In December, the US energy secretary announced that scientists had achieved a key breakthrough in the pursuit of nuclear fusion power by achieving a net energy gain in a fusion reaction for the first time, describing it as a “landmark achievement”.1 While there are still major hurdles to overcome, many scientists see the technology as the ‘holy grail’ of energy production that could eventually provide plentiful, zero-carbon power.
In financial markets, global equities appeared to make a more tentative breakthrough during the final quarter of 2022. Share prices made respectable gains after three consecutive quarters of declines, but market participants still faced multiple blockages as they continued to contend with heightened inflation, monetary tightening, and the growing prospect of recession. Indeed, equity and bond markets ratcheted up losses of more than US$30 trillion for 2022 as a whole, with the MSCI AC World index experiencing its worst annual performance since the 2008 global financial crisis.2
A number of developments helped to create a more supportive backdrop for risk assets during October and November. One of the key factors was the anticipation of a step down in the pace of interest-rate rises by the US Federal Reserve (Fed) and other major central banks. This was boosted by evidence of easing inflation, as the US consumer price index posted an annual increase of 7.1% in November,3 its lowest level for almost a year, amid signs that inflation was also peaking in the UK and eurozone. Meanwhile, economies appeared to remain fairly resilient, with the US adding more jobs than expected in November4 and many companies continuing to report strong demand.
A further positive was the growing expectation that China would reverse its zero-Covid policy, following mounting popular resistance and as restrictions continued to weigh on the country’s economy. The U-turn, which took place abruptly in December, made markets increasingly optimistic about a pickup in Chinese growth in 2023, with the country also taking measures to revive consumption and support the beleaguered property sector.
In December, while the Fed, European Central Bank (ECB) and Bank of England (BoE) did all slow the pace of rate increases as expected, opting for 50 rather than 75 basis-point hikes, markets were less comfortable with the hawkish tone emanating from the meetings, and global stocks trended lower. Bonds, which had rebounded earlier in the quarter, also saw prices retreat again during the final few weeks of the year.
Notably, the ECB stated that inflation remained far too high, while Fed Chair Jay Powell warned that “it will take substantially more evidence to give confidence that inflation is on a sustained downward path”.5 The US central bank’s ‘dot plot’ of individual Federal Open Market Committee (FOMC) members’ interest-rate projections suggested that rates would remain elevated during 2023, with 75 basis points of rate rises still to come.
The Fed also noted a deteriorating economic outlook, with the US economy now forecast to grow just 0.5% in 2023,6 while the Institute for Supply Management’s manufacturing purchasing managers’ index contracted in November for the first time since May 2020, following 29 consecutive months of growth.7 In China, soaring Covid cases in late December made it increasingly clear that the path to full reopening was likely to be a bumpy one, while the war in Ukraine continued with seemingly little prospect of a resolution.
In fixed income, UK gilts, as represented by the FTSE Actuaries UK Conventional Gilts All Stocks Index, returned +1.7% over the quarter (-23.8% over the 12 months to 31 December), while overseas government bonds, as represented by the JP Morgan Global Government Bond Index (excluding the UK) produced a return of -4.0% in sterling terms (-5.6% over 12 months). Corporate bonds, as represented by the ICE BofA Sterling Non-Gilt Index, returned +6.2% over the quarter (-17.8% over the year to date).8
In equity markets, sterling’s relative strength versus the US dollar during the quarter meant that North American equities produced a small negative quarterly return of -0.5% in sterling terms (-8.8% over the 12 months to 31 December). Emerging markets returned +0.7% (-6.4% over the calendar year), while Japanese equities delivered +4.8% over the quarter (-4.8% over 12 months). Meanwhile, Asia Pacific ex Japan equities returned +6.6% (-5.3%), UK equities returned +8.9% (+0.3%), and European ex UK equities produced a quarterly return of +12.0% for UK-based investors (-7.0% over the calendar year).9
Total returns (£), rebased to 100 at 31 December 2021
Source: FactSet, January 2023.
