Inflation is slowly heading in the right direction, but markets are betting on rate cuts that may not arrive
Over the past year, markets have been dominated by a central economic debate, as sentiment has swung between fears of higher inflation and interest rates and concern over the extent to which tighter policy might affect growth and earnings. Markets, along with central banks, have consistently underestimated inflation and overestimated the speed at which it would fall. Things are at last slowly heading in the right direction: inflationary pressure is coming down and the labour market is showing early signs of weakness. Policy tightening appears to be working.
The US regional banking crisis continues while a new political stand-off takes shape
Global equity markets were broadly flat during April, with further gains in the UK of 3% offset by a pullback of 3% in Asia and emerging markets. Overall indices have recovered from their sell-off in early March but have not yet been able to break out to higher levels. The regional banking crisis in the US continued to generate headlines, with First Republic Bank the latest to require a rescue package, although market fears about a broader contagion have waned. The logic is that the only banks that might fail are the ones that can safely be allowed to do so.
As tensions eased on one front, another problem unique to the US emerged. The combination of a Democrat President and Republican-controlled Congress led to a re-run of the 2011 and 2013 debt-ceiling political stand-offs. Talks to increase the limit on total government debt reached an impasse, as Republican leaders sought to extract a promise of future spending cuts before approving a higher ceiling. History suggests that after much political horse-trading, a deal will be struck at the last hour.
April also saw the start of the second-quarter reporting season in the US. Announcements were slightly ahead of expectations, although still down for the second consecutive quarter. Overall earnings were on track to decline 7.3% year on year, compared to a forecast decline of 8.1%.
The economy decelerates as the Fed hints at a pause
On the economic front, the cycle was evolving slowly with no major surprises. The US economy decelerated but continued to grow at a decent pace, and inflation continued to moderate, falling below 5% for the first time in two years. Employment is the ultimate lagging indicator, and there were early signs that it was finally starting to respond to the recent sharp rise in interest rates. Average monthly job creation slowed to 222,000 during the February to April period, from 338,000 for the previous six months, while wage growth also cooled.
The US Fed raised interest rates by a further 0.25% to a target range of 5.0% to 5.25% and hinted that this might be the last increase for now, in the most aggressive tightening campaign since the 1980s. However, it also cautioned that there would not be any cuts if the rate of inflation remained too high.
Stubborn inflation prompts a 12th consecutive rate hike
The Bank of England found itself in a trickier position, with weaker growth and higher inflation. The UK economy grew slightly in the first quarter, rising 0.1% overall, but shrank by 0.3% in March. The central bank backtracked from its previous forecast for a recession throughout 2023, instead expecting the economy to grow by 0.25%. However, it now also expected inflation to remain above target until 2025, falling to around 8% for the second quarter and 5% by the fourth.
The stubborn pace of decline led to a further rise in the UK base rate of 0.25% to 4.5%, its 12th consecutive hike.
A post-Covid rebound lifts growth above expectations
China's economy grew at a faster pace than expected in the first quarter, as the country emerged from Covid Zero. GDP expanded 4.5% year on year, up from the 2.9% recorded in the fourth quarter of 2022, led by a rebound in consumer spending.
A note from the desk
I am pleased to share our monthly update on market events. The overview seeks to summarise market movements together with our views and the rationale for the positioning of investments going forward. As always, should any aspect of this commentary prompt a question, we would welcome the conversation.
Martyn Charlwood · Managing Director
Markets price in rate cuts that the Fed has not yet endorsed
Since the banking crisis, expectations for US rates changed substantially. Markets were pricing in three rate cuts before the end of the year, despite continued rhetoric from the US Fed that, while it was likely to pause, it was not yet prepared to change course. In fact, the Fed had continued to hike rates twice since the closure of Silicon Valley Bank first sparked the turmoil. There was therefore scope for disappointment if markets were forced to accept that rates would stay higher for longer. Equity markets were likely to remain rangebound until this tension resolved.
The only banks that might fail are the ones that can safely be allowed to do so.
Our strategy has focussed on identifying cheap assets whose fortunes are less tied to the outcome of the inflation and rate debate. We have often commented on the relative value of the UK. Another market that stands out for similar reasons is Japan.
Our focus remains on cheap assets whose fortunes are less tied to the outcome of the inflation and rate debate, with emphasis on regions offering deep value in an uptrend.
Japan as the new opportunity
Markets move in very long-term cycles. In 1989 Japan was the largest global market and accounted for 13 of the top 20 listed companies by total size. In 2023 this list is dominated by 13 US companies, and not a single Japanese company remains. Stocks have been long out of favour yet have quietly been grinding out gains, while markets in the West have faltered. Our Japanese positions have received an additional boost from the decision to fully hedge the currency exposure to the yen.
Overweight the UK and emerging markets
Over the long term we believe that buying undervalued and under-owned assets in an uptrend is one of the best and safest strategies for returns. Japan, the UK and select emerging markets currently fit this criteria alongside gold and commodities.
Gold and commodities as diversifiers
Exposure to gold is providing positive returns and diversification while we wait for the macro outlook to clear. These assets are less tied to the outcome of the central debate around inflation and rates, and they serve as an effective hedge if inflation proves more persistent than expected.
A Buffett endorsement
A recent update from Warren Buffett has highlighted the potential for a relative change in the cycle back in favour of Japan. Buffett believes that the incredible period for the US economy is coming to an end and foresees weaker profits across much of his domestic US equity portfolio. In contrast, he has continued to build exposure to Japan, where deep value is gradually being realised as companies restructure, raise returns and buy back shares.
Important information
This article is a marketing communication intended for general information only. It does not constitute personal advice, a recommendation, or an offer to buy or sell any investment. If you are unsure whether an investment is suitable for your circumstances, please seek personal advice.
Past performance is not a guide to future performance. The value of investments and any income from them can fall as well as rise. Capital values are at risk and not guaranteed. Forecasts and views expressed in this commentary represent our assessment at the time of writing and are subject to change.
To discuss how this commentary applies to your own portfolio, we would welcome a conversation.
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