Inflation and the likely response from the US Federal Reserve (Fed) dominated markets this week, as Jay Powell, the chair of the Fed, said the inflation outlook had worsened since their December meeting, whilst not ruling out raising rates at every policy meeting for the rest of the year. Fourth-quarter US GDP came in higher than forecasted at 6.9% annualised. Volatility in the US market picked up appreciably, with the VIX index currently trading at 31, well above its long-term average of around 20. On Monday alone, US equities traded down by over 3%, before closing up 1.2% on the day, 4.4% higher from its low point. Volatility of this magnitude has not been seen since March of 2020, at the point Covid-19 was declared a pandemic. US technology stocks have now fallen over 16% since the November record high. The latest US inflation data is due out at 1.30pm today, London time, with forecasts pointing towards year-on-year inflation coming in at 5.8%. How markets react to this data will likely define their tone in the coming weeks, all else being equal. Although most economists expect US inflation to peak this year, that is not forecast for another couple of months. However, investors were reminded this week that not all technology stocks are speculative, with robust earnings and profits figures released from both Microsoft and Apple.
As of 12pm on Friday, London time, US equities fell 1.6% over the week, whilst US technology stocks dropped 3.0%. As the selloff became broader, European stocks lost 2.3%, although the UK’s stock market, being heavily exposed to so-called ‘old economy’ sectors such as energy and financials, was relatively defensive, falling 0.8%. The Japanese market fell 2.6%, as did Australian stocks, whilst the emerging markets dropped 4.2% having been relatively defensive year to date, succumbing to a sharp upwards move in the US dollar.
10-year US Treasury yields, which move inversely to price, traded back up towards their recent highs, now trading at 1.84%. It was a similar story for other developed market bonds, with German bund yields rising to -0.02% and UK gilts to 1.28%. The US dollar index moved sharply higher this week, trading up 1.8%, now priced at $1.11 versus the Euro and $1.34 versus Sterling.
It was a mixed picture within commodity markets, with gold falling 2.6% to $1,787 an ounce as expectations of rising US interest rates are priced into the market. Copper also fell, losing 3.8% over the week, now trading at $9,836, whilst iron ore rose over 6% over the week. Crude oil also rose, with Brent and US WTI (West Texas Intermediate) both rising by over 2.5%, trading at $90.2 and $87.3 a barrel respectively.
Both the Fed and market strategists have adopted a much more hawkish tone in respect of US interest rates in recent weeks. The Fed has committed to remain data-dependent as it adjusts to heightened levels of inflation, but nonetheless, it may be that they choose to front end load any rate rises this year to get ahead of the inflation narrative. Therefore, whilst expectations are for four quarters of a point rate increases, half a percent increases cannot be dismissed, depending on what the inflation data looks like between now and the Fed’s March rate-setting meeting.
Markets are going through a period of rebalancing, as investors must contend with inflationary pressures for the first time in many years. Those companies on high valuations with profits due to come through in later years are bearing the brunt of the pain. However, although growth is expected to slow versus last year’s high bar, it is still forecast to be a robust year for earnings, with both households and corporates sitting on cash built up during the pandemic. Stock market returns can still finish the year in positive territory despite the tough start. Volatility is likely to remain elevated, but opportunities to pick up stocks at more attractive levels may present themselves as markets work their way through this period of adjustment.
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