Investment Comment
13th January 2023
Jump-start
After the challenges of 2022, markets have opened 2023 with a spring in their step with both equities and bonds rallying as investors become more optimistic on the path of the inflation and what that means for the path of interest rates.
Inflation announcements have increasingly become a source of market volatility, but this week saw a relatively subdued response following the release of US inflation data. Headline inflation fell 0.1% month-on-month and year-on-year rose 6.5%, the smallest increase for over a year. Core inflation also slowed but still rose 5.7% year-on-year. The data was broadly in-line with expectations and, judging by the market reaction, already priced in. It seems likely that this improving inflation data will allow the US Federal Reserve to move to small interest rate rises, with only a 25 basis points increase expected next month, and the market is now only pricing in two more rises until we reach the peak for this current cycle.
Inflation pressures are easing…
Source: Bloomberg
As inflationary pressures ease this reduces the pressure on central banks to keep tightening policy through rising interest rates and this in turn has led to falling bond yields. As the chart below shows, yields rose dramatically, particularly for short-term bonds (2-year yield in the chart) peaking in October last year as inflation data kept surprising higher and central bank “hawkish” rhetoric was in full swing. However, as inflation data has improved and other economic data has signalled a slowing economy, expectations for rate rises have lowered. This powered a strong 4th quarter rally in markets, which has continued into the New Year.
…leading to a fall in bond yields
Source: Bloomberg
China recovering as economy reopens
In equities, the big winner so far this year has been China following the dramatic shift away from a zero-Covid policy as investors hope that economic growth will rebound as the country reopens. As we well know, the path out of lockdowns is rarely smooth. Cases have risen dramatically and some 900 million people in China have been infected with the coronavirus as of 11 January, according to a study by Peking University, equating to over 60% of the population. While official data shows just five or fewer deaths a day over the past month, this is likely to be a significant underestimate. Nevertheless, with such high infection rates already, cases will soon fall and, despite the human cost particularly amongst the elderly where vaccination rates are low, China is likely to come through this wave quickly and expected to post much stronger economic growth this year. Indeed, while the western world contemplates a recession, many Asian economies, including the most populous, China and India, look set to deliver solid growth this year, which is supportive of our preference for Emerging Asia equities in portfolios.
Recessionary risks
While the start of the year has been positive, we would throw a note of caution into the mix. As inflation slows, focus will now shift to the growth outlook. Economic growth is slowing and the risk of recession in the US is growing. If we do see a recession this will likely have an impact on corporate earnings. Earnings are currently forecast to rise in 2023 but in recessions typically fall over 20%, which would make a challenging backdrop for equities to perform. The fourth quarter earnings season has just begun and early results from the major US banks have been disappointing. We watch with interest and will update as it progresses.
We reduced risk in portfolios last year, selling high yield bonds and listed private equity, to increase our exposure to government bonds, which should perform better in a recession.
Gareth Thomas Head of Investment Management
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FP20230113001 EXP 10/02/2023