The drivers of the volatility continue to be the same as throughout 2022 – low investor confidence. This continues to endure due to the current backdrop; we are in a world of slowing economic growth yet high inflation. Central banks are keen to bring down inflation closer to target yet without causing long-term damage to the economy. Furthermore, the second largest economy in the world, China, is still impacting their own and global economic growth by reintroducing Covid restrictions whilst the war in Russia/Ukraine continues with seemingly no end in sight.
However, it is inflation which is primarily driving this low investor confidence. Stock markets reached a low point in June and we then witnessed a strong rebound through July and early August amid hopes that inflation had peaked (and the end of monetary policy tightening was close). The rally has given way to profit taking and higher volatility as US inflation figures were higher than expected. That said, there are some green shoots of positivity that we are nearing the end of this inflationary period both in the US and Europe. Indeed, inflation HAS fallen in the US for the last two months albeit, so far, not falling as quickly as hoped. One of the reasons we feel inflation will start to moderate is because of the way it is calculated, i.e. annually where the inflation calculation compares today’s prices to those from a year ago. As we move forward into 2023, inflation will then be taking into account the high commodity prices that immediately followed Russia’s invasion of Ukraine. To highlight this, at its peak in March the price of a barrel of oil was near to $140, whereas today it is closer to $90. Oil is not the only commodity being impacted by this pattern, big falls have been witnessed in the prices of iron ore and agricultural commodities. We have seen declines in wheat, corn, and soybean oil of 32%, 13%, 26% respectively. This should have a knock-on impact in supermarkets and restaurants in the coming months.
Supply chain issues
The global supply chain has struggled to cope since the pandemic but there are signs that these issues are being resolved and subsequently shipping costs are falling back. This dynamic has now left companies with high levels of inventories. When this happens, it typically leads to discounted prices, which again is another deflationary force feeding through, as is a slowing economy.
In the UK, the situation is slightly different compared to other developed nations because of OFGEM’s semi-annual electricity price caps. However, the recent energy support packages by the new Prime Minister will keep a lid on one of the key drivers to inflation this year. Capping energy bills means that this component of inflation will be at least stable over the next year, which potentially reduces inflation again.
Value of sterling
The value of a currency represents how a domestic economy is viewed on the international stage. The US dollar has been strong this year versus a basket of other currencies given its energy independence, perceived safe haven status and the Federal Reserve having been quicker to tighten monetary policy. Conversely, sterling has been weak due to the opposite reasons, in addition to an uncertain trading status following Brexit. In more recent days sterling has weakened further on the back of Government policy to support UK households amid the rising cost of energy and also announcing a series of tax cuts to stimulate economic growth. This mini-budget should be viewed as effectively the start of a two-year General Election campaign as otherwise loosening fiscal policy at a time when monetary policy is being tightened to tackle inflation is perverse. As the repayment of these measures is uncertain, the risk associated to the UK economy has increased and sterling has been marked lower accordingly, albeit the size of the falls in a short space of time highlights the continued nervousness that surrounds all investments at the moment. This is likely to result in UK interest rates moving higher to compensate for the increased risk whilst a weak sterling will add more pressure to the UK consumer and domestically focused businesses importing from overseas.
Sterling weakness is also not necessarily bad news from an investment perspective because overseas bond and equity holdings in different currencies have benefited and appreciated in value, as have the overseas earnings in the FTSE 100.
Investment Markets are forward looking
One of the most important points to remember right now is that investment markets are forward looking. Despite the poor media headlines on sterling, recession and inflation, investment markets look beyond the current environment and consider what could happen in the future when economic conditions improve. The effect of this is that certain companies are looking reasonably priced at current levels and this is why there has been a pickup in merger and acquisition activity in recent months, supported by the low value of sterling on the international stage. It also means that investment markets can recover strongly even when the economic news is poor, although we cannot say with certainty when investors will recognise the current valuations.
In summary, whilst sentiment is likely to remain fragile amid uncertainty as to the eventual peak and subsequent fall in inflation, the headwinds of 2022 will eventually reduce which will take the pressure off Central Banks as we move into 2023. In addition, we are moving into a seasonally strong period for markets and a US election cycle, which also historically benefits markets.
The next step
For more information or to discuss any of the issues raised in this article, please contact Andrew Lloyd-Owen on firstname.lastname@example.org, or call us directly on 0161 236 6936. Further information can also be found here.