Markets got off to a blistering start in January, reminding us just how quickly the mood can change in this uncertain investing environment. News of positive global economic developments boosted investor sentiment across the board, benefitting both shares and bonds as expectations of future rate hikes recoiled on the back of inflation slowing quicker than expected.
A more optimistic outlook for Europe – which averted an energy crisis thanks to a mild winter – and the reopening of the Chinese economy added to fervour. We remain somewhat sceptical at the sustainability of the rally, and have already seen some pull back in February.
Despite recent optimism, economic indicators continue to present a more nuanced picture, with opposing forces which could sway markets in either direction. However, the recent ‘mini-boom’ in asset prices suggests that most investors remain laser-focused on a single factor: inflation.
As we continue to see evidence of prices trending downward, investor sentiment has seen a major improvement. However, it is perhaps too early to call a victory over inflation. The parts of inflation that are a worry are those linked to the labour market and wages, which are reflected in the price of services. There has been little change here to warrant expectation that interest rates will be cut in 2023. The current market dynamics are reminiscent of the 2000-2001 episode, where the prices of shares moved in the opposite direction to bond yields; in other words, both share and bond prices moved in the same direction. This is bad news for diversification, but something we have to deal with when inflation and interest rates are the primary concern for markets.
Similar to what happened in October 2000, a market rebound driven by inflation anxieties subsiding may be short-lived. The sizeable contraction in corporate profits that followed drove a major shift in focus from inflation to recession concerns. As a result, we may experience a change in the way bond and share prices move relative to each other; so that a decline in share prices could be somewhat offset by a more resilient performance in bonds. That being the case, the benefits of diversification could support Plans in 2023.
Although we agree that a decline in inflation is good news, it’s important to distinguish between “good disinflation” (driven by a supply chain recovery) and “bad disinflation” (driven by job losses and demand destruction). We believe that markets may be underestimating the latter; the consequences of a “bad disinflation” could be a decline in corporate pricing power and corporate profits.
Simply put, if inflation goes down because people have to cut down on spending, then this creates a whole new problem for markets, as companies need to lay off staff which, in turn, affects consumer spending; and so, we go into a self-reinforcing cycle, which is the recipe for a recession. It’s not all doom and gloom, however, as economies and markets eventually recover — but we do think it’s better to be safe than sorry.
In anticipation of recessionary pressures getting the spotlight, we maintain a cautious stance on riskier assets such as shares — and continue to watch jobs and corporate margins very closely. Alternatively, an overly strong labour market may drive a second wave of inflation, which would also be bad news for risky assets.
In the US, inflation continued its downward trend, decreasing from 7.1% to 6.5%, which was in line with expectations. While this continues to move in the right direction, prices of services accelerated. The US jobs report indicated a further decline in December, although this was less pronounced than expected. Wage growth continues to trend lower, but a moderation in prices has led to a small improvement in consumer confidence.
According to recent data, US manufacturing activity is contracting further, as the global manufacturing downturn remains a potent headwind. Existing home sales in 2022 fell 17.8% (the sharpest annual decline since 2008), and prices have also been falling for six straight months.
In Europe, a mild winter and strong levels of gas storage have driven a significant decline in the average purchase price for natural gas. In turn, there has been a continued improvement in consumer, business, and investor sentiment. This positive sentiment was reinforced by better-than-anticipated GDP data and a further decline in inflationary pressures from 9.2% to 8.5%.
Closer to home, UK inflation data continued to moderate from 10.7% to 10.5%. Inflation in services – which remains under pressure due to a tight jobs market – rose to 6.8%, the highest since March 1992. Wage growth in the private sector is strong, and trade unions continue to put pressure on the government. However, consumer spending remains exposed to the impact of higher interest rates due to households’ exposure to tracker or short-term fixed rate mortgages.
On a more positive note, a recent statement from the Bank of England suggested that inflation may come under control sooner than expected, which means that market expectations of future rate increases have declined. As lenders set their fixed mortgage deals using expectations of future rates, we may see five-year fixed rate deals at sub-4 per cent for the first time since the ‘mini budget’ debacle.
January delivered one of the strongest months for share markets, supported by investor optimism over the potential for looser financial conditions (decreasing US interest rate expectations) on the back of falling inflation.
Developed and emerging market shares posted gains of 7.0% and 7.9% in January respectively, with a strong rise in Chinese shares (+12.3%) and European equities.
Within developed markets, Europe ex-UK shares (+7.4%) were among the top performers, benefitting from improved sentiment in the region and their relative exposure to cyclical sectors. The US also performed well (+6.2%), driven by expectations of a dovish Fed. The FTSE 100 and Japan delivered solid returns (both +4.3%), but lagged other developed regions in relative terms.
Emerging markets had another strong month led by Asia-Pacific (8.6%), especially China. Although cyclical indicators deteriorated as infections peaked after the relaxation of lockdown measures, high frequency data (including traffic and public transport data) suggests a quick recovery in economic activity. In addition to an increase in domestic consumption, the government’s infrastructure and monetary stimulus may also boost activity.
The decline in inflation and interest rate expectations in the US led to a weaker US dollar, which depreciated against most major currencies. Likewise, the improvement in investor sentiment and increased appetite for risky assets supported the pound (+2% against the US dollar). The Euro was relatively stable against the pound but continued to strengthen against the US dollar (+1.5%).
Investment type performance breakdown
In our Original Plans, shares (+4.73%), property (+4.90%), and bonds (+1.83%) all delivered strong returns, whereas infrastructure ended the month in negative territory (-2.79%), driven by the relative underperformance of defensive sectors amid improved market sentiment. The Plans’ higher allocations to lower-risk assets detracted from relative performance in January. Despite recent market positivity, we retain a cautious stance with an underweight position to higher-risk assets.
We also saw a strong performance in our Ethical Plans, with shares (+5.28%) and bonds (+2.04%) benefiting from their higher exposure to Growth sectors.
Summary with Plan details
Ethical and Original Plans delivered positive returns across all risk levels in January. The month was dominated by an improvement in economic developments and widespread optimism, with further declines in inflation being well received by both shares and bonds. The relatively stronger performance seen in share markets, saw Plans with a higher allocation to higher risk assets perform better than those with a higher allocation to bonds.
We continue to reiterate our cautious stance despite the strong rebound witnessed in January. Although relative performance may be negative in the short-term, we believe markets are running ahead of themselves and prefer to emphasise capital protection over short-term gains. We expect continued volatility as the market reacts and digests the flow of economic data, which itself has a high uncertainty.
Our Investment Team continues to actively monitor the financial markets and their impact on your Plan — and are always ready to act in your best interests to events as they unfold.
We are continually evaluating new market information and key market drivers to help keep your Investment Plan on track.
It’s important to remember that it’s normal for markets to go up and down, with periods of volatility to be expected when you invest. As always, we continue to look for opportunities to position your investments, with the goal of protecting your money and achieving your long-term objectives.
Please remember the value of your investments can go down as well as up, and you could get back less than invested. Past performance is not a reliable indicator of future results.