Commentary on February 2023
After a surge in January, the broad based rally enjoyed by markets since October last year has finally paused for breathe. Global equities retraced 2% of recent gains, led by a 6% decline in emerging markets following their recent exuberance over the reopening of China. The rally in global technology stocks also ran out of steam. In contrast, UK equities continued to make progress, closing 2% higher, with the large cap index recording a new high above 8,000. Gold also made a new high in sterling terms, before succumbing to profit taking along with other commodities. Bonds also retraced recent gains, with UK gilts and corporate bonds down 4% and 2%, respectively.
Recession, what recession?The US economy has continued to confound the economists calling for a recession. Recent data has painted a picture of a far more robust environment in 2023 than expected, with employment growth, retail sales, pending home sales and service sector activity all accelerating in January. On top of this, the pace of decline in inflation is proving sticky. The January CPI only dropped to 6.4% versus expectations of 6.2%. As a result, bond markets have finally capitulated to the more hawkish view of the US Fed that interest rates will have to stay “higher for longer”. Elsewhere, China is providing a further boost to global growth, with data confirming a strong rebound following the easing of covid restrictions. Chinese manufacturing posted its biggest jump in more than a decade.
Even the UK economy is faring better than expected. UK retail sales came in above expectations, with growth in January at odds with gloom over the cost-of-living crisis. House prices have continued to weaken however, as the higher cost of mortgage repayments is starting to bite. Inflation came in slightly lower than expected but remains in double-digit territory at 10.1%.
Brexit is back in the headlines, as the UK’s fifth Prime Minister since the referendum has reached a new agreement with the EU that aims to make the compromise reached over Northern Ireland’s trading arrangements more workable. There are strong hopes that the ‘Windsor Framework’ will finally provide a solution to this impasse and pave the way for warmer relations in future.
The mood in markets has improved dramatically since October last year as inflation readings have softened, China has reopened, energy prices have fallen sharply and labour markets have remained robust, allowing markets to rally on the ‘soft landing’ narrative. However markets were due for a pullback following recent strength. The stronger data in January has questioned this outlook, leading to speculation of a potential new ‘no landing’ scenario, where growth remains strong despite central bank efforts to engineer a slowdown to dampen inflation.
The general view remains that inflation has peaked and this will ultimately lead to a peak in rates at some point this year. Recent stronger data has now pushed the timing of this further out, along with the hope of any cut in rates soon after. To be fair the US Fed has been consistent in its message of “higher for longer”. But markets seized on their earlier comments that the “disinflation process has begun” to anticipate an early end to hikes and are now having to adjust accordingly. Higher growth comes with the risk of higher inflation, suggesting that the path back to central bank targets of 2% will not be quick or easy.
There remains a solid case for investing in commodities as a uniquely good hedge against the stronger growth, higher inflation scenario. This sector, along with infrastructure and gold, remains an effective ‘diversifier’ across our standard portfolios while such macro economic uncertainties prevail.
Dare we whisper it but the UK may also be back into vogue. UK stocks have been shunned globally and trade at a discount to their international peers across sectors. Citi have recently flagged that the overall UK index is now at a record 40% discount to the US on a forward price/earnings multiple basis. At least some of this discount has occurred due to the uncertainty created by Brexit. This factor may now be starting to fade. Another key issue has been the sector composition of the UK index, which has missed out on the prior strong gains in the glamorous technology stocks that have driven gains in other major markets.
The lesson of the past year is that investment trends do not last forever. Once a trend has reached an extreme level, it ultimately triggers a behavioural reaction that causes it to reverse. Moreover the moves in both directions tend to be exaggerated by investor herd mentality. The leadership trend of high-flying technology stocks finally peaked last year at an extremely elevated level. This has paved the way for a rotation in favour of more traditional sectors that dominate the UK market, such as resource giants, traditional bank stocks and consumer staple multinationals, where earnings are rising and valuations remain attractive with strong yield support. This trend is likely to continue, underlining our focus on both value and equity income.