Investment Update: January 2023

INVESTMENT UPDATE JANUARY

In the absence of a ‘Santa Rally’, markets ended the year pretty much as they started, with both equities and bonds declining over the month. This capped off a dreadful year for both asset classes, which was particularly impactive on lower risk portfolios. 

Whilst we have seen equities decline to a greater extent in some years, we haven’t seen them move in tandem with bonds to this extent before. In 2008, during the great financial crises US equites declined around 40%, but bond prices increased about 15%, whereas in 2022, equities declined around 20% and bonds declined around 19% (source: FT 29/12/22).

The causes for this abnormal behaviour have been written about on many occasions but are simply summarised as; aggressive central bank tightening of monetary policy in the face of inflation levels not seen for around a generation. The impact on bond prices in the UK, which move in the opposite direction of interest rates, is demonstrated in the next charts: 

UK Ten Year Gilt Yield in 2022

Source: CNBC 30/12/22

UK Gilt Fund Sector performance in 2022

The causes for the currently high levels of inflation are also well documented: supply chain issues and war in Ukraine, being the main ones. This was combined with an unusually strong labour market, as despite the economic headwinds, employment levels remained high. This is one phenomena that central bankers want to see reversed, as it has enables spending to remain stable and, crucially, it supports upward pressure on wages, thus fuelling inflation further.

The upside of low unemployment is that it kept consumer spending high and thus corporate profits strong. However, markets worry that the central banks focus on reducing this trend will have correspondingly negative impact on profits as the economy slows. The question being asked here is will central banks be able to quash inflation without driving economies into recession? The good news is at least, that inflation does appear to have peaked in most western economies which may stay central banks hands and cause a pause in rate hikes as we move through the year. 

And in European economies especially, one of the biggest inputs to inflation has been curtailed, for now at least: Natural gas prices have fallen dramatically across the globe, following Europe’s scramble to secure alternative supplies which caused a spike in even the normally range bound US natural gas price. Prices are now at or around pre-Ukraine war levels as a mild start to the winter in Europe, coupled with building up of gas storage and consumption reduction targets combined to push prices down.

Natural Gas prices fall to near pre-Ukraine war levels

Dutch natural gas futures 30/12/22, Source ICE

In the US, the jury is still out on whether the US economy will enter a recession in 2023. But even those expecting a recession concede that it is likely to be relatively mild: the jobs market is too strong for a deep and prolonged recession. 

The economic resilience being shown is offsetting the risk of earnings collapse discussed above. Much will depend on the interest rate decisions reached by the Fed. Jerome Powell is determined to avoid a wage-price spiral, which might imply that they will accept the risk of recession and err on the side of higher rates. But inflation peaked in the US several months ago, and the easing pressure might stay their hand; fewer or slower than expected rate rises will provide a boost.

The upshot is that, for the next few months at least, all the focus will be on exactly the same elements as it was throughout 2022: inflation and interest rates.

In the UK, concerns about the impact of rate rises on the housing market have been circulating for a few months. This is an important point, because a weaker housing market drags down other areas: when fewer people are moving home, durable goods sales (likes washing machines and refrigerators) suffer, and business falls for companies from lawyers to kitchen fitters, mortgage agents to landscapers. 

Whilst there will undoubtedly be some pressure in this area, it is unlikely that a crash is on the cards. About 68% of UK households own their home; of these, only about 28% are subject to a mortgage. At the start of the last rate hiking cycle, about 70% or mortgages were variable rate; today only 14% are variable.

The UK was the only major economy where equities were positive in 2022, thanks both to sterling weakness which boosts the overseas earnings of local companies, and to the high exposure to energy and banks which performed well last year. So, the UK’s strong performance should be viewed with some caution. 

UK CPI inflation for November also printed slightly lower than had been forecast at 10.7% down from 11.1% in the previous month.  It is possible domestic inflation has peaked too, although there is a lack of certainty here, as industrial disputes across state owned employers rage on with pay demands at high levels.  Fuel duty may be re-applied early in 2023 which will send inflation data higher again – so the UK market can be viewed with tentative optimism, as despite the outperformance many UK shares remain attractively valued. 

The news from Europe and Japan is different but equally important.  Mrs Lagarde (Head of the ECB) delivered a combative speech.  Out were previous dovish tones about inflation and in came hawkish commitments about raising interest rates and forcing inflation down from an apparently embedded 4% across the whole of the Eurozone.  This has pushed up German bond yields to 2.5% and Italian yields likely to north of 5%.  This disparity displays the relative weaker borrower status of Italy and their indebtedness and ability to service interest payments at higher levels brings some concern.  Other economically weaker nations in the bloc are not immune.

Japan had been relatively successful in banishing inflation from her shores and had defended ultra-low borrowing costs by yield curve control strategies including the Bank of Japan effectively buying up issued government bonds.  The policy has been broadly successful but with the Bank of Japan now owning more than 50% of all issued government bonds, the market has become dysfunctional.  Mr Kuroda, the soon to retire Head of the BOJ, announced the Bank will allow bond yields to fluctuate +/-0.5% soon.  This is important as it doubles the previous range and effectively sets the scene for Japanese borrowing costs to rise over time.  This will also encourage active Japanese investors to keep their money at home to fund regeneration programmes, rather than investing abroad.

China has unofficially abandoned its zero-Covid policy. The short-term impact of this is unclear. On the one hand, with fewer people caught up in lockdowns, there should be a boost to consumption and production. But with vaccination rates in China still relatively low, there is likely to be an initial spike in cases, which will create a headwind to consumption and production. In the medium- to long-term, the positives should outweigh the negatives, and the net boost to global growth should provide support for equities. 

Overall, with the potential for a peak in interest rates there is some room for optimism in 2023. However, in the short term, corporate earnings results will be key, especially in the US where earnings downgrades are fairly modest for the year at around -5%. So, any disappointment on this front could see the market here testing previous lows, as valuations are still not in ‘cheap’ territory. It is likely that bonds will lead any recovery and their forward-looking returns now seem attractive again following the huge retracement in prices in 2022. As we see visibility in the economic picture emerging later in the year, it is likely that equities will start to look forward to recovery with prices moving up to reflect this.

Rockhold Asset Management, with contribution from Alpha Beta Partners and Marlborough, January 2023