The recovery, which began in October ran out of steam in December and dashed hopes for an end-of-year rally. Global equities lost 3.9% in the last month of the year as worries over the future pace of monetary tightening resurfaced. All major markets performed negatively, except for China, where the government moved swiftly to unwind its zero-Covid policy. Japan was among the biggest losers in December, as the Bank of Japan surprised investors by announcing it would tolerate a higher yield on 10-year government bonds. European and UK stock markets fared better than the US, which lost 5.8% in December.
Markets continue to be driven primarily by the shifting outlook for inflation and central bank policy. The rebound was largely fueled by growing optimism that the worst of the inflation surge has passed. However, Fed and ECB officials unmistakably made clear that the hiking cycle was going to continue and even scaled up their forecasts for peak rates. The comments from ECB president Lagarde were especially hawkish, saying that rates would need to raise interest rates by 50 basis points a couple of more times. Fixed income markets adapted quickly to the more restrictive stance of the ECB: the Bloomberg Pan-European Aggregate bond index returned -2.9% in December. We think that (again) investors had moved too quick in pricing in a dovish pivot in monetary policy. The end of interest rate hikes is in sight, but the turning point has not yet been reached.
The same applies to the overall economic picture. Economic activity is likely to slow further, and there will still be a few months to go before growth passes its inflection point. Recent economic data suggest that higher interest rates are starting to have a bigger impact on the US economy. The ISM services PMI, which has been stable until now, plummeted far below consensus expectations to its lowest reading since Q2 2020 (49.6). This matches the darkening picture sketched by other leading economic indicators. The Prices Paid sub-index continues to trend lower, indicating that inflationary pressures are moderating. This dynamic with weaker economic conditions raises the odds the Fed will ease off the brake this year. However, with an unemployment rate at a 50-year low (3.5%), the Fed will need to see more evidence of a cooling job market before it can pivot to cutting rates.
By contrast, various measures have recently been pointing to an improvement in Euro Area sentiment, while the hard data are in fact worse than in the US. The European Commission’s December surveys show firming production expectations boosted industry confidence, while consumer sentiment continued to recover from its September low. The ZEW gauge of German investor sentiment hit its highest level since the start of the Ukraine war. Recovering sentiment reflects moderating price pressures amid an easing of the energy crisis.
China’s economic data indicate a broad-based weakness in business activity and domestic demand, lingering difficulties in the property market and shrinking exports. However, policy makers have reached the limit of their economic pain threshold and China’s stimulus rhetoric has become more aggressive. Furthermore, a full reopening is now imminent in China, after the government slashed the Covid-19 restrictions. Consumption and industrial production might both suffer a deeper but shorter blow as infections surge. Many tier-1 cities have passed the peak of Covid infections, and there are signs of a return of commuters. Thus, China’s economic activity might remain choppy in the next months before it starts to recover.
Equity markets have started the year on a positive note. While investors and central banks take comfort with slower growth (inflation) in the US, the macroeconomic momentum speaks against a sustained equity market recovery. Of all 36 countries for which the OECD publishes leading indicators, not a single one climbed in the seven months up to the end of November. Inflation is still high, and the lagged effect of interest rate hikes and quantitative tightening are likely to weigh on growth and corporate earnings. We continue to favor a cautious stance in our investment strategy until we have more clarity about growth, corporate earnings and interest rates. After a difficult year for fixed income, there is a growing case to be made that 2023 offers opportunities in high-quality bonds.
Please find attached our last Asset Allocation Update for January.