The fourth quarter saw a strong rally in global stock markets and positive returns for bonds in local currency terms. However, a recovery in sterling led to weaker returns when expressed in pounds.
The key economic themes included significant increases in interest rates from the main central banks as they attempted to manage inflation expectations and suppress wage growth. Economic growth forecasts for all the major economies were reduced.
This did not stop a rally in risk assets from mid-October to the end of November, as optimists began pricing in an improvement to global economic conditions from mid-2023 and a recovery in corporate profits. Despite a sell-off in December, the MSCI World index of developed stock markets finished 9.8% over the quarter in dollar terms but made a more modest gain of 1.7% in sterling.
The December sell-off was partly driven by the realisation that a profits recession between now and the subsequent economic cycle could test current stock market valuations. Another was a belated realisation by investors that cherry-picks the parts of Fed statements that are supportive of risk assets while ignoring parts that could not persist.
The Bloomberg Global Aggregate bond index (of investment grade bonds) rose 4.5% in dollars, helped by falling inflation in the U.S., the U.K., and central banks demonstrating their commitment to tight monetary policies with large interest rate hikes. Even the Bank of Japan, which has tried to stimulate inflation for more than two decades, made a modest move to tighten monetary policy in December.
In the U.S., the Fed’s target rate rose 1.25% to 4.25%-4.5%, while the Bank of England’s similar 1.25% rise took the benchmark rate to 3.5%. The U.S. Treasury yield curve inverted, with 10yr yields at the end of the year 0.53 percentage points lower than on the 2yr: such an inversion is taken by many to be a harbinger of recession.
Energy prices fell, particularly in Europe, as Russian oil and gas users found new suppliers from Norway, North America and the Middle East. This contributed to European stock markets significantly outperforming the U.S. over the quarter, as investors began to look at cyclical stocks that might perform best in an economic recovery.
Indeed, U.S. tech substantially underperformed over the period. While the broad MSCI U.S. index rose 7%, the NASDAQ fell by 1% (both in dollar terms). Social media companies reported falls in advertising revenue, rising interest rates chocked off investor interest in growth stocks and some of the best-known names such as Apple, Meta and Twitter- suffered specific company-related issues.
The collapse in November of the crypto broker FTX added to doubts over the long-term future of cryptocurrencies. Bitcoin fell 14% to $16,703.
Throughout the autumn, Chinese stocks had been sensitive to rumours that the Zero Covid policy might be lifted, sometimes persuading investors to buy back into one of the weakest stock markets of the year. But when restrictions were suddenly lifted in early December, stocks markets fell as fear grew that rapidly rising Covid infections would affect output and consumer spending.
Normality returns to the U.K.
There was a significant U-turn in fiscal policy from the U.K. government in the November budget. Prime Minister Rishi Sunak and Chancellor Jeremy Hunt ripped up the ‘borrow and spend’ September budget of their forebears, Liz Truss and Kwasi Kwarteng, and announced a period of fiscal austerity…to begin in two years, by when they will likely be out of office.
The gilt market, immensely relieved to see the back of Truss and Kwarteng, forgave the new team this sleight-of-hand and was unmoved when the Bank of England became the first major central bank to actively sell its bond holdings as part of its quantitative tightening program.
Sterling rose 8% against the dollar over the quarter. This partly reflected the dollar weakness that struck in early November and persisted for the next two months, as other central banks surprised markets with sharp interest rate hikes (e.g., the ECB). The dollar lost 4% on a trade-weighted basis during the last two months of 2022.
But sterling benefited from the same re-appraisal of the sanity of the U.K. government in the same way that gilts did. Indeed, the two are linked – as foreign investors bought back into gilts, they required sterling.
The MSCI U.K. index rose 8.6% in sterling terms.
The big unknown for 2023 is inflation, central banks, and the government’s response to it.
Headline CPI numbers are likely to fall in all the major economies over the first six months of this year, thanks in large part to the energy price rises of last spring falling away from year-on-year data (the ‘base effect’). If so, this should allow central banks to end rate hikes over the coming months and ease monetary policy during the second half of the year. This will benefit economic growth and give support to risk assets.
Market projections are for the Fed to settle at a target range of 5%-5.25% in the spring (i.e., 75bps above current levels).
The above is a popular narrative amongst investment strategists for 2023 and may come to pass. If so, the coming months may be a good time to buy stocks and credit. But there is a complication to the inflation story, which should be acknowledged.
Economists worry that there may be a limit to how much inflation falls this year. Though energy prices fall, core inflation could remain stubborn because of strong wage growth. Wage growth is strong because there is a reduced pool of workers in most industrialised economies, compared to pre-Covid days (as measured by labour participation rates).
Is it realistic to see 2% inflation in the U.S., U.K. and Eurozone while wages are rising -led by the private sector- at over 6% in the U.S. and the U.K. and around 5% in the Eurozone? The fight against inflation will increasingly be against wage growth, which central banks can achieve only by creating slack in labour markets (e.g., unemployment) by inducing a recession.
Therefore, an alternative scenario for 2023 is lower, but still stubborn, inflation. And a reluctance by central banks to ease monetary policy. This will be especially so if governments allow public sector wages to grow at private sector levels this year in the name of alleviating the cost of living crisis.
In such a scenario, weak global economic growth and falling but stubborn inflation may create another year of uncertainties for both risk assets and government bonds. One’s hunch, though, would be for the latter to outperform.
The above scenarios do not include geo-political risks, such as Putin expanding his war against Russia’s neighbours, China attacking Taiwan or the economic upheaval caused by the growing movement against globalisation.
And what will the net effect of China re-opening its economy be on global inflation? More factories producing more ‘stuff’ will help ease global bottlenecks in manufactured goods. But pent-up domestic demand and potentially a shortage of workers as Covid cases rise in China could be inflationary.
Investors are advised to ignore the forecasters. Instead, financial history shows that maintaining a diverse portfolio of investments -across regions, sectors and asset classes, with regular rebalancing will deliver the best long-term risk-adjusted returns.
- No Investment Advice: This financial commentary is for informational purposes only and is not intended to be, and should not be, construed as an offer to sell or a solicitation of an offer to buy any security or financial instrument or invest in any equity or investment strategy. It should not be used to form the basis of any investment decision.
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