Stock markets had a strong start to the year. Developed market equities rose 6% while emerging market stocks performed even better, up 9%. Meanwhile, bond yields fell, leading the Global Aggregate bond index to rally by 3.2%. Interestingly, the correlation between equities and bonds remained positive, like last year, but the asset classes moved together in a much more pleasing direction for investors.
The relatively mild winter has defused the energy crisis in Europe and reduced the risk of a deep winter recession. At the end of January, gas storage in the European Union (EU) was around three-quarters full, compared to only around 35% at the same time last year. The average purchase price for natural gas in January was also about 55% lower than the average price in the second half of 2022. Going forward, a more balanced gas market should mitigate some of the negative effects of the recent squeeze on the purchasing power of European households and the fiscal budgets of governments.
Exhibit 1: Asset class and style returns
The surprisingly quick end to the zero-Covid policy in China has raised expectations that the Chinese economy will experience a strong recovery in the first half of 2023, which should benefit both China and its trading partners in the region. In line with the experiences of Europe and the US, there is a considerable amount of excess savings and pent-up consumer demand in China due to the numerous lockdowns of the past years.
December 2022 inflation readings in the US and eurozone showed slowing inflation, which strengthened market hopes that central banks can end their hiking cycles soon. The prospect of less restrictive monetary policy and a weakening economy boosted demand for bonds and caused US Treasury yields to fall, particularly at the long end. That provided support for growth stocks. After outperforming growth stocks by 24%-pts last year, value stocks underperformed by 5 %-pts in January. Falling energy prices dampened momentum in the energy sector and the market rally weighed on the relative performance of defensive sectors like healthcare, utilities and consumer staples, which feature more heavily in value indices.
The December labour market report showed stronger than expected job gains and a fall in the unemployment rate to 3.5%, matching its 53-year low. However, average hourly earnings rose 4.6% year-on-year (yoy), lower than the recent peak of 5.6% seen in March 2022. If wage pressures continue to ease, the Fed may not need to push rates much higher. Headline inflation fell from 7.1% in November to 6.4% in December. Inflation was dragged lower by falling energy and vehicle prices, lower health insurance rates and lower airline fares. This was partly offset by a 0.8% increase in shelter inflation, which accounts for almost 33% of the consumer price index (CPI). However, cooling labour and real estate markets should help to take the heat off rental growth in the coming months, contributing to further moderation in consumer prices.
Exhibit 2: World stock market returns
Recent US housing activity data looks increasingly concerning. Existing home sales declined 1.5% in December. The annualised sales rate was lower than the weakest month around the onset of the pandemic. The median sale price of existing homes has now declined for six straight months through December. The situation for home-building permits is not much better. Single family home-building permits fell for a 10th consecutive month in December.
Despite poor consumer sentiment data in the past six months, US consumption data was relatively stable and contributed to fairly healthy Q4 GDP growth of 2.9% annualised. Nevertheless, a personal saving rate of 3.4% is far below the 7.7% pre-pandemic average; it likely reflects US consumers’ attempt to maintain their standards of living in times of sharply rising prices by reducing savings and increasing debt. Credit card debt rose by 15.2% yoy. This looks increasingly unsustainable as the excess pandemic savings cushion dwindles month by month. The S&P 500 rose 4.7%.
Indicators of economic activity in the eurozone surprised to the upside in January. The eurozone composite purchasing manufacturers’ index (PMI) improved to 50.2, signalling a significant improvement in sentiment and that the region might avoid a winter recession thanks to warm weather and government energy support measures. Consumer sentiment echoed this development with the fourth consecutive monthly improvement since the September 2022 all-time low. Inflation fell to 9.2% yoy in December. This is the second consecutive fall in yoy inflation and the lowest print since August 2022. The surprising resilience of the eurozone economy was reflected in equity markets as Europe-ex-UK equites rallied 8.1%. The improved sentiment also helped peripheral bonds, which outperformed German Bunds in January, contributing positively to the 2.3% return for European government bonds.
Exhibit 3: Fixed income sector returns
In the UK, inflation dropped to 10.5% yoy in December from 10.7% yoy in November. Energy and core goods inflation eased while service inflation rose as wage growth remained robust. Core inflation remained steady at 6.3% yoy. Business surveys continued to indicate that a recession is likely. Unlike in the US and Europe where most people are on long term fixed rate mortgages, the UK has a higher proportion of people on tracker or short-term fixed rate mortgages that will continue to squeeze spending as interest rates rise and some people have to refinance throughout the year. Despite the weak economic data, the FTSE All-Share rose by 4.7%.
Exhibit 4: Fixed income government bond returns
Disrupted by the zero-Covid policy and mass infections, China’s real GDP growth declined to 2.9% yoy in Q4 2022. In December, cyclical indicators deteriorated as infections peaked after lockdown measures were relaxed across the country. Retail sales decreased 1.8% yoy and industrial production decreased to 1.3% yoy, dragged lower by labour shortages. The government’s infrastructure investment push and monetary easing supported fixed asset investment, which remained relatively stable at 3.1% yoy.
Despite the weakness, December might be the bottom for Chinese growth. High-frequency indicators are pointing to a quick recovery in economic activity as infections peaked. Subway passenger flows recovered to 60-70% of pre-Covid levels in Beijing and Shanghai before Chinese New Year, and even exceeded pre-Covid levels in Shenzhen. We expect to see a sustained economic recovery in 2023 as a result of the reopening and policy stimulus. Service sectors should be the early beneficiary as pent-up demand is released. Sales of consumer goods should also pick up due to improving confidence and continued policy support.
With the significantly improved macro backdrop, the MSCI China index returned 12%, lifting the total return since its October 2022 lows to 50%.
In Japan, inflation accelerated to 4.0% yoy, the highest reading in 31 years. The Bank of Japan (BoJ) loosened its yield curve control, widening the band for 10-year government bonds from +/- 0.25% to +/-0.50%. However, in January, the BoJ had to intervene massively in bond markets to defend the new wider limit because investors are anticipating a further widening. As a consequence, the BoJ’s balance sheet exploded, dwarfing the quantitative tightening of the Federal Reserve. Therefore, global central bank balance sheets are actually, on aggregate, rising again. While the Topix performed in line with global peers (4.8%), Japanese government bonds underperformed (-0.1%).
Exhibit 5: Index returns for January 2023
The bear market in stocks and the crash in bonds in 2022 have created an attractive entry point for investors in both asset classes, from a long-term perspective. So far, January has shown that after a difficult 2022, and with inflation now falling, both equities and bonds can deliver positive returns for investors. Nevertheless, opportunities and risks remain. The end of China’s zero-Covid policy and a surprisingly resilient European economy as gas prices fall, should support corporate earnings. However, the downside risk from the improved growth outlook would be if it leads to more stubborn inflation and tighter monetary policies from central banks. We called our 2023 investment outlook “A bad year for the economy, a better year for markets” on the view that markets had already priced in a lot of bad news. Performance in January certainly suggests that was the case.