Market update – December 2022

US inflation may have peaked, but not interest rates

Global stock markets have continued their rebound. US equities have been particularly strong, following data released last month suggesting that we have passed the peak in inflation. In response, the S&P500 surged 5.5%, its biggest one-day rise in over two years. However, markets may be getting ahead of themselves. Headline US inflation remains at 7.7%, well above the Federal Reserve’s target of 2%. The Fed and other central banks are likely to continue raising interest rates in early 2023, even if there is a slowdown in the pace at which they rise. We still expect this will result in recessions in developed markets, which is not yet reflected in corporate earnings forecasts.

China forced to change approach on Covid

Coronavirus is now causing significant social unrest in the world’s second-largest economy. Beijing had been taking tentative steps towards easing Covid restrictions, but a surge in cases made further easing look unlikely. However, mass protests in key cities – which in some cases turned violent – have prompted the government to continue relaxing restrictions. While this is by no means a full reopening, the government does appear to be relenting on the unpopular strategy of "zero covid." A fuller reopening, when it eventually occurs, should trigger a cyclical upturn in Chinese economic activity. This could help boost global demand at a time when developed markets are in, or approaching, recession.

Sustainability remains a focus for policymakers

The macro-economy has been preoccupying investors this year, but there have also been significant developments in sustainable investment. Earlier this year, the US passed the Inflation Reduction Act, which included over $300 billion of spending on energy transition (along with tax increases intended to reduce the fiscal deficit and, in theory, inflation). Since then, the COP27 summit in Egypt resulted in an important agreement to create a "loss and damage" fund to help vulnerable countries hit by climate disasters. Over time, this could help improve the growth outlook for developing nations. This month, the focus will switch to biodiversity and another UN conference, COP15. Biodiversity is inextricably linked to climate change, with the WWF recently warning that the Amazon rainforest could "cease to function" as a carbon-sequestering ecosystem within the next decade.

Portfolio positioning

We expect that higher interest rates will lead to recessions in the UK, US and Eurozone. In this environment, we remain underweight equity and have a preference for higher-quality companies. We are more positive on fixed income and have been gradually increasing our exposure to government bonds. We also continue to favour alternative assets. While they face stiffer competition from bonds as a source of diversification, we think they still have an important role to play in portfolio construction. High levels of inflation in the UK have made meeting inflation plus return targets more challenging in the shorter term. Despite this, we remain confident in the ability to meet inflation plus targets over the longer term.