Equity markets are still up for the year to date but the optimism experienced in January has faded somewhat. In a sentence, we feel that earlier in the year markets were fighting the Fed, believing that inflation would fall relatively quickly. Recent data are causing the market to reassess and recalibrate to the reality that inflation is proving sticky.
Inflation Proving Sticky?
We have expressed concern in the past that core inflation would be difficult to reduce & the latest data (to end Feb for Euro area and Ireland) underpins that concern. Core Euro inflation is the yellow line in the chart below and as you can see it has been steadily increasing since the start of last year. The light blue line is core inflation for the US and this has remained relatively close to 6%.
Interest Rates Likely to Rise More Than Expected
As I write this the US Fed Chairman, Jerome Powell is testifying before US Congress. His message in summary is:
- Without controlling inflation (price stability) the economy does not work for anyone.
- The employment, consumer spending and inflation data that came through in January in the US were stronger than expected.
- As a result, he expects that there is a long way to go (to get inflation back to 2%) and the journey is “likely to be bumpy”.
- Having slowed the pace at which the Fed increases interest rates (to a 0.25% increase in January) Powell is now saying that the Fed is prepared to increase (again) the pace of rate hikes and that rates probably need to rise further than expected (just one month ago).
- Note, last month the ECB increased rates by 0.5% to 3% and signaled an intention to increase rates by a further 0.5% at its next meeting in a few weeks.
Natural Gas Prices Down
One of the reasons that headline inflation is falling is that energy costs, particularly natural gas prices, have fallen very significantly.
The highest spike in the chart above was in August 2022 and reflected the fact that European governments were buying gas at any price so they could fill storage tanks ahead of the winter. Once filled, the price dropped sharply. This winter in Europe has been relatively mild with the result that with about three weeks left in winter, storage tanks are still 60% full. This means that the challenge of refilling them ahead of the 2023 winter has become more manageable.
In time the fall in gas prices should feed through into a drop in electricity costs for people and businesses.
The 24th of February marked the first anniversary of the war. The UN High Commission for Human Rights official numbers note 21,293 civilian casualties between 24/2/22 and 21/2/23. This comprises 8,006 deaths and 13,287 injured. The Ukraine government estimates that civilian deaths may well be 10 times higher than official records at closer to 100,000. On top of that over
14 million Ukrainians have been displaced from their homes. Unfortunately, there is no immediate sign of an end to this horrific war and it remains a risk for investment markets.
Could we finally have a thawing of relationships between the UK and the EU? The so-called Windsor framework is a 100-page document which aims to improve the workings of the Northern Ireland protocol. The UK prime minister talks about the deal removing any sense of a border in the Irish sea while at the same time achieving a dramatic reduction in the number of checks required by the EU. Hopefully this deal can be implemented and that it leads to the restoration of the Northern Ireland assembly.
Our Investment Outlook
We are 14 months into a tricky couple of years for policy makers and investors.
- Headline inflation will fall during 2023. However, core inflation will likely prove sticky and remain well above central bank targets.
- As a result, central banks will continue to raise interest rates even in the face of slowing economies.
- Economies will slow further this year although the slowdown might be less than expected at the start of the year.
- However, we note that there are mixed signals. For example, labour markets remain tight complicating the lives of policy makers who need a softer labour market in order to control inflation.
- Slowing economies and high inflation, at some point, translate into reduced earnings for companies. So, we expect pressure on company earnings to show up in the first half of this year.
- The change in Central Banks policy stance from quantitative easing (QE) to Quantitative Tightening (QT) reduces market liquidity and increases the risk of market fractures.
- After abandoning their zero-Covid strategy we should see significant improvement in China’s economic numbers later in the year. A key question for this year is how China’s reopening will impact global growth and energy prices.
- Ukraine and other geopolitical risks remain significant with bad outcomes not currently priced into markets. The core assumption of markets at the moment is that the Ukraine war will not end any time soon.
- Overall, markets are likely to remain volatile until there is more certainty around (a) core inflation falling back to the target of 2% and (b) the depth and length of economic slowdowns / recessions.
For short-term investors, this is not a market to be in but for our clients who are long-term investors, we continue to advise them to follow their plan and use market weakness to build on positions.
John Tuohy is Chief Executive of Acuvest, an Irish-owned, independent advisory firm specialising in wealth management, pensions, and investment advisory services for individuals, companies, pension schemes, charities, and institutions. John is a Chartered Financial Analyst (CFA) and a Fellow of the Chartered Association of Certified Accountants.