If investors were hoping for a turnaround in fortunes, they hardly could have asked for a better start to the year. While 2022 brought plenty of downpours, the first month of 2023 was all sunshine in capital markets. January’s equity market returns were positive across all major economies – many spectacularly so. This was in large part down to the good feeling in bond markets, which saw yields fall and thus the relative attractiveness of equities increase. Across the major asset classes we monitor only one had a down month: commodities. But given how commodity inflation terrorised the global economy last year, this was viewed as an unequivocally good thing. The table below shows a full list of returns.
In the UK, the FTSE 100 posted a healthy 4.3% increase, despite increasingly dreary economic forecasts. The International Monetary Fund (IMF) reported on Tuesday that it expects Britain to be the only major economy to shrink in 2023, faring worse than even Russia. UK equities – largely dominated by multinational companies with overseas earnings – were unaffected. In fact, the UK was the only major economy to see its stock market grow in 2022, thanks in large part to the prominence of energy and resource companies in the FTSE 100. Last year’s returns were boosted by the low value of sterling though, while January’s performance was accompanied by an increase in the pound’s dollar value.
The good feeling was stronger elsewhere, with particular standouts being Europe and emerging markets (EM). European companies were boosted by the sense that they are over the hump of the continent’s energy crisis, while EMs are benefitting from an unmistakable growth drive in China. The world’s second-largest economy, having suffered under lockdowns and crackdowns for years, is now firmly on the path to opening up. This has helped sentiment not just around China, but around global growth in general.
US equities bounced strongly, with the broad S&P 500 index climbing 6.3% in sterling terms. The broader market was outpaced by an impressive rally in the Nasdaq composite index, which ended January 10.7% higher. This reflected the strong rebound of investor interest in US tech stocks, which suffered last year from sharply higher interest rates and widening corporate credit spreads. Long-duration growth stocks like these are extremely sensitive to financial conditions, so it is little surprise that the recent loosening helped them just as much as last year’s tightening hindered them. But tech stocks also got a boost from China, as the nation’s tech sector had a stellar month, with spill-over effects into the US.
Bond market dynamics were nonetheless a key component. In 2022, the Fed tightened monetary policy at the fastest pace in a generation, causing yields to rise and credit spreads to widen. Risk premia (the returns demanded for a given level of risk) subsequently fell, and equity markets saw an eye-watering drop in valuations. But yields have been falling ever since December, causing a substantial improvement in credit conditions. Global corporate bond prices (the inverse of yields) gained 2.2% in January alone, according to Bloomberg.
Behind this move are expectations for global monetary policy, and the Fed in particular. Sky-high inflation forced it to aggressively tighten policy in 2022, in the fear that overheating labour markets would lead to an unstoppable wage-price spiral. Over the last few months, global input prices – energy and commodities – have fallen back markedly, relieving some of the pressure. More importantly, there are signs that producer price inflation and wages have also fallen back. This has led to a ‘job done’ mentality in capital markets, which now expect the Fed to slow its rate rises and even reverse them later in the year.
There is a certain irony here. The reason markets expect the Fed to take its foot off the brakes is that US and global growth is weak, allowing inflation to cool. This pushes bond yields down, which has the technical effect of rising equity valuations, hence rallying stock markets. More importantly though, lower yields ease credit conditions, which improves the medium and long-term outlook for growth. In a sense, the very fact the economy is so weak is what gives investors the confidence we will avoid a deep recession.
We have seen this not just in falling credit spreads (the premium corporate borrowers have to pay compared to the government) but in the performance of rate-sensitive sectors. Tech is one example, but a clearer one is real estate. Property companies and funds were battered last year but have started 2023 in buoyant mood. Investors are looking past the pain of the current cycle to the joys of the next.
Risk premia across the board have benefitted. In fact, risk premia for many assets – like real estate – have now fallen so low that some valuations are starting to look expensive. This is the exact opposite of last year, and points to the fact that markets are now confident that the inflation crisis is behind us. This is a little precarious, given the much-discussed structural factors underlying higher inflation. The only conclusion we can draw is that markets expect the low inflation, mediocre growth regime of pre-pandemic times to return. Moreover, they are excited about it.
We should preach some caution here, as the effects of last year still have to be fully worked through. This is both in terms of downstream inflation (food price, etc.) and short-term financing pain for companies. Businesses tend to go bust not when things first go bad, but when they stay bad for a while. The Indian group Adani Enterprises (accused of fraudulent business practice) for example, has only just come into trouble, despite credit conditions tightening for more than a year.
On that front, we find it interesting the first half of January saw astonishing levels of corporate bond issuance. We had said before that companies which had held off refinancing might be tempted back into bond markets should yields fall, and this is precisely what happened. Fortunately, there was enough investor appetite to gobble up those issuances without destabilising credit markets – and issuance dropped off toward the end of the month. Bonds passed the first test of the year. Equity investors will be hoping they pass the next ones.
Asset class returns as at 31st January 2023
The text is taken from The Tatton Weekly and is provided by Tatton Investment Management. The information in this document does not constitute investment advice or a recommendation for any product and investment decisions should not be made on the basis of it.
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