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Article | 16 December 2022 | Podcasts
Today we’ll discuss whether interest rates too will reach a peak in 2023, meaning central banks can ‘pivot’ towards lower rates.
Who will reach this inflection point first among the major central banks, and how might financial markets respond?
Seamus Lyons CFA, Senior Investment Manager and Chris Iggo, Chair of the AXA IM Investment Institute and CIO Core Investments discuss what’s on their investment radar. Hosted by Lorna Denny, Investment Specialist.
Pivot to positive markets
Financial markets have been battered this year by runaway inflation and fast rising interest rates. So much so that 2022 will go down as the year where there was ‘nowhere to hide’. But as the year ends, inflation has perhaps hit its high watermark. We focus on whether interest rates too will reach a peak in 2023, meaning central banks can pivot towards lower rates. Which major central bank will reach this inflection point first? And how might financial markets respond.
Could you set the scene and give a few highlights of financial market performance?
It's been a pretty interesting year and not in a positive way either. We're likely to end the year with most mainstream asset classes down and some by a reasonable measure. January set the tone with bond and equity markets selling off on rising interest rate concerns, and this would be a dominant theme for most of the year. In late February we had the Russian invasion of Ukraine, which sent energy prices soaring and drove equity markets lower again. Not to be outdone, the second quarter of the year proved to be even more painful. This is where markets really began to worry about the consequences of the highest level of inflation we've had in over 40 years. And in response to that, central banks began to ratchet up interest rates at a great rate. June saw the first 75 basis points increase by the Fed (US Federal Reserve) since 1994. We've had another three of those since. And the ECB (European Central Bank) and other central banks began to raise rates as well.
Markets did enjoy some brief respite in the summer months, as investors’ hopes rose for a pivot from central bank tightening. But then there was a speech at Jackson Hole by Fed chairman Jerome Powell, where he gave a very sober and hawkish outlook for rates. And markets again began to sell off on the back of that and by late September most equity markets were in bear market territory. And many of the bond markets were on course for their worst year on record. However, since October we've actually seen some positive developments, with increasing signs that the inflation picture may be improving and growing expectations that central banks will begin to tone down their hawkish monetary policy.
So as we enter the final weeks of the year, the market mood definitely seems a bit less negative than it was not that long ago.
Is the rally since October all down to softening rhetoric from the US Federal Reserve?
That's a large part of it, but also markets have adjusted a lot already in 2022. And, if we think about the bond market, yields at the beginning of this year were very low. In Europe they were still negative in some cases, and there's been a big adjustment of 300 or 400 basis points movement in yields and interest rate expectations. I think one of the things we always need to keep in mind is it takes time for these things to impact on the real economy. It was Milton Friedman, the US economist, who once said that monetary policy acts with ‘long and variable lags’. We've had a lot of tightening already this year and it makes sense that central banks are now saying we've done a lot, we need to assess the impact and we may need to slow down in terms of further interest rate increases.
So the market is definitely focused on that view. There's no question that we'll probably see one or two more hikes from the major central banks, but we're closer to the end. And that's given markets some cause for, not exactly optimism, but certainly better sentiment than was the case earlier in the year.
The Fed has been at pains to convey this message of ‘higher for longer’ on interest rates.
I think it makes sense from an economic policy point of view. Because historically, when you have periods of fairly aggressive monetary tightening, like we've had this year, it still takes time for inflation to come down. Core inflation, which is what they're really concerned about, tends to be quite sticky. And it will take a year, or even two years, to get it back down to anywhere close to the 2% level they had as a target prior to this inflationary period.
What they don't want to do is declare victory too early. And that means that rates, say they go to 5% in the US, will stay there for some time. The challenge for the Fed and for markets, is that it takes time for inflation to come down, but it doesn't take that long for the economy, in terms of real activity, to respond. And we're already seeing that from a lot of the economic data. So there will continue to be this game of ‘chicken’ between the markets and the Fed about when they will, first of all, stop raising rates and when they will start cutting rates.
My view is that it will be some time before they're able to signal a cut in interest rates. So we're talking about the end of next year at the earliest.
The bond market rally has eased financial conditions, whereas the Fed aims to tighten conditions. How might the Fed respond?
I think it's difficult for Powell or any of the other Fed officials to do a rerun of Jackson Hole. They were responding to a rally in the markets in July, when they were a long way away from getting monetary policy into restrictive territory, where they want it. So I think it is more challenging and we'll continue to hear that ‘higher for longer’ message.
But the Fed also has the option of doing more with the balance sheet, reducing the balance sheet and tightening conditions that way, by reducing the amount of central bank reserves in the system. And it's been doing that in a kind of passive way so far, but it always has the option to do that in a more active way. That might not mean them doing much, but it would be a strong signal that they want financial conditions to remain quite tight.
Would you expect the Fed to hit the pivot point in interest rates first?
