Investment markets remain finally balanced. After a difficult start to the year for both equities and bonds, markets enjoyed a more positive summer. Positive earnings reports from companies suggested that consumers and businesses were perhaps being more resilient to inflationary pressures than initially feared. August however brought higher inflation reads, leading to a re-emergence of concerns surrounding the path of future central bank policy, and a pause to the more buoyant market movements.
Inflation, Inflation, Inflation
The rather large elephant in the room remains inflation. There are two trains of thought. One is that inflation has likely peaked, or soon to peak, and will naturally start to decline. The second is that it still has scope to rise further. Supply side pressures remain, war continues to rage in Ukraine alongside disrupted supply chains which continue to add to upwards price pressures within markets. Whichever viewpoint is more prevalent is currently driving market sentiment. Falling inflation is encouraging investors to take on more risk, rising inflation is giving cause for concern.
Inflation is high globally, there is no mistake about that. But it is impacting certain countries more severely than others. The UK unfortunately is perhaps uniquely disposed to the most severe inflationary pressures and the situation is expected to get worse before it gets better. Recent forecasts from US bank Citigroup have suggested inflation could exceed 18% in 2023. Much of these forecasts are a result of energy prices with the rising energy cap highlighting the cost pressures facing households. In the here and now, UK inflation topped 10% for the first time in 40 years as CPI inflation read 10.1% in July.
Central banks continue to have the biggest impact on market sentiment. The first six months of 2022 were marked by sustained downward pressure on both equities and bonds. Persistently high inflation could no longer be ignored as transitory, and central banks in a bid to regain credibility have rushed to increase interest rates. In the UK, the base rate has risen from 0.1% in December 2021 to 1.75% in early August. The US have increased rates to a range of 2.25%-2.50% while the European Central Bank raised rates for the first time in 11 years, albeit only to 0%.
Despite inflationary pressures, investment markets had enjoyed a mostly positive summer. Market sentiment was resting firmly in the camp of peaking inflation and worsening economic data gave merit to the argument that central banks may have to slow down on their hawkish policy. Combined with positive feelings towards company earnings reports, investment markets posted gains.
Late August played host to the Jackson Hole Symposium. An annual meeting of central bank governors from around the world to discuss issues such as price stability and economic growth. Investors will be focused on any actions and comments made at, and following, the meeting for clues of future policy direction.
As focus turned to this gathering and future central banking meetings it put a halt to the exuberant mood of markets. The key for investors is the balance between inflation and economic growth. Central banks will look to control inflation and raise interest rates, a negative for investment markets. Whereas there is the interplay that if economic conditions worsen, some economic data is already pointing towards recession, then this might solve the inflation problem and central banks might have to stimulate the economy. The latter is a boost for markets however it is not obvious what the outcome might be.
Oil, Currency, and UK Equities
Oil has seen price swings in recent weeks as this debate raged on. Oil has been a key driver of inflation and was one of the most noticeable rises when prices on UK forecourts reached record highs. Recessionary fears however are asking questions about the future level of demand for oil if travel and trade declines. This has seen a small pullback in the price of oil and has been one of the reasons for tempered inflation expectations.
Hawkish central bank policy combined with recessionary fears have provided conditions for a strengthened US Dollar. This has meant a depreciation for most currencies with the Euro/Dollar exchange reaching parity. Sterling has also weakened in the face of rising interest rates.
This has provided a boost for UK large-cap equities which benefitted from the depreciating Sterling. While the FTSE100 is viewed as a UK index, most of the benchmark’s companies generate their revenues overseas. The weakened currency provides a relative boost to these earnings and has been a large contributing factor for much of the outperformance of ‘UK equities’ for much of the year. The more domestic focused FTSE 250, made up of smaller more UK-focused companies, has faced similar pressures to other global assets as the slowing economy has decreased the appetite for risk assets.
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