We hope you are keeping well, and fighting fit after a month of zero calories and daily exercise? Unfortunately, this author wasn’t quite able to hit the nutritional and training targets set out in his new year resolutions, but optimism remains for the year ahead!?

Turning to investment and we also see optimism permeating market sentiment, with bond and equity markets enjoying an positive start to the year despite the persistence of inflation and higher interest rates. The catalysts for the improving market perception could be several, but how refreshing to point to Europe in the first instance. Thanks to the collective effort in accumulating gas supplies and fairer than average temperatures, it appears Europe may exit this winter with higher-than-normal gas inventories. Thereafter, and with the potential for further progress in rearranging supply chains, as well as usage efficiency gains, and the market is starting to believe the worst-case scenarios for the prevailing energy crisis are diminishing, or at least the probability is receding.

Europe is also benefitting from a reopening China following the dramatic unwind of their zero-covid policy. Such a course correction will likely benefit the service economy within China the most, as consumers return to restaurants and cinemas, rather than sucking in a huge number of imports. Nevertheless, Europe does have close trading ties with China so will enjoy a reasonable tailwind from the development.

Beyond Europe and China and we observe the inflationary trends in the US are also looking more benign. The collapse in commodity prices, the switch from purchasing goods to services, the weakening monthly house price and rental data, and the lagged impact of previously delivered interest rate hikes, are each weighing on the inflation calculation. Indeed, such conditions have allowed the Federal Reserve to slow its pace of rate increases to an anticipated 0.25% in February, with expectations hikes will cease altogether sometime in the first half of 2023.

We also point to the US labour market as a potential catalyst for improving market sentiment. Before discussing the drawbacks of such strength, we would first highlight wage increases are edging ever closer to the prevailing levels of inflation and, in so doing, offer a boost to ‘real’ incomes. The combination of an improving growth outlook for Europe, China and (to a lesser extent) the US, coupled with fading inflationary pressure and more accommodative central bank policy, is raising the prospect the world’s major economies might stick a ‘soft landing’ i.e. avoid a recession. It is considered such an outcome might prove a rewarding one for investors. Yet whilst such a narrative is both logical and comforting, there are material risks in play.

The ECB continues to deliver hawkish surprises, showing its determination to tackle the inflation menace. Such conviction might be the economy’s undoing, however, should it push too hard. As mentioned, the Chinese reopening story may disappoint relative to lofty expectations, particularly if Chinese consumers remain troubled by the threat of Covid. Inflationary challenges may also reignite, not least given the persistent strength in US labour markets and what this may mean for wages. Such a prospect may elicit a more hawkish course of policy from the Federal Reserve and threaten a more troubling growth outlook.

Despite these threats, we would again argue all may not be lost for equity investors. A off recession that seems so widely predicted may not inflict the same damage as one that catches investors off-guard. The recession may not be so severe either given the apparent absence of major economic imbalances i.e., banks, corporations and households don’t (in aggregate) appear to be shouldering quite so much leverage as in past, more devastating recessions. We should also remind ourselves that having moved off the zero bound, there are now interest rates to cut! Again, this policy flexibility might prevent a more damaging downturn and prove sufficient to reignite economic and investor enthusiasm.

Recognising the outlook remains uncertain, as well as our philosophical belief in the need for humility when investing, portfolios strive to seek appropriate levels of diversification to meet the investment challenges ahead. Relative to stocks for example, high quality corporate and even government bonds might offer a more defensive return profile in the face of less encouraging growth outcomes, particularly given the increase levels in yield observed through 2022. Alternative asset classes also assist portfolios in a more troubling period for stock markets.

Kind regards,

iPensions Wealth Team

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