“The yield curve is tried tested and true. I’m not going to say it’s infallible, but it is the best leading indicator there is. And we need that yield curve to re-enter a positive shape, led by Fed rate cuts. Remember, it’s all about interest rates. Don’t fight the Fed” – David Rosenberg of Rosenberg Research comments on the 1st December 2022. 

LAST QUARTER REVIEW

In December, the Federal Reserve (Fed) raised the federal funds rate by 0.5% to the 4.25% – 4.50% range following the fourth consecutive 0.75% increase earlier in the quarter and pushing borrowing costs to their highest since 2007. The American central bank has indicated that rates will need to rise to at least 5% during 2023, while remaining around 4% and 3% respectively in 2024 and 2025.  

Inflation in the US slowed to 7.1% in November of 2022, making this the fifth consecutive monthly decline since the peak rate of 9.1% in June and the lowest since December 2021 (7%). The predicted inflation rate for 2023 is, however, expected to remain at least three times more that the Fed’s 2% target suggesting a continuation of price increases in almost every area of the economy.

While US Treasury (UST) bond yields stabilised during the last quarter, the inversion of the interest rate curve became further exaggerated as follows, 10-year note: 3.88%, 7-year note: 3.96%, 5-year Note: 3.99%, 3-year Note: 4.22%, 2-year Note: 4.41%, 1-year Bill: 4.73%, 6-month Bill: 4.76%, 3-month Bill: 4.42% 1-month Bill: 4.12%. During 2022, the benchmark 10 Year Note declined 16%, the worst fall in history as inflationary fears drove yields at the longer end of the curve from 1.63% to 3.88% (10-year) and 2.01% to 3.97 (30-year)!

Despite the Fed’s aggressive monetary policy continuing last quarter, the US dollar, declined almost 8%. Wall Street, however, had a positive quarter as the benchmark S&P 500 rose more than 7% and the iconic Dow Jones 30 climbed more than 15%, although the tech heavy Nasdaq 100 fell another 1%.

In the UK, the Bank of England (BOE) raised interest rates (for the seventh consecutive time) by 0.50% to 3.5%, having already raised the rate by 0.75% earlier in the quarter. The BOE reaffirmed its intention to continue raising rates during 2023 as inflation remained frustratingly high, despite easing slightly in November 2022 to 10.7% from 11.1% in October, the highest since 1981.

The UK economy contracted 0.3% during the third quarter of 2022 and the BOE governor Andrew Bailey has warned we are likely to remain in a recession throughout 2023 as the central bank’s monetary policy impacts upon the nation. Reflecting this, the yield on the UK’s 10-year Gilt reached 3.6% compared to just 1.0% at the beginning of the year, although sterling strengthened from around $1.11 to $1.21 on the back of the new government headed by Rishi Sunak’s promise to keep a tight rein on fiscal policy.

Investors in UK equities had another positive quarter as the FTSE 100 rose more than 8% and is one of the few global stock markets showing a positive return during 2022. In contrast, during 2022, the S&P 500 fell almost 20%, and the Nasdaq 100 declined almost 31%, as Wall Street suffered its worst annual performance since 2008, while the Euro-Stoxx 50 was down more than 11% and the Nikkei 225 more than 9%!

The European Central Bank (ECB) raised interest rates 0.50% at its December meeting, following a 0.75% rate hike earlier in the last quarter. The main refinancing rate is now at 2.5%, a level not seen in 14 years while the ECB also warned that rates could rise further due to increasing inflation expectations.

There was no change in China as the People’s Bank of China (PBOC) kept steady its key rates at the September fixing with the one-year loan prime rate (LPR) unchanged at 3.65%; while the five-year rate, a reference for mortgages, was maintained at 4.3%. The central bank appears to be seeking a compromise between allowing the yuan to fall and supporting a Covid stricken economy, while inflation is relatively mild at around just 1.6%

At its December meeting, the Bank of Japan (BOJ) surprised markets by widening the band around its 10-year bond yield target while maintaining its key short-term interest rate at -0.1%.  Meanwhile the annual inflation rate in Japan edged up to 3.8% in November 2022 from 3.7% a month earlier, the highest since January 1991, exacerbated by high prices of raw commodity imports and persistent yen weakness.