Gold jumped +9.9% in US-dollar terms over the quarter (+0.1% over the calendar year), while in sterling terms the precious metal produced a smaller quarterly return of +1.4%, but an outsized +12.1% over the 12 months.10
Minutes from the November US Fed policy meeting revealed that there had been growing debate among officials as to the extent of further measures required to bring inflation under control.11 Given the time lag before interest-rate changes filter through to the economy, policymakers are likely to face a more difficult phase over the coming months as they run the risk of raising rates too much and excessively stifling the economy, or easing off too soon, which could see price pressures get out of control and allow inflation to become embedded.
While inflation related to everyday goods such as used cars and appliances has started to decline, and rising mortgage rates have had a downward impact on house prices, inflation linked to services has stayed elevated, partly as a result of the labour market, which has remained resilient. A key concern is wage growth, with average hourly earnings increasing by 5.1% year on year.12 Consumer spending has also remained robust, helped by excess savings.
US consumer price inflation
% change, year on year
Source: FactSet, US Bureau of Labor Statistics, January 2023
At the press conference following the Fed’s December policy meeting, Jay Powell warned that services inflation would not move down quickly, and that the Fed “may have to raise rates higher to get to where we want to go”. Such a scenario, which could see the Fed tightening more than currently expected, would also increase the likelihood of a recession.
In its latest economic forecasts, the Organisation for Economic Co-operation and Development (OECD) stated that it expects the UK to be the worst-performing economy in the G20 over the next two years, apart from Russia, with GDP forecast to decline by 0.4% in 2023 and rise by just 0.2% in 2024.13 It noted that while business sentiment had picked up in October, following a period of policy uncertainty, consumer confidence remained subdued. The UK’s Office for Budget Responsibility warned that households face the largest fall in living standards in six decades (primarily owing to inflation), and believes the economy has already entered a recession that could last for over a year.14
Following the panic seen in the gilt market in late September during Liz Truss’s short-lived premiership, new Prime Minister Rishi Sunak and Chancellor Jeremy Hunt restored some stability by replacing radical policies which aimed to slash taxes to aid growth with a renewed focus on fiscal discipline. While this has led to an improvement in government borrowing costs, mortgage costs have remained significantly higher than before the September mini-budget. Furthermore, while inflation may have peaked, it remained high at 10.7% in November, justifying, according to BoE Governor Andrew Bailey, “a further forceful monetary policy response”.15
Mild weather in Europe has lessened the risk of a shortage of gas supplies over the winter months, and therefore reduced the likelihood of industries having to pause production or shut down for any meaningful period. This, along with greater fiscal support from governments, has contributed to a brighter economic outlook, and while many economists still expect the eurozone to fall into a mild recession, 2022 growth forecasts were upgraded while retail spending remained robust.16 In Germany, the region’s largest economy, the number of jobs reached its highest level since the country’s reunification in 1990, while more than 40% of German businesses have reported shortages of workers.17
Eurozone retail sales
Index measuring evolution of turnover in retail trade, excluding motor vehicles,
adjusted for price changes and for calendar and seasonal effects.
Source: FactSet, Eurostat, January 2023.
At its December meeting, the ECB acknowledged pressures on wages and the strong labour market as key drivers of inflation, and President Christine Lagarde delivered a hawkish message on further interest-rate increases in 2023. The central bank also announced plans to start reducing its balance sheet of bonds acquired over the last decade.
On 20 December, the Bank of Japan (BoJ) surprised markets by announcing that it had decided to raise the upper limit of its yield-curve control policy. The change meant that 10-year Japanese government bond yields would be allowed to fluctuate within 0.5% of the central bank’s target of zero, instead of its previous 0.25% limit.
Although BoJ Governor Haruhiko Kuroda denied that the adjustment was a form of tightening, the move was widely viewed as the beginning of an exit from the country’s ultra-accommodative monetary policies. It followed a rise in the country’s core consumer price index to 3.7% year on year in November, which, while still low in comparison to Europe and the US, represented the fastest increase in 40 years.18
While it subsequently pared back some of its losses, the yen fell in October to its lowest level versus the US dollar since 1990,19 and high import costs owing to the weak currency were a key factor in causing the Japanese economy to contract unexpectedly in the third quarter. A US$200bn government stimulus package announced in October may help growth to recover, and the return of tourism and increased defence spending could provide a further boost.
