Markets built on a strong final quarter in 2022, with a month long rally in January. Major equity indices rose by 5% and the FTSE 100 index of largest UK listed companies tested an all time high. Although many headwinds remain, investors have been buoyed by the expectation that interest rates will soon peak. The monetary policy headwind, which affected all asset prices, has lessened over the last few months. Although interest rates are expected to rise in the first week of the month in both the US and UK, the magnitude and forward guidance should continue to soften. Interest rates and bond yields are important in the valuation of all assets.
Elsewhere, the reopening of the Chinese economic has been a notable positive for equities in particular. The prospect of the world’s second largest economy and largest producer of goods rebounding from Covid lockdowns tempers concerns that many Western economies are experiencing a sharp slowdown or are already in recession. In addition to this potential increase in demand, a less restricted Chinese economy should also lessen supply chain issues globally. This has been a particular issue for company profits and consumer inflation. With freight rates now in line with their longer term averages and the Chinese labour market fully functioning, the prospect of falling goods prices is now a possibility. Conversely, commodities linked with construction and manufacturing have risen.
The theme of falling inflation has continued this month, with declines across most major economies. The most notable progress on inflation continues to be seen in the US, where rates have now fallen from a peak of 9.1% in June 2022 to 6.5% in December. Furthermore, there are strong signs that further falls are likely. While the market is rationally predicting that this falling rate of headline inflation will lessen central bank’s resolve for higher interest rates, policy makers will want to see clear evidence that inflation is tamed before cutting rates. While there are some early signs of weakness in the labour market, demand for employees remains high and the conditions are tight. Loosening policy into such an environment is unlikely, as the labour market is the key feedback loop for inflation.
As we progress over the next couple of months, year on year comparisons for many items will begin to turn negative as the initial spikes seen on the Russian invasion of Ukraine have most impact. The speed of this may take some market observers by surprise and there is the possibility of a regime change or rotation in the market as investors consider a lower inflation, lower growth environment. It is worthwhile recalling that 2020 and 2021 were years in which high growth, highly valued stocks performed exceptionally well, only to underperform significantly in the following year. The pace of which market favorites change and a “new normal” can be established is usually very fast and should not be discounted.