26/01/2023
Market sentiment: A confident start to the year. The re-opening of China and weaker European gas prices has improved the outlook for the European economies, while hopes for a ‘soft landing’ for the U.S have grown. The U.S Fed appears able to reduce inflation without creating significant unemployment. However, the mood towards risk assets remains variable. Investors should remain invested in a wide variety of assets, so help reduce portfolio volatility.
Lagging economic data continues to be poor: last week we saw weaker than expected U.S retail sales and manufacturing data from December. Business leaders at Davos continued to fret over the impact of inflation and falling demand growth on their bottom line. But the worry over corporate earnings in the first half 2023 is a near-term concern, one that investors appear reasonably happy to look beyond. Investors are looking ahead to the second half of the year, and to a global economic recovery underlined by an end to interest rate hikes from the major central banks by mid-summer, and possibly rate cuts at the end of the year as inflation falls sharply on a year-on-year basis. At Davos, the IMF justified investor optimism for this scenario, announcing a likely upgrading to second half 2023 global GDP growth forecasts, and to calendar 2024 GDP estimates.
Why the tough talk from central banks when inflation is falling? The Fed’s vice-chair, Lael Brainard, and the ECB’s Christine Lagarde, both issued stern reminders to investors last week that they are determined to bring inflation back to 2%. Even though inflation is falling, and looks set to continue to do so. Investors stepped back, global stock markets fell. Why do the central bankers have this annoying habit of wanting to smother improving investor sentiment with warnings of inflation, and with that warning the implicit threat of higher than expected interest rates?
Central bankers are as delighted as everyone else that inflation is falling, but remain nervous that strong wage growth will lead to sticky core inflation, and a rise in long-term inflation expectations. By reminding the world of their determination to see 2% inflation, they are trying to keep those expectations low, and so influence pay growth. Fortunately, we are seeing evidence of moderating pay in the U.S, perhaps thanks to a fall in vacancies and -over the last month- some large layoff announcements.
A second objective is to burst rallies on financial markets, since rising asset prices boost investor confidence and household and corporate spending (the so-called wealth effect). This is the opposite of what central banks currently want to see happen, as they try to bring down wage growth and core inflation through suppressing demand.
We can expect more interventions from central banks over the coming months, as they try to manage down inflation expectations and wage growth. But there is a great deal of scepticism in the markets as to whether the major central banks will ‘punish’ investors with higher-than-expected interest rates, so long as wage growth is moderating (in the U.S) and gas prices are falling (in Europe).
The FTSE 100 and the power of compounding. The FTSE100 index has been hovering around its May 2018 all-time high of 7,877. It contains many of the value sectors that global investors currently crave: energy, mining, pharma, financials etc. These sectors also tend to be hugely cash-generative, and handing that money to shareholders through share buy-backs and dividend payments. Although the index is flat over the last four and a half years, an investor who put money in the market in May 2018 and has reinvested the dividends is up 20%, thanks to one of the highest dividend yields on major stock markets (it currently stands at around 4.2%).
China – many themes for investors to consider. Last week China reported much weaker than expected 2022 GDP growth, of 3% compared to the official target of 5.5%, due largely to pandemic restrictions. The easing of those restrictions is expected to trigger strong demand growth this year, though large numbers of Covid-19 cases may dampen the re-bound in the near-term. In addition, policy makers have to navigate a property crisis, a decline in exports as demand in the western economies slows and the increasing risk of dis-investment by western technology companies.
Nevertheless, Chinese manufacturers are preparing themselves for a recovery in demand by increasing imports of industrial raw materials, contributing to buoyant coal, copper and iron ore prices. Chinese stocks have had a strong re-bound since restrictions were lifted. It has been driven primarily by local investors. Foreign investors are more cautious, being uncertain over the macro-economic issues mentioned above, as well as over the impact of increasing state control on the largest quoted companies.
Meanwhile at Davos, Nicolai Tangen, of the Norwegian sovereign wealth fund, gave warning of a possible severe global inflationary shock coming from the re-opening of China. This may lead to a second wave of interest rate hikes in western economies, later this year. This risk is not considered significant by most economists, and consensus is for the Fed, Bank of England and the ECB to all end their current rate-hikes by June. But the effect of China’s re-opening on global inflation is a theme that investors should watch carefully.
Investors should remain diversified. There is no ‘right way’ to approach investing, since each individuals attitude to risk, and time horizon, differs. However, a disciplined approach to putting money into the markets, that ignores current trends the markets, when the outlook for corporate earnings and interest rates is so opaque. Investors should remain diversified in multi-asset portfolios, that offer exposure to equities, bonds and alternative asset classes. Holding cash is tempting, but it suggests an ability to ‘time the market’, to invest it at an optimum point in the cycle. See below for why this is near-impossible.
