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In this month’s update, Gary Shepherd, investment writer at Nutmeg, speaks with our chief investment officer, James McManus, about a positive November overall for markets. Topics include the current outlook for inflation, recession, and the latest from China where Covid restrictions are being partially lifted.  

Equity markets appear to have performed well across the board in November. Why is that?   

We saw back-to-back positive months for global equities for the first time in 2022. 

Markets were buoyed by the hope that in the world’s largest economy, the US, we’re finally seeing inflation begin to weaken. This allows the Federal Reserve – that’s the US central bank – to potentially slow interest rate rises over the months ahead.  

However, the bank’s governor, Jerome Powell, has been trying to make sure that investors don’t get too carried away. He’s been clear with the message that, despite recent weakness, current inflation levels are too high, and the Federal Reserve will need to continue to raise interest rates in the coming months to ensure inflation comes down to a level closer to its target of 2%.  

At the end of the month, however, Powell offered the suggestion that the central bank could slow interest rate hikes as soon as its next meeting in mid-December. Financial markets are still expecting a rise of 0.5% though, which is hardly a small increase in the wider context of monetary policy moves. 

It sounds like the Fed is saying what markets want to hear – slower interest rate rises could be positive for both bonds and equities. What else was going on in November?  

Global developed equity markets rose around 7% in local currency terms. European stocks also performed well, with a relatively warm start to the European winter reflected in energy prices far below their summer highs. With this, European countries were effective in reducing their gas demand.  

Emerging market equities had a good month too, after a torrid 2022 so far, with the US dollar weakening and China-related stocks seeing a strong bounce from recent lows on the potential for a loosening in Covid restrictions there.  

Chinese stocks finished the month up 28.3% and their Hong Kong counterparts up just under 24%, while emerging markets returned just under 12% for November.  

Some encouraging signs for US inflation and global markets. Having started to see inflation move lower, do you think there’s a risk that the Federal Reserve could raise interest rates too much now, as some market commentators have suggested?  

We’re certainly seeing the impact of higher interest rates on economic activity, which has been subdued in the services and manufacturing sectors. We’ve also seen a broad-based slowdown in the housing market and 30-year mortgage rates of over 7% in November. 

That said, the labour market is yet to show signs of material weakness. Certainly, there is some slowing in the pace of hiring and the number of individuals quitting their jobs, but wage growth remains strong and unemployment low. While the jobs market remains in robust health, services inflation will remain a challenge for policy makers.  

It’s important to remember just how hard the Federal Reserve has had to work to get inflation falling. While it is no longer accelerating, inflation is still at very high levels.  

There are also other factors at play; the re-opening and unblocking of supply chains being chief among them, and here, we are now seeing material progress. As such, goods inflation is moderating, with, for example, second-hand car prices now in negative territory compared to 12 months ago. 

Where does this leave policymakers? 

The Federal Reserve has always maintained it will be data dependent in its policy, but it will need to see a clear and convincing trajectory towards its target inflation level for policymakers to ease up on their inflation fight.  

That said, having acted at pace over the summer, policymakers may have bought themselves the option to slow down as the trade-offs on growth become more finely balanced. But for the meantime, central banks will continue to raise interest rates to lower inflation.  

They are aiming for what is known as a ‘soft-landing’, raising rates enough to control inflation, but avoiding plunging the economy into a recession. This has been very difficult to achieve in the past because the effects of raising interest rates are not felt immediately – which is why, as interest rates have risen we’ve seen more talk of in recent weeks on the possibility of a recession.  

Turning to the domestic economy, we also had a rise in inflation in the UK confirmed from data published in November. What did that tell us about the situation facing UK consumers and the likely course of UK interest rates in the months ahead?  

Unlike in the US, UK inflation continued to rise in November. The consumer price index (CPI) of inflation for October hit its highest level in 41 years, with an increase of 11.1% over a year ago. This was higher than average economist and Bank of England forecasts. Food and energy prices were key to the increase, with core inflation (excluding food and energy costs) stable month on month.  

According to the Office for National Statistics, had the UK government not intervened to limit household energy bills, inflation in October would have risen further to around 13.8%.  

That will of course be little comfort to UK consumers, who have faced a sharper increase in the cost of living than anticipated. October’s data showed food and non-alcoholic beverage prices rising at the fastest pace since 1977, disproportionally affecting lower income households, as this makes up a greater portion of their spending.  

It’s astonishing to see how much prices have risen, particularly when you go to the supermarket. Is there a light at the end of the tunnel?  

In time, the UK will benefit from easing supply pressures and falling goods prices.  

From an energy perspective, crude oil and European natural gas costs remain far below their summer peak as the winter gets off to a mild start in Europe. The government’s price fix for unit energy costs is now in place, which should help limit inflation from moving further into double digits. The recovery of pound sterling against the US dollar will also help.  

