The war in Ukraine continues with awful consequences for the people there. But financial markets are behaving as if it were all over, as equities enjoyed a remarkable rally last week. For European equities that followed on from strong performance in the previous week. We consider some possible explanations and look ahead to big events that could move the markets in the weeks ahead. That includes UK Chancellor Rishi’s Sunak March statement, which looks like being a full-blown budget.
The equity rally occurred despite central banks raising interest rates, nor was there any support from the bond market where yields rose strongly. The Federal Reserve started its rate hiking cycle, taking the funds rates up from the zero lower bound where it had sat for the last two years. That was expected, but the associated commentary from Fed Chair Jerome Powell was hawkish and the ‘dot plot’ of forecasts from the committee showed a string of rate raises to come. The ECB have also been hawkish. The Bank of England raised rates, but with a dovish twist as one member preferred to keep rates on hold. But that was because he was worried about recession – hardly good news for equities. For investors the big decision is whether the recent rally signals a renewed equity bull market or is merely a short-term bounce.
We’ll get some clues from the flash purchasing managers’ indices on Thursday – the first real indicators to show the economic damage wrought by the war in Ukraine. I’m guessing the numbers will be disappointing, with a contrast between data collected before, compared with after the war. But remember the global economy was looking very strong going into the war, so we’ll have to see.
Also this week, Rishi Sunak will, according to press reports, cut fuel duty and announce a range of other measures to ease the cost of living crisis. But Mr Sunak is a fiscal conservative in both senses of the word and, despite fears of recession, will want to demonstrate that government debt and the deficit is still headed down. I reckon public finances are improving rapidly – strong economic and rising inflation boost tax receipts while falling unemployment cuts the welfare bill, so he has plenty of room to support the economy and report improving public finances. Also watch out for the gilt remit – which will tell us how many government bonds will be issued. Given that the Bank of England is moving from a big buyer to a big seller as its quantitative easing programme goes into reverse – this will have big implication for the yields on government debt. If the UK does ease fiscal policy, they will be following nations in Europe who have collected announced plans amounting to 1% of GDP. By contrast, the European Commissions plans for a collective response have run into the sand.
Inflation pressures remain strong and with fiscal policy expanding, I expect bond yields to rise further. This is a headwind for equities. But the big issue is whether we’re headed for recession. In the US, rising bond yields will slow the housing market –remember that mortgages in the US are typically fixed rats for 5-30 years – and we are already seeing the first signs of a slowdown. But the market has been red hot and, in a bigger picture sense, mortgage rates are still very low. With the consumer holding big covid piggybanks of savings from the pandemic to cushion the blow from higher inflation, the US economy looks set to remain strong this year. Base effects will cut inflation too – and used car prices, which doubled in the pandemic and are now falling quick, will also help. Although inflation will fall, it seems unlikely to get to the Fed’s target of 2% without a major economic slowdown. But that’s a problem for 2023.
I did not expect the recent equity rally, so I’m a bit bemused. I don’t think we’re out of the woods yet, especially in Europe. Morgan Stanley have just cut their forecast for European earnings growth for this year from 10% to 3%, but most analysts haven’t downgraded their numbers yet. So I think we’re still in for a tough time for risk assets. While equities are likely to outperform over a longer horizon, this week’s data might revive fears of recession. I therefore remain cautious.
Past performance is not a guide to future performance. The value of investments and any income derived from them can go down as well as up and investors may not get back the original amount invested.
The information, opinions, estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time.