Market Reviews • 16th May, 23
April is often celebrated as the best month for the stock market, with historical evidence often pointing to it as the strongest performing month of the year. This has not proven to be true in 2023.
Markets began April on a positive footing, and remained positive until mid-month, as expectations persisted that interest rate cuts would follow quickly after challenges in the banking sector appeared to dissipate. However, as inflation data showed core inflation remaining sticky, optimism fell away. The failure of another mid-size US bank, First Republic, and its takeover by JP Morgan saw markets close largely flat for April.
2023 Performance So Far
So far, 2023 has largely been a mirror image of its predecessor, with both equity and bond markets making, and holding on to, most of the gains made early in the year.
- Relatively benign disinflation figures and hopes that interest rate increases would turn to rate cuts, helped the year begin on an optimistic note.
- This was interrupted by fears that inflation was proving much stickier and that rate increases might persist for longer and at a higher level than previously thought.
- The mood changed again with banking issues that gave investors cause to believe we had moved much nearer to the end of the rate hiking cycle.
While the problems in the banking sector were rapidly firewalled, the failure of another Californian lender in April, First Republic, illustrates the impact that rising interest rates have had on the US financial system.
For its real economy impact, it seems likely, as a result, that lending may be more constrained as a consequence in many parts of the developed world. In turn, this makes an economic downturn more probable, even if it has been pushed further out, perhaps into 2024.
Core inflation overtakes the headline
Whether the glass is half full or half empty is being heavily debated when it comes to inflation.
- On the one hand, data in April confirmed that we are seeing “disinflation” or a slowdown in the rate of inflation. Both US and European headline consumer inflation, which accounts for changes in the prices of goods and services in every sector, fell meaningfully.
- For Europe, the most recent headline inflation stands at 7% and for the US, 5%. So far so good.
- However, core inflation, which excludes the more volatile energy and food prices, actually went up. In the US, core inflation is now higher than the headline inflation number at 5.6%, in the eurozone it also stands at 5.6%.
This has given central banks cause to be more circumspect about if and when interest rates might fall. For the US, it has meant that expectations of where interest rates will land have hardened. At the end of March, there was an anticipation that rate cuts might begin in mid-summer. That has now moved back out to the end of the year.
While the tussle between market optimism and central banks pragmatism has continued, markets have been responding well to what is relatively benign disinflation, at least so far. However achieving the target of 2% appears to be some distance away.
Company earnings expectations flatten out
As the size of interest rate rises are set to moderate, company earnings are going to play an increasingly central role in the direction markets take.
- Today, equity valuations aren’t cheap. What you pay for an average euro of company earnings is currently marginally higher than historical average and that’s before we see the full effect of a downturn.
- On the other hand, plenty of individual markets and sectors are cheap by historical standards.
Early into the Q1 2023 reporting season, we’ve seen a slight contraction in company profit margins for the US market. If this holds, it would be the seventh quarter of contractions in a row.
- Five sectors are reporting above-average growth in margins compared to Q1 2022, led by energy. At the same time, six sectors are showing slower profit growth compared to 5-year averages, led by communications.
- There have been some positives that helped the market mood towards the end of the month – for example, Deutsche Bank, whose top line results were the best since 2016. This was along with better-than-expected sales numbers for a number of the largest technology names.
This presents a near-term headwind for markets as equity prices typically follow earnings. Whether this comes to pass will rest largely on the extent of any slowdown that is driven by 1) higher interest rates and 2) tighter lending in some regions.
Recession risks still persist
One of the impressive features of the past quarter has been just how robust the world economy has shown itself to be, despite fears to the contrary. Yet, while the much talked about recession hasn’t arrived, growth is weakening.
- US economic growth grew by less than expected in Q1 at just 1.1% per annum (buoyed by strong consumer spending) and growth estimates for the eurozone are at 1.3% per annum.
- Labour markets have remained very tight and indeed, in many parts of the developed world, labour shortages have been a feature.
- With high levels of savings still somewhat intact from the pandemic period, consumers who had been spending on goods, are increasingly spending on services despite a falloff in confidence.
- Supply lines that had been damaged in the Covid-19 period are largely restored and the reopening of China has given the world another source of demand.
China takes to the stage
March saw China’s National People’s Congress open with an economic growth rate of “around 5%” as its target. This objective came on foot of a disappointing 3% growth in 2022, after widespread extensions of lockdowns created a stop-start year for China’s economy.
Reopening came this year but recovery looks very much dependent on the state’s policies to deal with its property sector and on restrictions that its technology sector faces.
The People’s Bank of China has been active in supporting the reopening:
- firstly, injecting liquidity to support the property sector and
- secondly, cutting the Reserve requirement for banks by 0.25%, which has the effect of enabling banks to increase lending.
The Chinese authorities have also indicated they will increase government spending support and cut taxes for small business.
So far the effect seems to be working, with March seeing the Chinese services activity expand at its fastest rate in a decade and retail sales looking strong. Economic growth estimates for Q1 2023 suggest growth of 4.5% per annum.
The events of recent years - Covid-19, the consequent high levels of inflation and interest rate responses - are beginning to wane in their influence, however slowly. These events have already left, or will leave the stage in the coming year. They will leave a changed investment landscape where inflation may remain at a manageable, but, structurally higher level than the previous decade. With that, interest rates are likely to remain more elevated.
During this transition, economic growth, recession, and company earnings will feature more prominently in market thinking.
For the long-term investor transitions such as this should hold no fear, and may indeed present moments of opportunity, for they hold within them the seeds of what the future economy will be shaped into.
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