Is the bear market over?

Last year was one of unfortunate records. The UK experienced the sad death of the country’s longest-serving monarch and its shortest-ever premiership. The invasion of Ukraine led to the most significant military conflict in Europe in 75 years, while the global economy is experiencing the highest inflation since the 1970s. It is perhaps no surprise that 2022 was a difficult year for investors.

Stocks and bonds both fall

2022 was particularly challenging as both stock and bond markets suffered in tandem. Normally, when shares are struggling, bonds can provide some “defensive ballast” and help smooth returns. That was not the case last year. Both asset classes fell by a double-digit percentage (as of the end of November). It was the worst combined performance for an equally split portfolio of UK equity and bonds in over 50 years.

The unusual behaviour of the two major asset classes is very much a reflection of inflation. In the absence of economic growth, high inflation generally has a negative impact on markets. Bond investors demand higher yields to help them generate a real (i.e. after inflation) return. Higher bond yields result in lower bond prices and tend to pose a headwind to equity valuations. This has been exacerbated by the steep rise in central bank policy rates which has further undermined the valuation of bonds and stocks. In the US, the Fed’s key interest rate has risen from a target of 0.0-0.25% at the end of 2021 to 4.25-4.50% at the end of 2022. We have quickly gone from “free money” to money that costs quite a bit. Interest rates have also been rising in the UK and eurozone, but they have not yet risen as far.

Bonds and equities moved in tandem in 2022

Total return from the S&P 500 and US Treasuries since 2000

Past performance is not an indicator of future returns and may not be repeated

Source: Refinitiv Datastream.

This dramatic increase in borrowing costs will have a significant impact on economic activity, though it will take time for this to become apparent. Schroders' economists now expect recessions in the US, UK and eurozone in 2023. The better news is that this may be a shallower contraction than in the past. In the UK, for instance, the forecast is for a loss of output of less than 1% in 2023.

It is not unusual for equities to fall into a “bear market” – defined as a 20% fall from the peak – as the economy heads into a recession. At the end of November, US stocks were down slightly less than this but were down by as much as 25% in US dollar terms in early October. UK stocks have fared better. But, as I have mentioned before, this is partly a function of the weakness of sterling which means UK multinationals’ earnings are worth more in GBP terms. It also reflects the FTSE 100’s relatively high exposure to energy, resources and financials.

A peak in inflation, but not yet interest rates

The key to a more enduring recovery in both the economy and markets is getting inflation under control. By itself, this will do a great deal to improve consumer confidence. It will also allow the Federal Reserve and other central banks to stop raising interest rates. As the economy slows, they may even switch their focus to supporting growth – by cutting interest rates – rather than fighting inflation. We had a glimpse of what this might mean for stock markets in November, with US equities notching up some impressive rallies in response to cooler inflation data and a possible softening in the Federal Reserve’s stance. This included a one day jump of 5.5% by the S&P 500, the largest rise in over two years.

US inflation may be starting to cool

…but still remains higher than the Fed would like

Source: Refinitiv Datastream, Schroders

However, we think that stock markets may have been getting somewhat ahead of themselves. For one thing, inflation still has a long way to fall before it is on a clear path back to central bankers’ target of 2%. The Fed may need to keep rates high for some time before it can start signalling any reversal in its policy. Secondly, it is not yet entirely clear that the economy is slowing enough to take the momentum out of inflation. Labour markets, in particular, remain surprisingly robust. US payroll data suggested that the economy added just over a quarter of a million jobs in November, some way above estimates. It could simply be a matter of time until previous interest rate rises have more of an impact. But, it is also possible that interest rates will have to rise higher than the 5% peak currently anticipated by investors. This would come as an unwelcome shock to bond and equity markets.

China is on a very different trajectory

The picture is somewhat different outside of developed markets, especially in China. Inflation and growth both remain subdued, as the country grapples with coronavirus and a slowdown in its highly indebted property market. Both issues were a source of rare social unrest last year – with “mortgage strikes” earlier in 2022 and protests against lockdowns late in the year.

The government’s desire to avoid further unrest could mean we soon start seeing more positive developments for markets on both fronts. Beijing was quick to ease Covid restrictions after the protests against lockdowns, even though cases are rising rapidly. The government appears to have little choice but to back down on its unpopular strategy of “zero Covid”. While this could see higher levels of infection and mortality over the coming months, it should pave the way to a fuller reopening of the Chinese economy at some point this year. Any cyclical upturn in Chinese activity could help boost global demand at a time when developed markets are in, or approaching, recession.

Global order remains precarious

This time last year, I noted three geopolitical flashpoints to keep an eye on Ukraine, Taiwan and Iran. The situation in Ukraine escalated far more quickly than any of us anticipated, with tragic consequences that are still playing out. We will continue to monitor developments in Eastern Europe closely.

2022 showed that geopolitics can have very significant implications for investors, even if they have minimal direct exposure to the countries in question. This could become apparent once again if there is an escalation of tensions with Iran, which is continuing to advance its uranium enrichment capability. It is possible we would see further disruption to global energy supplies, making the challenge of combating inflation even harder.

The situation in Taiwan also remains a worry. Investors have far more direct exposure to Taiwan and China and both are crucial to global supply chains. We do not expect an invasion of the island, but even diplomatic tensions could spill over into the global economy. Another round of “trade wars” is the last thing the world needs as it struggles to recover from the economic shocks of the past few years.