While there was significant volatility, equity market returns during May were relatively flat. Following weeks of persistent selling, the month was saved by a sharp rally seen during the final week. Fixed income markets remain under pressure as both the Federal Reserve and the Bank of England raised interest rates by 0.5% and 0.25% respectively, taking the headline rates to 1%.
The major market focus continues to be on inflation, interest rates as well as the inherently linked cost of living crisis. However, there are signs that these are beginning to peak. So far this year, markets have increasingly priced in higher interest rates, following inflation and central bank guidance higher. Although several interest rate rises have already been enacted, markets are anticipating that these will accelerate through the remainder of the year. While this is possible, with the economy slowing and political will weakening, market expectations are beginning to look stretched. Any dovish surprise by central banks would likely be very supportive for both fixed income and equity markets. Furthermore, the main drivers of higher inflation are close to having their maximum impact and are expected to roll over during the second half of the year. A plateauing or falling headline rate of inflation may calm investors and central banker concerns, at least in the short term.
Recent actions by the UK government to subsidise retail energy prices suggest that politicians at least believe that stimulus is necessary, contrasting with the suppressive action of higher interest rates from central banks. Furthermore, such actions will have a direct and tangible impact on UK inflation in the latter part of the year. Attempting to raise rates further, into a recessionary environment is likely to prove challenging, especially if increases are ahead of market expectations.
Elsewhere, one of the more recent drivers of market weakness has been the COVID lockdowns in China. This led to fears over demand as well as the potential for additional supply disruptions, compounding existing issues. However, more recent data and messaging from the Chinese government suggests that these measures are likely to be eased. Given the potential for a small economic rebound in the areas where these measures were imposed as well as the reduction of downside risks in supply to Western economies has seen markets react positively.
The war in Ukraine continues to have an impact on markets, particularly through energy prices, which remain persistently high. There are also medium-term issues developing, particularly in the supply of agricultural products, of which both Ukraine and Russia are major exporters. This may become a growing focus for markets over the coming months.