It has been a volatile week for equities as markets fret over the potential for a policy error as central banks attempt to regain control over a sharp spike in inflation to levels not seen in forty years. On Wednesday, the US Federal Reserve raised rates by 0.5%, a quantum not used in over twenty years, whilst communicating to the market that the same should be expected over the subsequent two rate-setting meetings. This led to a sharp rally in equities, as this seemingly ruled out a 0.75% increase, whilst also largely being priced in. However, all of this move and more was swiftly undone on Thursday, as markets rotated sharply by a level not seen since March 2020 when lockdowns were first introduced in response to the Covid pandemic. US Treasury yields, which move inversely to price, rose above 3% for the first time in more than three years. Investors are now waiting for the release of the US non-farm payrolls later today, with expectations that wage growth will have exceeded 5% year-on-year for the fourth month in a row.
As of 12pm on Friday, London time, US equities were up 0.4% over the week, whilst the US technology sector recorded a small loss of -0.1%, although futures markets are currently pricing in further falls when the market opens later today. European equities were down 4.2%, whilst the UK dropped 2.0%, although this masked a 4.7% fall in UK mid-cap stocks. Japanese equities rose 0.9%, whilst Australian stocks fell 3.1% and Emerging markets lost 1.6%.
10-year US Treasury yields traded up to 3.08% by the end of the week and German bunds also sold off, with bund yields touching 1.08%, a level not seen in seven years. UK gilts were somewhat more stable, as the Bank of England acknowledged that simply raising interest rates may not solve the UK’s inflation problem whilst so much of it is imported in. 10-year gilts fell in value, now trading at 1.94%, having exceeded 2% earlier in the week. UK rates were raised rates by 0.25% on Thursday to reach 1%, the highest level since February 2009, with the bank forecasting inflation to top 10% in the fourth quarter. The Reserve Bank of Australia had set the tone earlier in the week, as it too raised rates by 0.25%. Australia’s 10-year bond traded up to just shy of 3.6% mid-week, a level not seen since 2014.
Gold fell 1.6%, now trading at $1,882 an ounce, as did copper, falling 3% to $9,512, whilst iron ore fell by 6% over the week. Crude oil bucked the trend as the EU stepped closer towards a plan to ban Russian oil imports, although Hungary looks set to vote against the policy. Brent crude traded up 3% to $112.6 a barrel, whilst US WTI (West Texas Intermediate) traded 5% higher at $110 a barrel.
It has been a difficult year for markets so far, as stimulus policies put in place during Covid have supercharged demand whilst supply chain bottlenecks and the Ukrainian war have only served to compound the rise in inflation. And now the siren of recession risk grows ever higher as central banks attempt to regain control of the narrative. However, if we take a step back and look dispassionately at markets, in reality, what has really happened is a rebalancing in valuations. Expensive stocks have become cheaper, whilst cheaper stocks have become more expensive. Valuation dispersions had become extreme and an increasing discount rate on the risk-free asset i.e. government bonds has led to the market reappraising prices.
Looking forward, how much further this readjustment has to run is always difficult to judge, however, what is unlikely in the immediate term is for the investment winners of the last decade simply to reassert themselves. The market is much more sensitive to valuations today and this is likely to endure, at least until the inflation genie has been put back into its bottle. Whilst the increasing risk of a recession due to a policy mistake by central banks means that we are increasingly looking to move up the quality spectrum in terms of the companies we invest in, rather than just focus on ‘value’ or ‘growth’. Companies with strong balance sheets, solid earnings, low gearing, and defendable competitive positions married with lower valuations are becoming much more attractive places, increasingly referred to as the ‘forgotten middle’.
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