renewed tensions between the US and China (albeit with overtures recently of a rapprochement).

Inflation - Headline inflation continues to ease over the quarter on the back of lower energy prices, but core inflation generally remained stickier, forcing global central banks to maintain their tight monetary policies.

The chiefs of the world’s central banks are now warning that their job is far from done.  Jerome Powell, Chairman of the Fed, said on 29th June “getting inflation back down to 2% has a long way to go.”  Just two days earlier Christine Lagarde, President of the European Central Bank, told a meeting of policymakers in Portugal “we cannot waver, and we cannot declare victory yet.” Meanwhile Andrew Bailey, Governor of the Bank of England, recently said that “interest rates will probably stay higher than markets expect.”

So, can we expect more turbulence in the coming months?

Volatility in rates, currency, and equity markets is likely to remain elevated in the coming months and quarters. The two main contributing factors are uncertainty surrounding the cumulative and lagged effects of monetary tightening, combined with ongoing geopolitical tensions.


Is it the end of the current rate cycle?

One important factor behind the rise in US equity markets in recent weeks is the increased confidence among investors that the Fed is coming to the end of its rate-hiking cycle, despite high inflation.

The Fed paused its hiking at its June meeting, though its updated ‘dot plot’ points to two additional 25-basis-point hikes this year. A pause in rate hikes might seem imprudent considering current inflation data. The core consumer price index, at 5.3% year-over-year, is well above the Fed’s target and was up 0.4% month-over-month in May alone. The labour market also remains tight. Despite a modest increase in the unemployment rate, job openings have actually increased, and employment growth remains robust.

The scale of the potential lagged effect of rate hikes on the US economy is still uncertain.  But, equally, after 500 basis points of rate hikes in just 14 months, the most rapid pace of Fed tightening in 40 years, uncertainty around the scale of the potential lagged effect on the economy is high. We have already seen signs of financial instability and fraying balance sheets as both corporate bankruptcies and credit card delinquencies are rising. Against this backdrop, the Fed needs to consider risk management across all its areas of responsibility: price stability, full employment, and financial stability. And, while the former suggests the Fed should keep hiking, the latter two dictate a more cautious approach.

For investors, this means we may now need to consider that the Fed may be willing to let inflation stay modestly above target for an extended period. Higher inflation and a Fed on hold is not necessarily a bad combination for equities, as higher nominal growth would provide an earnings tailwind. But it does increase the potential downside, particularly if markets begin to fear the Fed is risking inflation expectations running out of control.

All of this leaves investors asking, “Can I get a better risk-reward by betting on the last couple of percentage points' gain for the S&P 500 or by locking in yields in high-quality bonds?” We prefer the latter, while diversifying into real assets, including infrastructure, and gold, to provide a partial hedge against long-term inflation, and positioning for a weaker dollar.


Recession easing

Inflation in the eurozone fell to 5.5% in June, down from 6.1% in May, the slowest rate this year. But, core inflation, which strips out volatile food and fuel costs, rose slightly to 5.4%, up 0.1 percentage point compared with a month earlier.

Against this inflation backdrop, the European Central Bank delivered an expected 25 basis point hike, raising the deposit rate to 3.5%. The central bank said the forceful transmission of past rate hikes into tighter monetary and financing conditions justified the change to a slower pace of hikes.

Markets currently expect two further rate hikes to a terminal deposit rate of 4.0%. The latest bank lending survey showed a further tightening of credit standards and a pronounced weakness in credit demand.

GDP growth in the euro area is now expected to be at 1.0% for 2023 and 1.7% for 2024 thereby avoiding a recession.


So far the UK has avoided a technical recession

The Bank of England voted to hike rates by 50 basis points to 5.0%, in a 7-2 vote. The Bank retained existing forward guidance, highlighting that “if there were to be evidence of more persistent pressures, then further tightening in monetary policy would be required”.

The May inflation report was not well received by investors. Headline Consumer Price Index (CPI) remained at 8.7% year on year, significantly above expectations of 8.4%. Even more concerning was the acceleration of the core CPI component from 6.8% year on year to 7.1%. Core CPI is now at its highest rate since March 1992. Markets re-priced rate expectations to a peak rate of 6.5%.

This pushed yields higher and Gilts (UK government-issued bonds) ended the month as one of the worst performers among government bonds. UK equities were hit by weak commodity prices. The FTSE All-Share Index fell 4.6% for the month, underperforming its peers.

According to KPMG the UK economy will likely escape a recession thanks to a better outlook for energy prices, a more resilient global environment, and continued tightness in the labour market.  They expect GDP growth to remain weak with just 0.3% in 2023 and rising to 1.1% in 2024.


Continued dynamism

Weeks of roasting temperatures in Beijing and elsewhere in northern China have raised the threat of drought and shortages of hydropower. That has added to the problems of China’s economy, which is far from sizzling. The purchasing managers’ indices, published by business magazine Caixin, show that China’s services industries lost momentum in June and its manufacturing activity remained weak. The property market is also flagging. Attention is now turning to the government’s response.

