Are high quality bonds primed to bloom in 2023?

Runaway inflation, uncertainty about interest rates, Covid-19 impact in China, and Russia’s war in Ukraine were the ‘unknown’ factors driving markets over the last 12 months. This year we are likely to get more clarity on a variety of key issues that should boost investor confidence. Here, Patrick Farrell, Charles Stanley’s Chief Investment Officer and Head of Research, examines what we know now – and what we don’t…

The factors that are going to drive stock markets will change as 2023 progresses. We are now getting more clarity on several issues that have been of great concern to investors. In short, the big macro issues such as inflation, employment and central bank action that drove markets lower are becoming less of a focus to investors – but micro issues such as company earnings will become more of an investor priority. So, let’s look at each of these issues.

Central banks

Headline inflation has peaked in the US and we may have seen the peak already in the UK and Europe as well. We will then see a period of disinflation – where the rate of price rises falls as the year progresses. Falling energy prices and monetary tightening by central banks have now started to feed through to the real economy, helping inflation to level off. This has allowed us to get a handle on the ‘peak’ interest rate levels determined from central banks. We now expect US interest rates to peak at just above 5%, with the UK peaking at between 4% and 4.5%.

What we do not know is how long rates will stay at elevated levels. In the key US market, there is some disagreement on this between markets and statements by the Federal Reserve (Fed). Jerome Powell, Chair of the central bank, remains hawkish.

He insists that interest rates will need to stay ‘higher for longer’ to thoroughly vanquish inflation, but futures markets are pricing in a so-called ‘Fed pivot – where the central bank changes its policy and moves to a more accommodative stance.

Experience dictates that ‘fighting the Fed’ in such a way can become a very expensive business for investors – particularly when their resolve seems elevated, as it is now. It also means the Fed may be more aggressive in the short term. If markets remain buoyant and too optimistic on the future, the Fed may raise rates more sharply at upcoming meetings. The impact of quantitative tightening and the substantial reduction in market liquidity this will cause is also an unknown factor. Unwinding the special monetary action taken to deal with the great financial crisis and the Covid-19 pandemic is an unprecedented move. The Fed may have to stop in some form its current shedding of Treasury bonds and mortgage-backed securities (MBS) if liquidity shortfalls threaten the central bank’s control over its overnight interest rate target.

"Headline inflation has peaked in the US and we may have seen the peak already in the UK and Europe as well. We will then see a period of disinflation – where the rate of price rises falls as the year progresses."

Economic growth

Inflation is now heading in the right direction and forecasts of growth this year have been gloomy. For example, the World Bank predicts that growth in worldwide economic output will be just 1.7% in 2023, and their economists have warned that the downturn would be widespread and exacerbated by any adverse developments. However, we do not know how deep or prolonged any growth slowdown or recession will be. The US economy has been very resilient to the rise in interest rates overall to date. However, housing and manufacturing are certainly feeling the strain. The UK economy is struggling more but continues to show pockets of growth. Jobs markets on both sides of the Atlantic have been robust, but the data now indicates that any wage-price spiral – where inflation becomes embedded in the system because of the level of wage rises, which add extra costs for businesses resulting in further increases in the price of goods – is unlikely. Indeed, it is possible that there will not be the level of job losses seen in previous downturns because of the tightness in labour markets.

Companies have been complaining that it has taken them a significant amount of time to find the right employees. Many will be reticent about letting them go only to have to go through a challenging and costly recruitment and training process once a recovery starts to bed in. The employment market is being keenly watched by the Fed and it is one where investors need to keep fully abreast of pertaining issues.

Ukraine war

The impacts from the prolonged conflict in Ukraine are starting to become clearer. The sanctions on Russia will see greater investment and less bureaucracy around green energy. However, some targets on climate change are likely to be missed, as burning coal becomes essential to ensure electricity supplies to businesses and households. What is unclear is how the war will progress – there is no end in sight yet for this human tragedy.

Covid-19

Western economies are still recovering from the impact of Covid-19, which has resulted in many changes to society. The pandemic accelerated existing trends in remote working, e-commerce, and automation. It also caused companies to examine their supply chains to make them more secure – the twentieth century trend of outsourcing to low-cost destinations such as China proved to be a great expense and problem for many businesses, as lockdowns closed their suppliers and transport of goods was hindered by restrictions at ports. The major unknown in the case of Covid-19 relates to Beijing’s reversal of its tough lockdown policies and the potential impact on society. Covid-19 was spreading rapidly before protests forced Beijing to relax strict social-distancing rules – and new case numbers are likely to accelerate. Relaxing pandemic restrictions risks a significant rise in deaths in a country where a low proportion of the elderly is vaccinated. The country has a serious vaccine problem. The inoculation of the elderly has not been professionally managed and the Chinese-developed vaccine that has been deployed is not particularly effective. Chinese leader Xi Jinping is steadfastly unwilling to accept Western-developed mRNA inoculations and vaccine hesitancy amongst the elderly is pervasive.

Companies

A major focus for investors will be the downturn’s impact on corporate margins and reactions to earnings pressure on different sectors and companies. It will take a few quarters of reporting to determine the impact on company bottom lines. For example, supermarkets were upbeat reporting their Christmas sales numbers. J Sainsbury’s hailed a “record” Christmas, with sales up 7.1% year-on-year in the six weeks to 7 January. Tesco said like-for-like sales at its UK stores rose by 5.3% while Marks & Spencer, which owns a substantial food business, grew its same-store sales by 7.2%. But much of the rise was a result of high inflation pushing up the value of goods being sold, masking weaker sales volumes. UK consumer prices rose 10.7% in November year-on-year. We won’t really have an idea of what is going on until April’s annual results releases, where we will have profit figures to assess exactly what is happening to margins and volumes.

What this means for markets

As a result, you should expect to see continuing stock market volatility throughout 2023, but the factors that will cause a negative market reaction will change as the year progresses. They will move from the still important macro-driven data points as investors feel comfortable with the direction of travel to the more micro driven factors for individual companies and the impacts are likely to be more localised as it becomes clear how the companies and sectors are being impacted.