Top of mind –
Has inflation peaked?
As we gather further evidence inflation is softening, we continue to evaluate what challenges we may see in 2023.
The market shifts we are witnessing suggests the answer is yes.
For the past two years, global interest rate rises, and generationally high inflation have been the core drivers for the sharp losses we have witnessed in the fixed income and equity markets.
Rising inflation has driven higher yields on government and corporate debt, hurting bondholders. Equity markets meanwhile have seen extreme volatility, as the shift from years of low inflation and interest rates to high inflation and rising interest rates weighed on company valuations and sent stock prices plummeting.
GOVERNMENT BOND AND CORPORATE BOND PRICE INDEX AND EQUITIES MOVING IN TANDEM.
Inflation and rising interest rates have led to a de-rating across financial assets. We are now asking ourselves the key question, when inflation peaks and central banks stop raising interest rates so quickly - will equities and bonds experience sharp recoveries, or will they face new headwinds?
There are several indicators that inflation has peaked. Global activity indicators, such as the JP Morgan Global Manufacturing PMI, have been declining, signalling a contraction in economic activity. This should help temper inflation. Commodities, freight rates, and supply chain bottlenecks have all eased, driving down goods inflation. There are also signs the labour market is slowing in the US, with both the Atlanta wage tracker and the US average hourly earnings year-on-year growth softening recently. US job openings have edged down. Even stickier parts of the economy – such as rent – appear to have peaked, as recent data shows slower growth in asking rents in the US.
For us, the most crucial data was the two most recent US Consumer Price Index (CPI) reports in November and December, showing a softening trend in inflation, with data below market expectations. The latest prints saw the slowest month-on-month increase in inflation since August 2021.
How are financial markets reacting to peak inflation?
Financial markets reacted swiftly and dramatically on the news that inflation may be softening more than expected. The S&P 500 ended 10 November up 5.5%, the biggest daily jump since April 2020 and nearly 1% on 13 December following the most recent CPI report.
The pound rallied strongly on both occasions, as the US dollar sold off. Government bond yields fell in tandem. These reactions begin to confirm our thesis – the inflation picture will change significantly in the next six-to-12 months, which will encourage central banks to reduce the rate of interest rate increases. We believe that this will benefit both equity and fixed income markets.
Elephant in the room – could the recession be worse than forecasted?
As we gather further evidence inflation is softening, we continue to evaluate what challenges we may see in 2023. In one scenario, growth could slow more than anticipated and next year’s recession could be worse than current forecasts. This will likely hurt equities, as one could expect corporate earnings outlook to deteriorate, though bondholders will benefit, as government bond yields would be expected to fall.
Another scenario is that although inflation is falling, it could remain at a higher level for longer, potentially forcing central banks to be more restrictive and keep interest rates high. This scenario would continue to be an ongoing headwind for equities and debt. If inflation has not diminished and is more ingrained in the global economy - through commodity constraints, or tightness in the labour markets- there could be further work for central banks. Although it tentatively appears we are entering a disinflationary environment, we remain aware that the underlying drivers of inflation are highly uncertain and cyclical.
It is essential to be mindful and nimble as we move ahead to 2023 to ensure we are prepared to face similar issues that plagued the market in 2022.
Investor’s reaction to a slowing in inflation
In our latest Investment Committee series, we theorised that should inflation in the US peak, the UK and Europe would likely follow suit. The market reactions following the latest CPI print reaffirmed our thesis about inflation peaking, highlighting how quickly equity and fixed income markets react and underscored the importance of shifting asset allocations in a timely manner.
We believe the factors affecting the global economy and markets are transitioning from interest rates and inflation to earnings and growth. As such, we have previously increased exposure to both equities and bonds, while favouring the pound and euro over the US dollar as we expect these to experience strong rebounds in the new environment, which seems to be playing out.
It is possible that equity and bond markets fall further, which means we were slightly early in adding exposure, however this would present further opportunities to buy at a lower valuation. It is also possible the risks we mentioned abate and global markets recover more quickly. Ultimately, by adding risk in a slow and structured manner, we are positioning ourselves to optimise the opportunities presented from this year’s market turmoil.
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 Atlanta Fed, https://www.atlantafed.org/chcs/wage-growth-tracker
 US Bureau of Labor Statistics, https://www.bls.gov/news.release/empsit.t19.htm
 US Bureau of Labor Statistics, https://www.bls.gov/news.release/jolts.nr0.htm
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