Market Update Monday 9th January 2023

The new year starts where it left off – inflation, inflation, inflation

Markets have picked up in the new year from where they left off last year, looking for evidence of a slowdown in economic activity, and therefore inflationary pressures. Investors are trying to judge when the tightening monetary policy cycle will come to an end, and the likelihood and depth of any impending recession. Headline inflation data (including food and energy) released by Germany, France and Spain, has come in weaker than forecast for December and lower than the prior month, helping to spur an early rally in European equity markets. Whilst US equities have had a harder start to the year, as despite leading indicators pointing towards a slowdown, the jobs market remains tight, and markets continue to worry about the effects of wage pressures on the inflationary outlook. Later today, the latest employment data in the form of the non-farm payrolls will be released, however, earlier this week, the ADP private payrolls came in stronger than forecast and higher than the figure for November, with 235,000 new jobs having been created.

Against this backdrop, as of 12pm on Friday, European equities rose 3.6% over the week, with the UK market climbing by 2.7%. Whilst the US market fell 0.8% and the US technology sector dropped 1.5%. Both onshore and offshore Chinese stocks have started the year on a strong footing, benefitting from an easing in Covid restrictions, despite an explosion in the spread of the virus. Chinese ‘A’ shares rose by 2.2%, whilst offshore Hong Kong stocks are up 6.1%. This has helped to propel emerging markets up by 2.9%. However, this hides a wide dispersion in returns in the emerging world, with Latin America down by 1.0%, suffering from falling oil prices. Australian equities rose by 1.0%, whilst Japanese stocks fell by 0.8% following the Bank of Japan relaxing its zero-yield policy control before Christmas. Yields on 10-year government bonds can now trade in a range of plus or minus 0.5% around zero, versus the previous range of plus or minus 0.25%.

Government bonds strengthened

Government bonds strengthened in price, as the continued strength in the US labour market raised concerns that US interest rates will continue to rise, increasing the risk of a recession. 10-year US Treasury yields, which move inversely to price, fell to 3.72%, whilst shorter-dated 2-year yields, which are more sensitive to interest rates, rose to 4.47%. 10-year German bund and UK gilt yields fell to 2.29% and 3.56% respectively.

Commodities

Gold rose by 0.8% over the week to trade at $1,840 an ounce, having risen close to 12% since its lowest point in 2022, recorded in November. Copper was little changed over the week, trading at $8,361 a tonne, whilst iron ore continued its recent recovery, rising by 1.5%, benefitting from the relaxation of Covid controls in China. Crude oil traded down, with Brent crude falling almost 9% over the week, now priced at $78.5 a barrel. European natural gas rose by 2% over the week but has fallen to levels last seen in 2021. On the back of a warm winter, prices have fallen by over 50% since the highest level for December, and by over 70% since its peak reached in August of last year. It is a similar story in the US despite prices never having reached the stratospheric levels witnessed in Europe. US Henry Hub gas prices have declined by over 45% since the peak for December, and over 60% since the highs of August.

Issues under discussion

No imminent let-up in future tightening

The dominant narrative of 2022 continues into the new year: inflation, the response from central banks, and the probability and depth of a recession.

Headline inflation, that is, including food and energy, looks to have peaked, with recent inflation prints coming down faster than estimates. However, core inflation, excluding food and energy, remains stubbornly high. The US Federal Reserve has moderated its rate increases, although comments from the chair, Jerome Powell, and minutes released from the last meeting suggest no imminent let up in future tightening whilst inflation remains significantly above its target of 2%.

Monetary policy acts with a lag of somewhere between twelve to eighteen months, therefore the danger is that the Fed over-interprets the need to continue tightening, leading to a sharper downturn than required some time in 2023.

The flip side of this, is that some investors look to history and suggest that when periods of inflation have come about before it has taken much longer periods of tightening to tame it. Therefore, bond yields have further to rise from today’s levels before inflation is brought under control.

The truth is, there is very little consensus on what the root causes of inflation are, and therefore similarly, the remedies.