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The final quarter of the ‘transition year’

06 January 2023

Although inflationary data has started to show signs of trending lower in the final quarter of the year, central banks remained broadly hawkish despite slowing the pace of interest rate hikes.

Royal Exchange

Sanjay Rijhsinghani, Chief Investment Officer

Over the quarter, the Federal Reserve (Fed), European Central Bank (ECB) and the Bank of England (BoE) all increased rates by 1.25%. For most of the year, all eyes were on the Fed given its swift hiking cycle. Hence, slowing the pace from 0.75% hikes to 0.5% amidst softening price pressures was initially seen as dovish. However, they pushed back hard on a quick policy reversal and indicated that they expect rates to peak above 5% and remain there for some time. The ECB joined them by pushing their own hawkish message and drove market rate expectations higher. The hawkish chorus was cemented by the Bank of Japan (BoJ) surprising investors and shifting the cap on their ten-year sovereign bonds. While the target remained at 0%, the cap was lifted from 0.25% to 0.5%, bringing about speculation of what is further to come. 

The BoE managed to follow the path of the other banks despite the fluid political situation. The volatility that ensued from the mini budget was remarkable and quickly led to a change in government. The appointment of Jeremy Hunt as Chancellor and Rishi Sunak as PM, backed by a more fiscally sound autumn statement, meant that interest rates will not have to rise as high as feared and garnered support for sterling.         

Over to the East, China sought to move decisively away from its zero-Covid strategy, bringing some welcome relief to the local population and Chinese equity markets. Further stimulus measures have also helped improve sentiment.  While the risk of a surge in Covid cases in the near term may bring about travel restrictions, the medium-term path forward is clearer and economic growth is again a priority. 

Whilst we saw most other major equity indices post negative returns for the month of December, the last quarter, was in the main, a positive one for both bonds and equities globally. Currency markets were very volatile, with the dollar paring its gains following softer inflation prints and more hawkish central bank activity elsewhere. The change from the BoJ also drove a sharp rally in the yen.

Looking back at 2022 as a whole, it may well be heralded as the ‘transition year’. Less than 12 months ago, the path taken by central banks was seen as unlikely. However, 2022 quickly brought about the end to a decade mired by low inflation and near zero interest rates, exacerbated by the terrible Russian war in Ukraine. As higher rates and ‘sticky’ inflation became a reality over the course of 2022, we witnessed a repricing of assets that resulted in a decline in virtually all asset classes. Equities and bonds both registered double-digit declines.

Looking ahead, there is every reason to believe that both equities and bonds should outperform cash and inflation over the medium term. As each month goes by, we are getting closer to the end of the current tightening cycle. Inflation pressures driven by the pandemic shock will abate which should see inflation fall to more normalised levels. After a decade of developed market bonds yielding virtually zero, and investors forced to increase their risk to get returns, bonds are now much better placed to deliver attractive levels of income. Although higher rates and quantitative tightening result in a slowing of demand, if this results in a sustained fall in inflation, equities may fall back into favour. While markets are likely to remain volatile depending on what type of recession we may see, we have to be highly selective in our equity exposure. As history has shown, selective companies with solid balance sheets and pricing power should be able to perform well through this environment.

                                                                                   

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