Global oil prices were little changed during the quarter with West Texas Intermediate (WTI) and Brent Crude futures at $79 and $84 per barrel respectively and will end the year at levels similar to twelve months ago despite WTI hitting a 14 year high of $130 in March 2022. There was even better news from European energy markets as Dutch front-month gas futures fell 46% in December, the most since early September, dragged down by forecasts for mild weather during the holiday season and ample supplies.

The price of natural gas in Europe ended the year at €80/MWh little changed from its price twelve months earlier after falling from the record levels of nearly €350 hit in August, as increased US Liquefied Natural Gas (LNG) imports, increased wind generation, and fuller-than-normal stockpiles eased concerns about shortages. In Germany, storage facilities were 87.3% full as of December 21st and the EU average held at 83%, above the five-year seasonal average, while gas supplies from Russia via Ukraine have been stable and weather forecasts point to milder than usual winter weather until at least February of this year.

GDP Data shown are to the 30th September 2022; Interest Rate, Equity & Bond Index Data are to the 31^st December 2022; Equity Indices used: US – S&P 500, UK – FTSE 100, Eurozone – Euro Stoxx 50, China – Shanghai Shenzhen CSI 300, Japan – Nikkei 225, Germany – Xetra Dax; Sovereign Bond Indices used: S&P US T-Bond, S&P UK Gilt Bond, S&P Eurozone Sovereign Bond (Eur), S&P China Bond, S&P Japan Government Bond, S&P Germany Sovereign Bond.

CURRENT CONSIDERATIONS

During the last year, global equity and bond markets were dominated by inflation expectations and the monetary policy response of the Fed and other central banks.  The ongoing war in Ukraine adds further uncertainty and provides additional upward pressure on the cost of energy and other basic resources.

The silver lining to spiralling energy and commodity prices during 2022 is that, in Europe, where the Ukrainian conflict has potentially had the most adverse impact, the average temperature during the autumn and, so far this winter, has been well above average. Consequently this, along with record imports by the EU from the US of LNG, means energy storage facilities that last winter had been severely depleted are now almost full.

Whilst this has helped markets to be more relaxed about the ongoing military conflict in the short term, there are inevitably increasing concern for outcomes over the longer term. From an investment perspective, we feel this coming year will prove challenging,

Of course, hindsight is a wonderful rear-view mirror, but it is disappointing that central banks failed to recognise the inflationary warning signs that were all too apparent at least eighteen months ago following the unprecedented fiscal and monetary stimulus pumped into economies post the lockdowns of 2020. Thankfully the focus of central banks is now once more fully engaged in taming inflation, albeit at the almost certain expense of short-term economic recession across the developed world, resulting in rising unemployment and failed businesses.

As most economists both at central banks and in the private sector recognise, the inversion of interest rates along the yield curve of the US Treasury market has historically proved a very accurate determinant of when recessions in America are on the horizon. In normal economic times when the American economy is growing and Gross Domestic Product (GDP) is increasing, the shape of the yield curve slopes gently upwards with the lowest interest rate for the shortest dated T-bill (1 month) and the highest at the long end (10-year T-Note and the 20-year and 30-year T-Bonds).

However, when the yield curve inverts, a reversal of this pattern occurs with the interest rate at the short end exceeding that at the long end, which historically, as we have advised in previous Market Views, has proved a reliable indication that a recession is on its way. Research by the St Louis Federal Reserve has shown that every recession since 1957 has been preceded by a yield curve inversion with a time lag of between 8 and 19 months, from when the 10-year and 1-year yields have inverted to the onset of a recession (defined as two consecutive quarters of negative GDP).

On the 12th July last year, the UST curve was inverted all the way back to the 1-year bill (3.07%) compared to the benchmark 10-year note (2.96%), suggesting that 2023 will see the US (and most of the developed world) economy suffer a recession. On the 16th November the yield on the benchmark 10-year T-Note was 3.67% while the yield on the 1-month T-bill was 3.81% and interest rates along the curve have remained inverted since then.

Accordingly, at some point dung this year, the US economy is likely to enter recession, as will the UK. BOE governor Andrew Bailey has already advised Britons to potentially expect the worst recession for decades.

From an investment perspective, Wall Street has historically also proved to be an accurate discounting market, albeit nothing like as reliably so as the US bond market. The challenge therefore will be in determining when the US stock market is likely to have bottomed and is about to begin a new bull phase in anticipation of the recession being over and a new economic expansion commencing.

