Persistent inflation and strong economic data have fuelled concerns that central banks may have to raise interest rates by more than expected and hold them there for longer.
Financial markets enjoyed a strong start to 2023, with signs that inflation had peaked suggesting that central banks would be able to reduce interest rates later in the year. However, this optimism faded in February.
US government bond prices fell owing largely to continued talk of ongoing interest rate rises from various Federal Reserve (Fed) members. The country’s economy appears to be holding up, with inflation remaining around 6% in January and the employment market showing signs of strength. Job vacancies in December were much higher than expected, new jobless claims remained low, the unemployment rate dropped further and payroll data was higher than forecast.
The Fed raised its benchmark interest rate by 0.25 percentage points to a range between 4.5% and 4.75%, following six consecutive larger increases, and acknowledged that further rises are likely. Markets were encouraged that Fed Chairman Jerome Powell didn’t oppose their recent optimism, although some of his colleagues suggested rates could rise beyond 5%.
The US central bank believes restrictive monetary policy will be necessary until there are clear signs that inflation is heading back down towards its 2% target. The implication is that interest rates could stay higher for longer.
Geopolitical tensions were also a cause for concern. Markets dipped after an alleged Chinese spy balloon was shot down off the coast of South Carolina. Meanwhile, Russia said it is suspending its participation in the New START nuclear arms reduction treaty with the US.
Brexit deal could boost UK growth
In late February, a Brexit deal emerged that could positively impact UK trade and investment. After months of work, UK Prime Minister Rishi Sunak and President of the European Commission Ursula von der Leyen announced a new deal, aimed at fixing post-Brexit problems in Northern Ireland.
UK consumer prices continued to rise in January, with annual food inflation still above 10%. The Bank of England (BoE) raised rates by 0.5 percentage points to 4%*. The UK narrowly avoided recession after fourth quarter GDP was reported as flat after growth fell by 0.2% in the third quarter. Although the UK escaped a technical recession, December’s economic numbers were disappointing.
Wage growth is heading towards 7%, which is not compatible with the BoE’s 2% inflation target. However, job vacancies have been falling for eight months, which should ease the pressure eventually. Consumer price inflation fell by more than expected in January to 10.1%, while public sector borrowing was less than forecast. On a positive note, the UK stock market reached a new closing high in early February, passing the previous peak set in May 2018.
Euro area inflation stays high
In the euro area, core inflation remains high, and the European Central Bank (ECB) raised rates by 0.5 percentage points in February, with another 0.5% rise pencilled in for March. The bank also intends to begin selling bonds back to the market – a process known as quantitative tightening – at a rate of €15 billion per month on average through to the end of June.
The region’s economy grew by just 0.1% in the fourth quarter of 2022, in part due to government spending on support for consumers and businesses.
A mixed results season
The results season has been mixed, with companies exceeding expectations marginally. Sales have increased on average, but profit margins have fallen. The expected fall in profit forecasts for 2023, which we’d expected, are generally coming through, but rising share prices are making valuations more expensive.
Martin Lawrence, Director of Investments at Wesleyan, said: "In the short term, we feel financial markets have risen too far too quickly. Over the longer term, stock and bond markets continue to offer value for investors. Given the more attractive yields now available in fixed income markets – owing to higher interest rates – we have been purchasing corporate and government bonds for some of our funds.
"We also believe the commercial property sector looks attractive, which is still reeling from last year’s interest rate increases, and we are looking for investment opportunities."
* Bank of England