China’s central bank cut interest rates by a smidgen last month (June 2023). The finance ministry also extended a tax break on electric vehicles. On 29th June the State Council, China’s cabinet, announced it would introduce new measures to support household consumption. Later this month, the Politburo, the policymaking committee of the Communist Party, may decide on more infrastructure spending. It will probably include more investment in China’s capacity to cope with an increasingly inhospitable climate.

China still plays a critical role in terms of global growth, so any disappointment has implications internationally.

In Japan, Q1 real GDP rose by 1.3% year on year, driven by strong private consumption and non-residential investment. April’s Consumer Price Index (CPI) also accelerated further with the Bank of Japan’s key inflation measure (excluding fresh food and energy) rising 4.1% year over year - the biggest increase since 1981. As a result, investors are getting increasingly optimistic that Japan is on the way out of the deflationary stagnation of the past. This sentiment is supported by the TOPIX, which has reached a 33-year high and has outperformed other major developed equity markets.

The IMF revised their recent forecasts to imply that they expect the economies of Asia and the Pacific to contribute about 70% of global growth in 2023. This represents a significantly larger proportion compared to previous years.

How have the markets performed?

We have selected key indices as a representation of the markets rather than a substitute for the whole market as they are the most recognisable for our clients.

NB: Figures rounded up to the nearest whole number.

Equity markets have surged higher in the first half of the year. However, these gains have been very narrowly focused, particularly in the US, where the top-10 companies by market capitalisation have contributed nearly 90% of the S&P 500 index’s +15.9% year-to-date upswing - the highest percentage in history.

The Nasdaq Composite index has benefitted from the strong performance of the technology sector and is up +31.7% year-to-date. Conversely, the Dow Jones Industrial Average, which is much more cyclical, is only up +3.8% year-to-date.

Bond markets have mostly moved sideways year-to-date as credit spreads have tightened slightly amid supportive overall investor sentiment and bond yields have moved higher in June, to end the first half of the year close to unchanged.

Energy prices have fallen sharply as investors increasingly priced in a recession and the China post-pandemic recovery lost momentum.

Interest Rates in 2023

All the major central banks now have a mandate to ensure that interest rates rise and fall within what are considered stable inflationary limits.

In most instances this is 2% per annum, the 'goldilocks' scenario whereby the underlying economy is neither 'too hot nor too cold'.

NB: The figures in the final column are an amalgam from several different sources, so are more akin to a trend rather than a prediction.  They are for the full cycle rather than a fixed period.

In the last two weeks of the quarter, central bankers have toughened their stance on the persistence of inflation and the need for further monetary tightening. Despite the Federal Reserve pausing its interest rate hike cycle on 14th June, the ‘dot plot’ of policymakers’ interest rate expectations showed that the Federal Open Market Committee (FOMC) expects more rate hikes bringing rates to between 5.5% and 5.75% by year-end. Federal Reserve Chair Powell also confirmed that more tightening measures are to be expected.

The following day, the ECB raised its key deposit rate by +0.25% to 3.5%, the highest level in 22 years, and President Lagarde confirmed that the central bank “still has ground to cover” and would raise rates again in July.

In the UK, the Bank of England unexpectedly raised its key interest rate by 0.5% to 5.0% on 22nd June 2023.

Which asset classes should we consider?

The return of rising rates feels more ominous for investors. True, part of the story is that the economy has held up better than expected at the start of the year, and certainly better than feared once banks began to buckle. Yet the bigger part of the story is that inflation has proved unexpectedly stubborn.

Although recession has been avoided or delayed, few are predicting stellar growth. In these circumstances, rising rates are bad for stocks and bonds. They hurt share prices by raising firms’ borrowing costs and marking down the present value of future earnings. Meanwhile, bond prices are forced down to align their yields with those prevailing in the market.

Does this mean another 2022-style crash? Certainly not in the bond market. Last year the Fed lifted rates by more than four percentage points. An extra quarter-point rise or two this year would have nothing like the same effect.

Shares, though, look vulnerable on two counts. One is that most of the stock market ran out of momentum some time ago. The S&P 500 index of large American firms has risen by 15.9% this year, but the entire increase is down to its biggest 10 tech stocks, all of which seem gripped by AI euphoria. Such a narrowly led, sentiment-based climb could easily be reversed.

The second source of market vulnerability is the earnings yield, which offers a quick-and-dirty guide to potential returns. The S&P 500’s is 5.0%. This means stockholders are taking the risk of owning equities for an expected return that the Fed is already offering risk-free.

As our ‘Year of Inflections’ continues to evolve, events over the past months continue to show how quickly the outlook can shift.  There are still considerable uncertainties, in both directions.  With inflation still sticky and question marks about the economic and central bank outlooks, markets are likely to remain volatile.

Against this backdrop, we still think it is sensible to focus on strategies to build resilience, mitigate risks, position for opportunities created by regional divergences, and diversify portfolios.  Stay tuned for more drama.

Mark Estcourt


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