We hope you are keeping well, have enjoyed some down time over the festive break and are feeling more equipped for the challenges in the year ahead. That is certainly the case for this recharged (though somewhat heavier) author!

Turning to investments and in a year so bereft of good news it was, at least, encouraging to observe a modest equity market recovery in the final quarter, though December’s weakness did take the shine off the aggregate quarterly statistics. In a similar vein to performance patterns seen through 2022, UK equities enjoyed relative success among global peers, whilst bond markets, so often looked to for portfolio diversification, suffered material weakness.

Another (all too) familiar sight over December was the hawkish rhetoric from the major central banks, particularly the US Federal Reserve (the Fed) and, perhaps more surprisingly, the European Central Bank (the ECB). Though the data isn’t totally convincing, evidence informing we are ‘past peak inflation’ is building, and the anticipation for a ‘dovish pivot’ had been growing. Indeed, such expectations were the likely cause of market disappointment through December, as central bank policy fell shy of delivering the level of ‘generosity’ that had been hoped for. Though both the Fed and the ECB slowed their pace of interest rate hikes in December, both institutions were keen to stress their commitment to tackling the persistent inflationary threat, which is still well above target. The punchline from the pair was a “higher for longer” interest rate setting.

Given such a firm position from these important actors, many investors will be quick to categorise the stock market resilience through Q4 as a ‘bear market rally’ – an alluring but temporary feature of a more dominant downward trend. Whilst it is hard to dismiss such claims given policymakers current disposition, can their collective hawkishness be maintained (for much longer) if the inflationary picture is turning? One assumes it would certainly be more difficult, indeed one might argue it would be a little irresponsible if the labour market started to show signs of significant weakening as well (which it is currently not).

But why might inflationary pressure fade? To begin, commodity prices are well off their highs and year over year base effects should materially dampen their contribution to the inflation calculation moving forward. Weakening data relating to house prices and rental agreements further support a gradual fading of the inflationary threat. The easing of supply chains as the pandemic moves further into the past also bolsters hopes of easing goods price inflation.

We would concede a genuine ‘pivot’ in central bank strategy, where policy shifts from hiking interest rates to cutting them, does not seem an imminent prospect; levels of inflation are too high, and the labour market too strong, for that. However, a further reduction in the increment of hikes, or perhaps even a pause at some stage in the first half (or even first quarter) might remove investor’s worst fears surrounding growth outcomes and offer some market relief.

But whilst this modification in monetary policy might support markets, our fear is attention would soon ‘pivot’ to focusing on the level of interest rates again, rather than their incremental change. Given our read on the communication efforts from central banks interest rate policy will soon move into restrictive territory if it’s not there already. Should such an outcome prevail (and persist) the risk of recession would rise materially. Indeed, this is already the base case for many investors.

An immediate recession may not happen, of course, not least if inflation falls fast enough and the policy response is so generous as to prevent it. The strength of the jobs market and the high level of US savings might also support consumption and ward off a more troubling downturn too. Nevertheless, recessionary risks have risen, and investors should steel themselves for volatility ahead.

But again, we would argue all is not lost for equity investors. A recession that is 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 some interest rates to cut! Again, this policy flexibility might prevent a more pernicious 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, our 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 in our efforts to help diversify portfolios in a more troubling period for stock markets.

Finally, let us please wish you all a prosperous New Year.

Kind regards,

iPensions Wealth Team

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