May market commentary

May 2023 Market Commentary

We hope you are keeping well and have enjoyed the string of bank holidays falling so kindly upon us this season despite the rather damp conditions. Clouds continue to hang over markets too, though April was broadly a positive one for investors. But it’s often the case that markets climb a ‘wall of worry’, as the bears’ ‘fear of missing out’ forces a reassessment and reallocation into riskier investments. Indeed, it’s often when there is seemingly nothing to fear, and there’s no more bears left to convert, that the greatest problems appear.

Getting more granular on the investment landscape and it would appear there were two significant catalysts for the additional headway made by markets in April. We would first suggest that, despite recent news flow, the risks of systemic bank failure further receded from investors’ minds over the month. We would also note that, after a relentless march higher over the prior 12 months, the prospective end to US interest rate hikes also likely buoyed sentiment. We recognise, of course, the heightened inflationary pressures in the UK and Europe will delay the end to their respective tightening cycles, however, the peak in interest rates is still coming into view.

But whilst the benign market reaction to the prospect of a more accommodative interest rate policy is coherent, the more complete narrative highlights the risks which prevail. The significant catalyst behind falling interest rate expectations has been the anticipation of more restrictive behaviour from commercial banks. Such entities are likely to behave more cautiously in the face of increased costs, as depositors demand better rates to remain customers, and as regulators increase levies to cover heightened regulation. Rising bank costs, however, will further increase bank sensitivity to loan losses and, therefore, will likely impinge on the level of bank lending, particularly into the more speculative areas of the economy. Reduced lending would act as a brake on both growth and inflation expectations; a combination which has compelled investors to anticipate lower levels of interest rates. Recall, that investors will utilise interest rates to discount future cash flows to a present value. All else equal, therefore, and share prices benefit from falling interest rates.

Should banks withdraw particularly aggressively from lending activity, however, then the prospect of a more damaging downturn would increase. In such circumstances the positive impact of falling interest rates might be dwarfed by the prospect of surging unemployment, collapsing revenues, and tumbling profits. Investors should not, therefore, consider falling interest rates as a ubiquitously positive backdrop. There should be conditionality attached, particularly amidst a more extreme event.

In the face of more persistent inflationary pressure, investors should also be alert to the risks of a ‘higher for longer’ interest rate environment; particularly if central banks are less fearful of bank failures. A more restrictive monetary policy raises the prospect of more troubling economic outcomes later in the year, or early in 2024, and might become an increasing headwind to markets.

Investors should brace themselves for further volatility on this basis, but we would again argue all may not be lost for equity investors in such an environment. A recession that seems so widely predicted may not inflict the same damage as one that catches investors off-guard. We would also highlight the conditions driving a ‘higher for longer’ interest rate environment might prove more constructive for market performance than widely communicated. The ‘higher for longer’ policy is still an end to further tightening and, if accompanied by low (but still positive) growth and falling (if above target) inflation, could still be a rewarding mix for investors.

Kind regards,

iPensions Wealth Team


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