January Investment Summary
What a nice start to the year, especially given the ugly finish to 2022. Major equity markets closed January up between 5-10% in GBP terms for the month. The stellar performer was the NASDAQ , which returned over 10% as many of the large cap technology stocks, that did poorly last year, rebounded sharply.
So why were markets so strong? We think there has been an unusual mix of developments that are creating a (brief) moment of positivity for markets. Firstly, inflation is coming down. The latest Consumer Price Index print for the US was 6.5%, down considerably from last summer’s peak of 9.1%. That is progress. So much so, that the US Federal Reserve (Fed) is slowing the size of their rate hikes - only 25 basis points at the last meeting. Indeed, early indications suggest that they are close to pausing the rate hiking cycle. US economic growth is still steady, so hopes (dreams?) of a “soft landing” are rising. In Europe, inflation has also begun to fall from their even higher peak level, and the winter has been relatively mild, so the fear of a dramatic shortage of natural gas and energy rationing has been reduced. Energy costs have fallen considerably, and this feeds directly into business and household real income. Lastly, China has abandoned its severe Zero Covid Policy. The subsequent rebound in economic activity following the reopening has been abrupt and chaotic to say the least. We may never learn the true scale of illness, hospitalisations, and deaths, given that the Chinese authorities are particularly aggressive in preventing the reporting on conditions there. What we do know is that there has been a huge surge in economic activity as Chinese consumers, who have been locked up for over two years, are now travelling and spending. This is good for the global economy, and the impact will grow larger over the next few quarters. So, providing that the improvement in inflation doesn’t stall, this positive scenario can continue to perform subject to periodic earnings shocks (Intel and Goldman Sachs are two prime examples) that can damage individual names and sectors.
The long run challenge is that inflation is still too high. Global central banks are vowing (hoping) to bring inflation back down to their respective 2% targets, but it is not certain how high interest rates must go to achieve that, nor how long rates will have to stay in restrictive territory to succeed.
Official overnight policy interest rates have now reached 4.8% in the US, 4% in the UK, and 2.5% in the Eurozone. Interest rates have reached these levels much faster than financial markets ever expected. However, historically speaking, interest rates are not high. Yes, they are higher than zero, but they are only back to normal, in our opinion. Are they high enough to continue to lower inflation? That is debatable.
At the time of writing, the European Central Bank (ECB) has just hiked rates by 50-basis points at their meeting on February 2nd, whilst indicating that there is another 50-basis point hike in March. The Fed and the Bank of England, who have both held meetings this past week, each suggested that further rate hikes would be needed. All three central banks acknowledged that inflation was coming down, and they all felt that balance sheet reduction, and the cumulative tightening that has so far occurred, would begin to have an impact. Markets seized on this as evidence that a soft landing was taking place. Inflation was coming down without deep recessions taking place. Hurrah!
In the US, housing and industrial activity are clearly slowing but the labour market is still exceptionally tight. Latest figures show that unemployment has fallen to a 53-year low. This is despite the Fed hiking 450 basis points in a year! Either we will see a big, delayed reaction in the labour market or the Fed will have to hike to higher levels than markets are pricing.
Europe has received help from a milder winter, so there was no need for energy rationing and energy prices fell back down alleviating the negative impact on businesses and households. The recovery in the Euro is also helping in the inflation fight. The ECB has been the slowest to raise rates so don’t be surprised if they tighten further, even if the Fed pauses hiking.
At the most recent meeting of the Monetary Policy Committee, the Bank of England managed to sound upbeat, forecasting a sharper fall in inflation and a shallower slowdown in activity than they had previously forecast. That said, the International Monetary Fund recently pointed to further challenges ahead for the UK economy, with rising interest rates and higher taxes expected to create an overhang for economic activity.
The Bank of Japan (BoJ) after adjusting their yield curve control policy in December, left it unchanged in January although markets sense a change in policy is coming. Japanese ten-year government yields sit right at the BoJ’s 50-basis point limit and the Yen has managed to stay around ¥130/$, well down from ¥150/$ seen last summer. Why does this matter? Japan has been a huge exporter of capital and when this ceases, or reverses, it will affect a great many asset prices and not in a positive way.
Lastly, we are concerned that we haven't seen all of the fallout from the shift to higher interest rates after a decade of zero (or negative) interest rates. All debtors refinancing their debt are going to find themselves paying much more to borrow. We have already seen evidence of this, with European investment grade corporates refinancing bonds at some 250-basis points higher than their existing debt. This is the highest level since the late 1990’s.
Well, what should we do? From a sector perspective, we still like energy and mining. There has been inadequate capex in these sectors for years and demand is still rising. The push to switch to renewable sources of energy is increasing demand for all sorts of industrial metals. Whilst fossil fuel demand keeps rising as renewable energy sources are not yet able to replace that source of energy. Higher prices and higher profits for firms in these sectors will continue.
We are also happy to hold shorter duration fixed income, as you are (finally) paid a decent level of interest unlike last year. This year will not be a repeat of last year for fixed income performance. In equities, we believe a quality, value focused portfolio will offer the best returns in what is likely to remain a very challenging environment for risk assets.
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