Bevan Blair, Chief Investment Officer at One Four Nine Portfolio Management, gives his latest outlook for global markets
He said: “Higher than expected inflation, rising interest rates and lower than needed growth has continued to influence market as we move from Q1 into Q2 – what is different however is that the future path of interest rates is much less certain than it was even three months ago.
The devil is in the detail here – core inflation (i.e. inflation minus energy and food, whose prices are more cyclical and therefore less sensitive to rate rises) has plateaued and is not showing signs of falling as fast as headline inflation. This matters because core inflation is considered to be the most sensitive part, of the basket of goods and services in the inflation calculation, to interest rate changes. If, with all the rate increases we have had over the past 15 months, core inflation is still not under control and proving stickier than expected then the actions of central banks have either failed or have not gone far enough.
This is where the uncertainty comes into play. At the beginning of Q1 markets were pricing in no more than two or three more rate rises in both the US and the UK, and for the current cycle to end by the second quarter of 2023. During January, Federal Reserve members had been moderating their language around the future path of interest rates confirming the markets’ thoughts. However, by the middle of February the tone, if not the content, of members’ pronouncements had shifted markedly to a much more hawkish stance. The message was clear: “You the market are underestimating the effects of core inflation, we the Fed are much more concerned of its future path, and we will do everything necessary to bring it under control – so expect more rate rises for longer”.
By early March expectations for the Fed Funds rate at the end of September 2023 had moved up from 4.77% at the end of January to 5.69%. The market was expecting at least four 25 basis point moves more than they were in January. They had already got one of those during the early February meeting as the target rate moved from 4.5% to 4.75% but now more were coming.
Then everything changed over the weekend of 11 and 12 March as Silicon Valley Bank (SVB) went bust quickly followed by US bank Signature. Markets reacted with rate expectations dropping from 5.2% on the Friday to 3.9. The Fed returned to their tightening programme, but the two weeks of quantitative easing wiped out six months of quantitative tightening. A contagion effect in the banking system has not transpired as of yet, however the future path of interest rates is still highly uncertain with Credit Suisse’s forced takeover hardly helping matters.
So, we consider the path of future rate rises is now even more unclear. The market is worried about inflation but it is now equally worried about the solvency of the banking system as a whole and the effect rate rises are starting to have on the wider economy. Yet the environment for fixed income is now materially different with investors being rewarded for taking on risk in fixed income.
The hikes from the first half of 2022 are only now starting to be felt in the economy and markets. The rate rises from the second half of 2022, which were higher than the first half will not have their full effect felt till the second half of 2023. It is this lag-effect that worries us. Economic activity is at best anemic globally and both UK and Europe are worryingly close to recessionary conditions. Growth in the US is more robust, but still below long-term trends. We are also starting to see a fall in earnings for equities. In the last three months earnings have fallen across all developed economies. In Japan earnings have fallen 6.7% on average over the past three months, in the US 4.1%, the UK 4.7% and Europe 2.8%. This is not a conducive environment for equity markets.
Nevertheless, our forecasts for equities are still much better than they were two years ago. Back then we were forecasting global equities to return 3% p.a. over the next 10 years. Today the expectation is for equities to return just over 6% p.a. for the next 10 years. While our models are suggesting a much better long-term return there remains significant short-term risks, as evidenced by falling earnings and slowing economies. Falls in equity markets last year released significant pressure on valuations, but as we see rising equity markets and falling earnings these valuations will come under pressure again.
Therefore, we do not feel now is the right time to extend equities. We are however heartened by the fact that our equity fund managers are seeing a better earnings environment for their underlying companies. The companies they invest in tend to have low leverage, sustainable business franchises, strong balance sheets and growing dividends and should withstand market turbulence better than the average company.
With cash starting to offer some decent nominal returns, bonds through the worst of the rate rises, and equities at a better valuation point, there is a significantly higher probability that a balanced portfolio performs better than over the last two years, providing positive return and providing some diversification. For those that have been uninvested now is a better point to enter the market, and for those that have ridden the wave, there is much to be hopeful about for recovery in hard earned capital.