But in a similar way to the US, the UK labour market remains very tight and wage growth continues to come through, even as hiring demand shows signs of slowing.  

Where does this leave the Bank of England?  

The Bank of England raised interest rates by 0.75% to 3% in November, underlining the need to act tough on inflation, which is currently five times higher than the target level.  

The Bank’s latest forecasts for the UK economy made tough reading – although they were released before the Autumn statement in mid-November, their outlook for a long, drawn-out recession is unlikely to have changed.   

Just how long and drawn out could a recession be? 

In its base case scenario, the Bank of England is expecting eight negative quarters of economic growth, the longest recession since the second world war, though a relatively mild one by historical standards in terms of how negative growth turns.  

What does that mean? Well, it means the cut to growth will not be as deep as past episodes. While it won’t be painless, we shouldn’t expect the type of environment we faced in the aftermath of the global financial crisis.  

We’re unlikely to see a very sharp rise in unemployment, for example, and when we think about the infrastructure of the financial system, it’s more resilient and less fragile now than it was in 2008.   

The Bank still expects inflation to fall sharply from the middle of next year, as energy prices normalise, and economic growth slows. However, it has cautioned that inflation is likely to remain above 10% in the near term and above 5% for 2023. 

Interestingly though, there remains somewhat of a disconnect between the Bank of England and financial market investors. They have different expectations of how high interest rates will need to rise to combat inflation effectively.  

The Bank of England’s governor, Andrew Bailey, suggested that current market expectations are too high. Investors think wage growth could continue, given the labour shortages experienced across the UK jobs market, which would necessitate further interest rate rises.    

You mentioned China when it came to top market performers for November. Earlier this month we saw images of protests from China against Covid restrictions, turmoil which would seem at odds to positive market returns?  

Even before the protests we saw signs of some loosening in the approach to Covid from Chinese authorities, despite near record high cases in China at present. For example, quarantine for travellers was cut earlier in the month.  

China’s stance on Covid has been damaging to its domestic and trade economy, and that’s had an impact on global growth too. Remember, over the past decades China’s economy has developed substantially, and it is a critical source of not just economic growth for the global system but also trading volumes.  

Restrictions have damaged that trade in recent years for the world’s largest manufacturing hub. Look no further than Apple’s current supply challenges as a symptom of a wider problem.  

That, alongside a more explicitly inwards focused policy, has damaged China’s longer-term appeal in the eyes of many western investors and businesses. Put simply, the world’s largest trading economy has not been open for trade in the same way since March 2020. 

In this environment, Chinese stock markets and wider emerging market Asia have suffered, underperforming peers as growth and confidence have faltered. A more inward-looking China and the consolidation of power in the party congress under President Xi has heightened fears over topics such as the future for Taiwan, again raising risks for investors.   

So, a loosening of restrictions, however far that goes, will be treated as good news from a growth perspective, but it won’t fully restore investors’ confidence in the Chinese economy or Chinese policymakers’ inward lens in the coming years.  

Did you and the team make any changes to the portfolios in November? 

Yes. We made a small change in our highest-risk portfolios where we trimmed our position in US financial stocks and also global energy stocks.  

Both of these positions have fared relatively well since they were introduced; so, with a view to rebalancing winning positions, we took profits on around half of both positions and reinvested the proceeds back into the wider US stock market.  

As we come to the end of another year, it’s time to ask what might be the key themes for investors going into 2023?  

We think many of the main themes of 2022 – so that’s geopolitics, inflation, and central bank policy – will continue to be an important focus for investors in 2023. Certainly, inflation will continue to dominate headlines, though we hope in a more positive way in the New Year.  

Of course, we don’t have a crystal ball and we don’t expect the macroeconomic environment to improve overnight, but we do expect there to continue to be good opportunities for investors who take a long-term perspective.  

After their sharp moves in 2022, government bond markets now offer investors better yields than they have done for much of the past decade. Equity markets also offer investors much more attractive entry points from a valuation perspective than 12 months ago, though we still think there is reason to be selective and for volatility to persist into 2023.  

We’re also looking at opportunities from the potential for strength in the US dollar to recede, what a changing landscape in China means for the outlook for emerging markets, and whether the events of 2022 that have placed such focus on energy costs and supply are a long-term positive impulse for responsible investing and energy transition.  

We’ll be updating clients with our 2023 investment outlook in the coming weeks.  

The Nutmeg investor update is available as a podcast, listen to this month’s update below.

About this update: This update was filmed on 6th December 2022. All figures, unless otherwise stated, relate to the month of November 2022.   

Source: MacroBond, Nutmeg and Bloomberg.   

As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance and forecasts are not a reliable indicators of future performance.