February Market Update

Last year was a very disappointing one for investors. For starters, equity markets produced their worst annual returns since the Global Financial Crisis. The US equity market, for example, was down 19% while our local market was down 12%. This was unfortunately compounded by bond markets delivering their weakest annual returns in decades.

We’ll remember last year as the year in which many countries around the world experienced the highest rates of inflation since the 1980s. As central banks started to view the higher levels of inflation not as transitory, but instead as more persistent, they increased their target interest rates aggressively. This saw bond yields, which move in the opposite direction to bond prices, rise rapidly. At the same time, equity investors started worrying that the strong monetary response from central banks would lead to a global recession.

Fortunately, it’s not all doom and gloom. The final quarter of 2022 ended with some light at the end of the tunnel, as risk sentiment turned more positive. This was on the back of the US Federal Reserve (Fed) reducing the size of the interest rate increase it delivered in December (opting for a 0.50% increase, as opposed to 0.75%); China easing its zero-COVID approach earlier than anticipated; and a milder start to winter in Europe that translated into lower energy prices.

It’s the beginning of a new year and as we consider how things may unfold, we are cautiously optimistic. Inflation looks like it has peaked in several countries such as the US and Canada), while it’s close to peaking in others. We’ll therefore likely see only a few more interest rate increases from most central banks during the first half of this year. Bonds look a lot more attractive now than they did a year ago. The yields offered by these securities are appealing, and they potentially provide greater downside protection (versus more recent years) if equity markets fall.

The harder question to answer is how equities may perform this year. As we know, several economies around the world are expected to experience slower growth, which will have a negative impact on the earnings of companies. That said, financial markets are forward-looking, and so some of this ‘bad news’ will already be priced in. There are of course many different scenarios of how things could pan out, but it seems unlikely that the world will enter a deep recession. The reasons for this are as follows:

1. Central banks look like they are getting inflation under control. As such, we’re potentially close to the peak in interest rates.
2. China easing its zero-COVID approach means that the world’s second largest economy will return to stronger growth sooner, which will support global growth. There should also be fewer supply chain disruptions.
3. There has been a strong policy response from governments in Europe to counter the energy crisis.
4. Although jobs will be lost as global growth slows, it is not anticipated that unemployment rates will rise sharply. For example, the Fed is expecting the US unemployment rate, which was 3.5% at the end of last year, to reach 4.6% by the end of this year. That’s still low by historical standards when one considers that the US unemployment rate has averaged 6.2% since 1980.

If all goes according to plan, the global economy should start recovering by the end of the year. Nevertheless, although unlikely, a key risk for equity markets this year is that the rapid tightening of monetary policy by central banks in 2022 may lead to a more severe recessionary scenario. As always, the challenge with implementing monetary policy is that there is a significant lag between when a decision is made and when its impact on economic activity is realised.

This article is solely for information purposes. It’s not financial or other professional advice. For help, please contact BNZ or your professional adviser.

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