After a difficult year with activity stifled by the zero-Covid policy, a major property downturn and the regulatory crackdown on the technology sector, China appears set for growth to pick up in 2023. However, it faces several headwinds as it reopens its economy. Volatility is likely to persist over the short term as authorities look to manage soaring Covid cases without reimposing onerous restrictions, and businesses have to cope with large numbers of sick workers.
In the medium term, while pent-up demand should boost consumer spending to some degree, a backdrop of rising household debt has made financial conditions tougher for many. The future trajectory of the property sector, which is a key component of household wealth, remains uncertain in spite of a new wave of government support. Furthermore, should Europe and the US fall into recession, demand for goods is likely to be affected.
Throughout 2022, the Fed and other central banks aggressively moved to curtail soaring inflation, creating a domino effect that has driven equity and bond markets down considerably. The meteoric rise in interest rates has affected access to capital and the cost of capital, with the intention of slowing economic activity.
As we enter 2023, some commentators believe that slowing inflation could allow policymakers to pause the tightening of monetary policy, with the Fed already having scaled back the pace of interest-rate hikes in December. It is also clear that China’s policy is changing, with the stepping up of support for the property sector and the easing of the controversial zero-Covid policy. Building on this, if Europe’s winter remains mild and the region avoids an energy-supply crunch, sentiment could improve further, particularly if there were signs that the conflict in Ukraine could de-escalate. Such a bullish scenario should certainly not be discounted, but leading indicators of global nominal growth point towards a continued slowdown in 2023.
Predicting the future intentions of central bankers could be futile, as the lengths to which they must go to curb inflation may be unclear even to them at this point. However, the Fed, ECB and BoE have all clarified that their priority is to curb inflation, and have signalled that they will continue their tightening measures until the desired goal is achieved. This policy direction has stoked fears of recession and its impact on corporate earnings. Currently, the consumer is proving to be resilient as job markets remain robust in major economies, but it may prove difficult for central banks to tame inflation without damaging the employment market. Higher interest rates typically create a snowball effect, leading to a slowdown in spending, which then ripples its way throughout the economy, ultimately dragging down corporate earnings. Since the effects of monetary tightening lag, and are thus not felt in real time, it seems likely that economies have not yet begun to experience the full effects of higher interest rates.
Beyond the purely financial sphere, there are several broader structural trends that are influencing economies and helping to create market conditions that are very different from those of the recent past. Frictions between nations have been rising, and Western economies are demonstrating greater concern for national self-interest, adding momentum to the deglobalisation trend and necessitating the rethinking of supply chains. Meanwhile, climate change and decarbonisation efforts are likely to affect the nature of future growth, while China, whose influence on the global economic outlook has become increasingly important in recent decades, is expected to see a continued shift away from a manufacturing-led economy towards one based around domestic consumption.
Against this backdrop, and with the days of easy returns and accommodative central banks seemingly a thing of the past, we believe it will be important for investors to harness true, differentiated research into individual securities, and to seek out idiosyncratic ideas.
Rising interest rates and high inflation created an extremely challenging environment for bond investors during 2022. However, in the scenario in which economies enter recession, central banks stop raising rates, and inflation continues to trend lower, the outlook in 2023 could be considerably more favourable for government bonds. Should a ‘soft landing’ not be achieved, and economies enter a deeper recession, yields could be driven lower and a rally in government bonds could gain added impetus; nevertheless, we do not believe it will be a straight-line rally and suspect that central banks may occasionally step in to pour cold water on it.
10-year government bond yields (%)
Source: FactSet, January 2023.
For corporate bonds, credit spreads (yield premiums over government bonds) are likely to widen as economic momentum declines and fears of defaults rise. Among high-yield issuers, we expect default rates initially to remain low, owing to a very well staggered debt-maturity schedule and solid corporate balance sheets. However, we see this outlook as increasingly offset by the rising volatility/liquidity premium in credit markets.
In this environment, we think it will be important for fixed-income investors to take advantage of diverging trends. Some governments are attempting to fiscally stimulate their economies through measures such as help with household heating bills. In other places, there is rising pressure from organised labour for wages to increase. While this is understandable, these societal pressures and government-led initiatives are counteracting the efficacy of central-bank policies. The net result is that bond and currency markets will respond differently over different time horizons.