I would, but we also have to take into account that probably the UK and European economies are a lot weaker than the US, so it could be closer to home for us that we see the peak in rates first. I think the Bank of England and the ECB have not been as clear-cut about their medium-term outlook, in the same way as the Fed has been. And obviously there's more risk on the real growth side in the European economy, largely because of the energy situation. So that could be the surprise, that either the Bank of England or the ECB signals an earlier end to the rate hiking cycle.
What has been driving the equity market rally?
It's very much been the same story here too. Bonds and equities have been very correlated this year, moving in tandem for much of the year. Equity markets don't mind a bit of inflation, but they don't like very high levels of inflation, given its dampening impact on economic activity. So when hopes grow that inflation is starting to come under control, markets tend to respond very positively. The October CPI print showed inflation was slowing much more than expected and equity markets reacted very positively to this. The Nasdaq was up over 7% on the day and something similar happened back in August, when another CPI figure came out better than expected. So equity markets are very much linked to the interest rate side of things.
Higher rates dampen economic activity, which in turn reduces growth and corporate earnings, so any improving picture here or the potential for a Fed pivot is always going to be taken well by the equity market.
Given a tough economic outlook, is it possible that equity markets have got ahead of their fundamentals?
That could well be the case. Most equity markets have enjoyed a pretty strong rally since early October, well into double digits in many cases, and much of this seems to be on the premise of a Fed pivot. But the Fed has been very adamant that rates will remain higher and for longer. And whilst the inflation picture is definitely improving, it may well have peaked and reduce from here, it is still very elevated and it's going to take a long while for inflation to revert back to target levels. This is all going to weigh on economic activity and on corporate earnings, whilst that's taking place.
On the corporate earnings side we have seen some downgrades in recent months, particularly some of the forecasts for earnings in 2023. There needs to be a bit more cutting there, as things are too optimistic, certainly for the latter half of next year, in terms of earnings growth rates.
So there are definitely some difficult times ahead for equities. And given the recent rally, I think it increases the chances of a bumpy ride for equities next year.
Are central banks looking to crush growth near term, in order to drive inflation out of the system?
That’s definitely one way of putting it. The causes of inflation are quite complex. We have to go back to Covid and the supply chain disruptions and then the energy crisis, coming after a very long period of very low inflation. Economic agents, consumers and firms have responded very quickly to this big surprise on the inflation front. And that runs the risk of seeing inflation become more embedded. We see it here in the UK, all this industrial action by trades unions is a response to declining real wages as we've seen prices go up. Companies put up prices as well in response to increases in their own costs. Central banks need to impact on the one thing that they can control. That is the cost of borrowing, in the hope that this will slow demand relative to supply, getting back to a more equilibrium level of inflation.
I think we can wave goodbye to the QE (quantitative easing) era. That is now consigned to history for the time being. Not to say we won't use those tools again in the future, but for now the focus is on getting the inflation rate down.
And that means that interest rates and financial conditions are going to remain tighter than they have been in recent years. Many investors won't have lived through a period where rates are higher, so there's a challenge not only for consumers and companies, but also for investors to get used to this new environment. Certainly, both the tone and the target of the central banks have changed and I don't see them going back to where we were. Unless we have a very, very deep recession in the next year.
What would you see as the main drivers for equities in 2023?
I think a lot of the drivers will be a continuation of the factors that have impacted markets this year. The level of inflation and the pace of its moderation towards target levels, is going to be key. Monetary policy is obviously still on the horizon. All eyes are going to be on the Fed, for when they stop raising rates and, more importantly, when they begin to reduce them.
Corporate earnings might come to the fore a bit more next year. They've been pretty resilient for much of 2022, however next year could prove more difficult as revenues for these companies fall and the prices rise, in what will still be an inflationary environment. We're expecting weaker growth, possible recessions, in many of the key markets. And depending how long and how deep these recessions are will have a big impact in equity markets.
Maybe a quick word on China, which has endured another very difficult year in 2022. There are growing signs of an easing in their strict zero-Covid policy, so we might finally see some better performance here. Indeed, if the Chinese economy were to begin firing once again, this could well be a catalyst to lift global growth and drive demand.
How does all that work for the bond markets?
The level of yield that you can get now in the bond market is so much more attractive than it was a year ago. It's made investors a bit more interested in fixed income again. It's still a defensive asset class, a defensive strategy, but you're getting more income potential from these high yields without having to take more risk. It was the case, when yields were very low, that investors were having to take on more credit risk or more duration risk, in order to get higher yields. Today you don't have to do that. You can invest in something relatively safe and get a decent yield. For example, I was looking at the US investment grade corporate bond market. For one to three-year maturities the yield is over 5%. And it hasn't been that high for a very long time. These short duration bond strategies are very attractive to me at the moment.
It’s less clear for the longer duration part of the market, because yields have come down again quite a lot over this fourth quarter. But for institutional investors, who need to buy bonds to match their pension liabilities or insurance liabilities, the market is again offering better levels of yield than it has for some time.
