Market update – January 2023

All eyes still on inflation

Central bankers may well start to sound less anxious about inflation in 2023. However, investors must still contend with the slowdown that will result from the steep rises in interest rates we have seen over the past year. If inflation cools quickly, this slowdown could be relatively shallow and short-lived, as central banks signal a willingness to cut interest rates to support growth. Schroders’ economists anticipate that the Federal Reserve may be in a position to cut rates in the second half of 2023, with the Bank of England and European Central Bank to follow. However, the path of inflation remains far from certain. Markets could become more volatile if it becomes apparent that interest rates will need to rise higher - or stay high for longer – than is currently anticipated.

China’s Covid u-turn

Beijing has surprised investors by quickly dismantling the coronavirus restrictions that have been weighing on Chinese activity for over two years. At some point, this is likely to result in a strong rebound in economic activity, potentially boosting global demand and complicating efforts to bring inflation under control. However, the timing of this recovery remains unclear and China could face a prolonged period of weakness as it experiences a Covid “exit wave.” This uncertain outlook is reflected in the performance of commodities, which are still highly dependent on Chinese demand. Prices jumped late last year as it emerged that Covid restrictions would be eased: they have since retreated as it has become more likely that the boost to activity may be delayed.

Geopolitics will remain crucial to the outlook

Russia’s bombardment of Ukrainian cities over the holiday season is a sad reminder that there is little prospect of a de-escalation of the conflict any time soon. By contrast, it looks increasingly likely that both sides are preparing for renewed offensives in the spring, as Schroders’ Senior Adviser General Sir Nick Carter suggested in a recent webinar. Besides the humanitarian cost, this will have global economic implications as the world grapples with continued uncertainty over energy and agricultural supplies. There are other international flashpoints to worry about. Taiwan is likely to remain a source of tension between China and the US and could lead to further disruption in global trade and supply chains. Iran’s nuclear programme, alongside the challenge from domestic unrest, could also be a source of instability in the Middle East.   

Portfolio positioning

There are three key indicators we are looking for before turning more positive on equities: a peak in US interest rates; a softer US labour market and corporate earnings forecasts that better reflect the likelihood of recession. It is very possible that these conditions are met over the coming months. We already have a more constructive view on fixed income and have gradually been increasing our exposure to government bonds. We also still like alternative assets, which 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.