David Rosenberg, who has been a respected Wall Street economist and market analyst for several decades recently warned against being deceived by bear market rallies, as his research suggests there is likely to be at least one more before the S&P 500 finally bottoms, potentially 20% or even 30% lower than where we are today. Historically for the bear market to end, the all-important Treasury yield curve has to shift out of inversion towards a positive slope in the context of a Fed easing cycle. 

History suggests it is almost certainly too soon to contemplate the bottom is in on Wall Street while the Fed is still raising interest rates into an inverted yield curve. Most equity market bottoms have occurred after the Fed has ceased raising interest rates and has switched to actually reducing them!

As the Fed has pledged to continue raising rates, we feel that the pivotal point is unlikely to come this year and may not materialise until sometime in 2024. The time to go long on Wall Street will be when the Fed has cut rates sufficiently enough to steepen the yield curve, allowing the bear market on Wall Street to finally end.

FORWARD OUTLOOK

Caution and patience are most probably going to be our watchwords this year as we foresee one or two more bear market rallies on Wall Street followed by further lows before the bottom is in! Notwithstanding this, the outlook for commodities remains positive, as it was during 2022 when many of the companies active in this sector managed to buck the bear trend that engulfed global equity markets.

Nowhere was this more evident than on the London Stock Exchange and the FTSE 100 which is dominated by international stocks that focus upon the energy and materials industries. The FTSE 100 index ended 2022 broadly unchanged compared to where it began the year in stark contrast to the non-commodity heavy and domestically focused UK Mid-cap 250 and Small Cap indices which performed in line with most other global equity markets fell 20% or more during the year!  

Adding to the persuasive buy signal for commodity focused equity companies is the realisation by the global authorities that while carbon emissions may be responsible for climate change and that green energy is the future, traditional energy sources will likely play a significant role for decades to come. When this realisation is combined with the likelihood that Russian energy will continue to remain either off limits and / or be discouraged from being used, the outlook for energy producing companies remains attractive for the foreseeable future.

Provided the Fed does not lose its resolve to continue raising interest rates in the US until the inflationary threat is finally extinguished, the result will be a return to a deflationary trend following this year’s recession, suggesting investing in long dated US Treasuries and UK gilts could offer attractive potential medium-term gains. The yields on the benchmark UST 10-year Note and the 30-year UST were just 1.63% and 2.01% at the beginning of 2022, but in 2022 breached 4% for the first time in more than a decade! 

During 2022, portfolios benefitted from a reallocation away from small and medium cap funds into UK large cap focused funds which proved to be more resilient due to their dollar earning commodity and resources company exposure, and typically also offered higher dividends relative to overseas stocks. These arguments continue to prevail, and we are likely to advise an increase in allocation to these sectors this year whilst reducing exposure to Wall Street and other global equity markets until the Fed has begun to reduce interest rates again.

For now, the dollar strength during 2022, especially relative to sterling, appears to be over and we anticipate the $/£ exchange rate this year to remain neutral thanks largely to interest rates in the UK catching up with those in America. This is also now more likely to be the case following the reversal last quarter of the costly fiscal budget that was unveiled by the government during the short tenure of Prime Minister Liz Truss.

Overall, markets remain potentially volatile, and accordingly, maintaining a well-diversified and balanced portfolio will be key. We will continue to look to decrease allocation to growth funds where appropriate (with the exception of energy and resource companies in the commodity sector) and reallocate to more defensive oriented funds aligned to value and income.

We shall keep a close eye on developments and, in particular, any changes in investor sentiment with respect to both inflation and the strength of the dollar in order to determine when may be an opportune moment to look again to growth. As always, investment risk is at the forefront of our advice and, whilst it is often necessary to undertake adjustments in portfolio allocation in order to meet individual preferences, we are confident that our advised portfolios will remain well placed in meeting our clients’ needs.

From all of us at Ash-Ridge Asset Management, we wish you and your loved ones a Happy, Healthy, and Prosperous 2023!

Copyright © Ash-Ridge Asset Management 3rd January, 2023.

Data Sources: Bloomberg; Brookings Institute; Economic Cycle Research Institute: Financial Sense; Financial Times; German Federal Statistical Office; Hoisington Investment Management; Macro Voices; National Bureau of Statistics China; Office for National Statistics; Real Vision; S&P Indices; The Cabinet Office Japan; The Economist; The Federal Reserve; The National Bureau of Economic Research; Trading Economics; UK Debt Management Office; US Debt Clock.org; Wall Street Journal; Zero Hedge.