Markets narrowly avoid bear territory as inflation stays above 8%

Growth continues to slow as cost pressures mount

Purchasing Manager Indices suggested ongoing economic growth, albeit at a slowing pace, as supply issues, rising costs and geopolitical uncertainty led to subdued order books. This was more marked in the UK than abroad. Unemployment fell further, with unfilled vacancies hitting record levels in the United States. Inflation fell slightly in the US, but the headline rate across the US, UK and Eurozone was consistently above 8% on an annual basis. There was better news from China, which announced an easing of lockdown restrictions and a desire to stimulate the economy.

Jerome Powell was confirmed for a second term as Chair of the US Federal Reserve, using his acceptance speech to reassert the likelihood of consecutive 0.5% interest rate rises at the June and July meetings. He also admitted that, with hindsight, it might have been better to have raised rates earlier. European Central Bank President Lagarde broke with convention to explicitly warn that interest rates would be returned to zero by the end of September. With European rates currently negative, this implied two 0.25% rises, starting in July.

Growth is now seen as bad news, and moderation as good

The scenarios being debated by market participants are stagflation and recession, with only a faint possibility of a managed slowdown. The concern is that any period of further growth would be inflationary, and so central banks will keep raising rates until growth disappears. Taking this a stage further, evidence of continued growth is being read as unwelcome news, as it will provoke further rate rises. On the other hand, any moderation in growth would be seen in a more positive light, raising hopes of a soft landing.

Recently published composite global PMI numbers point to a very mild expansion in activity, but the manufacturing sector figure is below 50, indicating a contraction, while new orders are only just in expansion territory. Things look starker in the UK, where a confluence of factors is causing a cost-of-living crisis. Although the job situation remains strong, this is a lagging indicator. More telling has been the slowdown in consumer spending as incomes are diverted to essential supplies. On top of higher taxes, rising energy and petrol costs push up the rate of inflation but also act as a further tax on disposable incomes, leaving less for discretionary spending.

Last year was about companies being able to pass on price increases. This year, changing consumer spending habits and substantially higher gas and other commodity prices are hitting margins. There is a school of thought that this has already been allowed for in market valuations, but the sharp fall in Target's share price suggests scope for further downside. There are many known negatives dominating financial headlines and few positive arguments. We expect market volatility to continue, and we remain open to the possibility of a further decline. But with investment risk-off positions anecdotally at extreme highs, there is also a risk to being out of the market if some of the worst scenarios do not play out.

We remain of the view that a diversified portfolio, favouring equities over bonds, remains the best way of producing inflation-beating returns over the long term. The returns on cash and bonds remain at extremely low levels and well below the current levels of inflation. We used the mid-month rally in fixed interest bonds to sell one of our corporate bond funds, and we are currently reviewing a number of new funds in readiness for when the markets present a good entry level.