Monthly Market Commentary - March 2023

The narrative surrounding financial markets shifted in February. A series of stronger than forecast economic data releases raised concerns that central banks may raise interest rates higher than previously expected. This caused equity markets to hand back some gains following a stellar start to 2023 whilst bond markets erased January’s rally entirely, ending February around the same levels as at the start of the new year.

February began with three key central bank decisions in the first two days, as the Federal Reserve (Fed), Bank of England (BoE) and European Central Bank (ECB) all raised interest rates further. The Fed’s 25 basis point increase took the Fed funds rate to 4.5%, the BoE’s base rate stands at 4.0% after a second successive 50 basis point increase while the ECB is still playing catch-up, with another 50 basis point rise taking the main refinancing rate to 3.0%. All these moves were broadly in keeping with market expectations and supported the hitherto prevailing belief among market participants that monetary policy was approaching the endgame for this tightening cycle.  

This optimistic view was first seriously challenged by a blockbuster US jobs report just two days after the Fed announcement. The report showed 517,000 jobs were added in January – the highest reading in almost a year and almost double the last four releases. As a sign of how regularly this data has exceeded expectations, nonfarm payrolls have now come in above consensus forecasts for 10 consecutive months. The unemployment rate also ticked lower to 3.4% and the absence of any real signs of weakness in the labour market caused some consternation among investors, leading to growing concerns that perhaps the markets had moved ahead of themselves in expecting an imminent end to rate increases.

The terminal rate, that is the level at which the Fed will cease increasing interest rates, has risen to around 5.4% with no rate cuts in 2023, according to derivatives markets. This represents a marked change from the beginning of the year when the same markets expected a peak below 5% followed by two rate cuts before year end.

On the inflation front, the US consumer price index reading rose for the first time in four months. The personal consumption expenditures (PCE) price index, seen as the preferred inflation gauge of the Fed, showed a 0.6% increase in January and a 4.7% rise annually – both higher than expected and in the case of the latter, the first increase since September. Retail sales also beat expectations and taken together these provided further cause for concern, suggesting the pace of disinflation has slowed somewhat of late, particularly in goods’ prices which had contributed to the pullback from last year’s peak in inflation.

The MSCI All Country World Index ended February down by just under 3%, although a 2.3% depreciation in the GBP/USD rate meant that UK-based investors were shielded from the bulk of the loss. UK stocks outperformed on the month with large cap benchmarks rising around 2.7%, driven to new all-time highs by record profits for oil majors BP and Shell. European indices also provided a positive return, gaining just under 2%.

Since equity markets bottomed in October there has been a notable underperformance from US stocks, a theme that continued last month with a 2.6% loss. Still, they ended February up by around 3% on the year. Consumer discretionary and industrial sectors continue to perform well, driven in-part by the China reopening story.

An interesting development in US stocks has been the relative strength in technology shares, which declined around 1% in February but remained up nearly 9% year-to-date. These shares are typically among the most sensitive to rising interest rates - as was shown by them being some of the worst hit shares during 2022’s declines - and with another move higher seen in bond market yields, their relative strength seems a little inconsistent.

One possible explanation for this is that the “riskier” parts of the market have seen money flow back in as general sentiment has improved in recent months, suggesting that money managers continue to follow patterns that had served them well until last year, acting in a manner not in keeping with what we see as a clear paradigm shift over the last 18 months - old habits die hard.

As you were

Bond markets have returned to start-of-year levels after completing a round trip following the strongest January in over 20 years. Gilt markets ended February down around 3% with linkers off by 5%, while credit outperformed, posting a 2% decline. Financial conditions have eased slightly since the start of the year, despite the ongoing central bank tightening. This can be explained to some extent by the move higher in equity markets but does seem counter-intuitive and shows that the Fed’s intent to cool economic activity, in a bid to rein in inflation, is maybe not having as great an impact as expected.

Leading indicators in China point to heightened optimism caused by the reopening of the economy, with purchasing managers indices for February moving firmly back into expansionary territory and topping estimates, in both manufacturing and services. This has undoubtedly provided a sizable tailwind to the global economy, although its impact on inflation remains a little less clear. Although Chinese equities have bounced strongly in recent months, valuations remain favourable, and we believe there is still potential for more upside.

In conclusion, recent developments have clouded the outlook somewhat and while our view remains constructive, near-term risks have risen. We have revised our tactical asset allocation in models to reflect this, trimming our exposure to UK and North American equities while adding to our fixed income holdings and raising cash slightly.

It has been nearly five months since global equities bottomed out and following the subsequent rally the risk to reward dynamics have become less favourable. The current macro picture has lots of moving parts and there is an elevated degree of short-term uncertainty. Tighter monetary policies and the lagged impact of inflation are thought to be slowing economies. We have seen evidence of this in manufacturing, but the service sector is currently painting a different picture. This may be because labour markets remain close to their tightest levels on record and the expectation of sizable pay rises among consumers, but it remains at odd with the Fed’s intentions of cooling economic activity.

While we do not believe central banks will go well over the top and crush economic activity, the longer this dynamic persists the greater the chance of a central bank error. Our risk appetite could be described as fairly neutral overall and with attractive nominal returns on cash and bonds at present, we have taken the opportunity to take a little bit of risk off the table.