With the potential for slower growth and lower capital returns from global equity markets, making the income component of returns more significant, we see a favourable backdrop for select income stocks. Insurance, for example, remains a necessity for consumers during a recession, and certain businesses in this sector are likely to benefit from higher interest rates on the back of higher inflation. We think listed infrastructure securities, issued by companies with hard asset-owning business models which often provide essential services, can also hold up as a buffer in this inflationary environment. Infrastructure assets are generally regulated, and the revenue from them is governed by long-term contracts with built-in inflation pass-through mechanisms.
As the world becomes increasingly fragmented, companies across the globe will need to rethink their supply chains and reinvent how and where they manufacture products. Greater stockholding to avoid supply-chain shocks may increase capital intensity and put pressure on returns. However, companies that enable this localisation, as well as companies that benefit from it, could provide attractive opportunities for investors.
Another area where we see potential is health-care innovation. There are many elements of health care that we believe could see the equivalent of multiple decades of progress condensed into just the next few years. New forms of health-care delivery, for example telehealth and better primary care offerings, are expected to become much more robust. Elsewhere, areas of technology such as digital transformation, a more frictionless economy (providing better experiences for consumers through automation), and cloud computing remain in relatively early stages of development, allowing room for further potential growth.
Finally, industrials and materials companies engaged in the transformation of materials, substances or components into new products are driving innovation around areas such as the energy transition, infrastructure and the move to electric vehicles.
We cannot solve our problems with the same thinking we used when we created them.Albert Einstein (1879-1955)
1 How US scientists moved one step closer to dream of fusion power, Financial Times, 13 December 2022
2 Stock and bond markets shed more than $30tn in ‘brutal’ 2022, Financial Times, 30 December 2022
3 US consumer price inflation eased more than expected in November, Financial Times, 13 December 2022
4 US economy adds more jobs than expected in November, Financial Times, 2 December 2022
5 ECB raises rates to 2% and warns of more increases to come, Financial Times, 15 December 2022
6 Fed raises rates by a half point as central banks enter new phase, Financial Times, 14 December 2022
7 November 2022 Manufacturing ISM® Report On Business®, Institute for Supply Management, December 2022
8 Bond market returns sourced from FactSet, 1 January 2023
9 Equity market returns sourced from FactSet, 1 January 2023 (All sterling total returns, FTSE World Index)
10 Gold bullion returns sourced from FactSet, 1 January 2023
11 Most Federal Reserve officials back slower rate rises ‘soon’, Financial Times, 23 November 2022
12 US economy adds more jobs than expected in November, Financial Times, 2 December 2022
13 UK’s growth prospects worst among top economies, warns OECD, Financial Times, 22 November 2022
14 UK households face largest fall in living standards in six decades, Financial Times, 17 November 2022
15 Bank of England raises interest rates to 3.5%, Financial Times, 15 December 2022
16 ‘We were too gloomy’: Europe’s business leaders turn more upbeat, Financial Times, 30 November 2022
17 Germany’s hot labour market set to trigger more eurozone rate rises, Financial Times, 2 January 2023
18 Japan inflation nears 41-year high on weak yen and soaring energy costs, Financial Times, 23 December 2022
19 Weak yen puts Japan’s economy into reverse in third quarter, Financial Times, 15 December 2022
All data is sourced from FactSet unless otherwise stated. All references to dollars are US dollars unless otherwise stated.
These opinions should not be construed as investment or other advice and are subject to change. This document is for information purposes only. This is not investment research or a research recommendation for regulatory purposes. Any reference to a specific security, country or sector should not be construed as a recommendation to buy or sell investments in those securities, countries or sectors. Issued in the UK by Newton Investment Management Limited, The Bank of New York Mellon Centre, 160 Queen Victoria Street, London, EC4V 4LA. Registered in England No. 01371973. Newton Investment Management Limited is authorised and regulated by the Financial Conduct Authority, 12 Endeavour Square, London, E20 1JN and is a subsidiary of The Bank of New York Mellon Corporation. 'Newton' and/or 'Newton Investment Management' is a corporate brand which refers to the following group of affiliated companies: Newton Investment Management Limited (NIM) and Newton Investment Management North America LLC (NIMNA). NIMNA was established in 2021 and is comprised of the equity and multi-asset teams from an affiliate, Mellon Investments Corporation.