Not so bad? Almost good

Posted 2 December 2022

December has begun on a positive footing for investors. A renewed pivot in sentiment, with market participants choosing to focus on the positives rather than the negatives, has brought the third extended market upswing of 2022, with various equity markets now trading above bear market territory again.

How the tides have changed over the past two months. After the last US interest rate rise back in early November, the US Federal Reserve (Fed) Chair Jerome Powell said “We think that we have a ways to go (sic), we have some ground to cover with interest rates before we get to that level of interest rates that we think is sufficiently restrictive”. While Powell noted it was “very premature to be thinking about pausing” he also said it might be appropriate to slow the pace of increases “as soon as the next meeting or the one after that”. Back then, investors were inclined to interpret that as rates continuing upwards and quickly. Bond and stock markets sold off in dismay.

But last week saw the release of the minutes of that November meeting and, this time around, investors appeared to want to find reasons to buy risk assets. The minutes were in line with the previous statement from Powell, but inflation data has turned less scary in the meantime. And with the news headlines full of stories of tech firm staff layoffs, signalling an easing of tight labour conditions, markets started to see an end to rate rises. Current interest rate futures have US interest rates peaking below 5% and with that peak brought forward to April next year (rather than above 5% in May/June). In other words, it is no longer premature to contemplate the Fed going easier or at least less aggressive at slowing the economy.

In addition, various members of the rate-setting Federal Open Markets Committee have been talking in a slightly dovish manner, so it is not surprising that, up until Friday lunchtime, markets were having a good old weekly run up. However, today’s above-forecast US non-farm payroll data dealt a blow to the dovish narrative. While surrounding labour market data has shown reasonable signs of a slowdown, it is not yet feeding through to the most important US national labour market surveys. The US picked up another 263,000 employees, another outsized month of jobs growth. Meanwhile the unemployment rate stayed the same at 3.7%.

One can piece together a positive spin from this data. Lots of jobs being filled while the unemployment rate stays the same ought to mean more people returning to the labour market. Greater participation is a key part of non-inflationary growth and should be viewed very positively by both the Fed and markets.

Yet the measured participation rate actually fell!  People in or seeking work went down from 62.2% to 62.1% of the working age population. Even worse, they worked fewer hours and the rate of growth of average hourly pay went up slightly to 5.1% year-on-year.

So, it’s all very confusing. Market price action saw a sharp rise in bond yields, with the two-year US Treasury gaining 0.2% initially, up to a 4.4% yield. The S&P 500 sold off some 2%. As we write, both have regained ground, but it could still be quite volatile into the close.

Despite today’s volatility, markets have in fact been experiencing more stability in the past couple of weeks. We think this suggests investors have had more savings than earlier in the year and have been less fearful to invest them in risk assets. It also appears to be a wider phenomenon than just in the US. We suspect households have started to believe that financial savings, especially the less risky assets like bonds, offer better value than buying goods or holding cash. This is a better test of household inflation expectations than just asking people what they expect the rate of inflation to be next year: they are putting their money where their views are. Should bond yields rise again, or equities sell off, the attraction of increased prospective returns should mean that the savings rate would probably increase rather than decrease, a dynamic which would stabilise markets in the medium term.

More savings are likely to be met with more capital demand for those funds in the new year. A number of companies have delayed issuing bonds or loans in the hope that yields and credit spreads will decline from the painfully expensive levels of a few weeks ago. Thus, with more bond supply becoming available, the current situation does not mean markets are likely to carry on rallying on the back of the recent increased investor demand. Neither does a higher savings rate mean stronger growth in the near term. But more liquidity is likely to reduce the sense of risk.

The changes in China’s COVID policies – less broadly reported than the protests of lockdown-tired citizens – have helped its equity markets and added a fillip to other regions. We write about emerging markets below with a longer-term perspective. However, the near-term moves have been strong and a good proportion of the money flow into emerging markets has come from developed market investors.

It is still not all plain sailing though, while geopolitical risk linger in the background. While China has not been the largest buyer of cheap Russian oil and gas supplies (the honours belong to India and Turkey), this week President Xi Jinping said China was willing to expand energy trade links with Russia in the future. So even if the markets present good opportunities, the political risks of investing in China will remain apparent while the Xi regime remains in place.

We write about November’s strong asset performance below. The best-performing developed market was the UK’s FTSE 100, helped by good performance from the materials sector. Sterling’s strength also helped performance at least relatively, since dollar-based assets rose but then had some of their value eroded because of the dollar’s pullback.

Sterling has indeed had a pretty good run, back to $1.22/£  and €1.167/£, a rise of 20% and 10% from the really depressing lows of early September. We can interpret this recovery to pre-Truss levels as markets having regained confidence in the general competence of the UK government. However, that was the easy part. Sterling’s decline since the Brexit referendum had all to do with a diminishing growth outlook for the UK. Getting the growth outlook back onto a higher trajectory is going to be the hard part for politicians. This week’s Chester by-election result illustrated this challenge may not belong to a Tory government, and while Keir Starmer may be seen as good as any candidate for prime minster, the act of developing the next Labour manifesto into a credible agenda for growth rather than redistribution will be watched ever more closely.

The sentiment shift of this autumn – even before the economic pains of the winter have come through –  is encouraging. However, it also means that regained market levels remain vulnerable to a whole host of factors that are fiendishly difficult to forecast – from central bank agendas and desire to reassert their credibility, to the geopolitics of China and Russia, to the level of consumer demand destruction from higher (energy) prices and interest rates that will eventually hurt corporate profits. This past week felt comfortably calm and given we all deserve a peaceful Christmas, let us hope it stays that way. Alas, we would advise not to bet on it.

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