So overall positive returns from fixed income are likely over the next 12 months. They'll be small, but they'll be positive, which is a nice change from the last two years. And that gives multi asset investors the opportunity to have some bonds in the portfolio. They'll act as a hedge against equity exposure, which they haven't done for a few years because of positive correlations between the two asset classes.
What are the other big themes we should be looking out for in 2023?
I'm going to mention the word inflation again. We have touched on this a lot already, but I have a sense that inflation may linger higher for longer than expected and markets are going to have to get used to this.
Another interesting theme could be deglobalisation. This is a trend that's been increasing in recent years. Trade between the US, and by association much of the West, and China and its allies is going to fall further. This could be an issue and obviously is not going to help the inflation picture either. That's another trend which I think is going to grow further.
In terms of market dynamics, I think we might see a changing of the guard in terms of leadership. In recent years we've seen the mega cap growth companies, particularly in the US, delivering supernormal profits for such an extended period now. As a result, they have become the largest companies in the world. But I don't see this theme continuing. They're going to have slower growth due to increasing regulation, deglobalisation and saturated markets. These are the headwinds they are now facing. Some of the tailwinds that they've had, such as low interest rates and cheap supply chains, are not as supportive as they once were. So I think that's an area that's going to change, in terms of sectors for next year. Financial stocks have had a good year in 2022, but again next year they could be one of the areas to go for.
And in the energy markets?
One of the interesting potential developments is around energy. Oil prices have come down a bit recently, but high energy prices this year have allowed the energy sector in the equity market to perform very well. It’s the only sector to have positive returns this year. Because higher oil and gas prices generate supernormal profits and that's been to the benefit of those companies. It'll be interesting to watch that because, since the Russian invasion of Ukraine, governments around the world have been trying to diversify their energy sources and boost renewable potential.
All of these factors might come together and drive traditional energy prices lower over the next year. And that could mean the leadership of the energy sector in the stock market would come to an end. But it would also be very beneficial to the broader industrial sector if energy prices were at more reasonable levels. So that's a kind of optimistic view. What happens to oil prices as we go into a period where demand is slowing, but also lots of structural changes in the energy market? It could be one of the more positive developments in 2023.
How does all this impact the Architas outlook for assets as we move into the new year?
Following the recent positive developments on the inflation front and from central bank policy as well, we sense that the backdrop for equities and bonds is less negative than it was. And also we're seeing investor sentiment improving dramatically. So our preference at present is to reduce relative risk in our portfolios into the year end, for reassessing earlier in the new year. With this in mind, we've recently gone back to neutral in equities. Whilst 2023 is definitely going to bring its own challenges, we may even see a bit of a hangover in the early weeks of the year after a strong finish to this year, barring some negative developments, we sense markets might remain resilient into the year end. So equities is an area we’re less negative on than we have been.
On the bond side, we moved to a more neutral view there a month or so ago. It's an area we've been negative on for most of this year. In the near term we expect yields to remain somewhat range bound. The fed funds rate is likely to get to 5% or 5.25% in the next few months and pressure is definitely going to return on yields. But for now, we think the market is going to remain focused on the improving dynamics here.
Our main active call at the moment is on investment grade credit, in terms of the yields now on offer in some of these asset classes. Particularly US credit, but just global credit in general is very attractive, we think. Why it's more interesting now is that we have a bit more benign near-term outlook and this allows you to clip that additional carry (coupon) that's an offer, without the risk of credit spreads widening.
What Black Swans, or ‘unknown unknown’ events, might catch the markets off their guard in 2023?
Polishing the crystal ball here! I think one thing that we always have to be concerned about when we're in these periods of monetary tightening, is some kind of liquidity event or financial instability. We had a bit of a taste of that with the UK gilt market at the end of September. I would be watching closely what's going on in the crypto world, we've had some volatility there. Essentially, an increase in volatility will break out somewhere, as the Fed continues to tighten and as liquidity, particularly at the short end of the money market curve, becomes more stretched.
Remember that the Fed is reducing its balance sheet and the level of reserves in the system, and I think that could be a cause of some tensions in some parts of the market. I'm not sure where it will happen. That's the problem- you're never sure where these bouts of volatility will break out. But I think around some of the private debt markets or leveraged loans, or just in strategies that have relied very heavily on cheap financing, we could see some outbreaks of market volatility. And that may be something that threatens systemic stability, that the Fed may eventually have to respond to.
On the geopolitical front
Always hard to call. But I think in China, with President Xi getting a third term and essentially now having absolute power, this is definitely going to have some big consequences. There are some obvious ones, in terms of maybe geopolitical conflicts and more aggression with the US. But even internally in China, you begin to see this a little bit already with more unrest, protests and greater instability. It's hard to see how it actually might play out, but you might see a bit more instability and some unintended consequences or unexpected events happening. This could have some larger global consequences, given China’s importance to the global economy and how reliant we are on some of its products. So I think that's an area, maybe not in 2023, but definitely in the years to come.