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Dear Investor

General Market Overview

Globally, particularly in the US, inflation data and the resulting interest rate impact dominate the macroeconomic and market environment. The Federal Reserve (the Fed) (and other central banks) are racing to slow inflation before it becomes “entrenched”. Recent data releases would indicate that they are currently struggling with that objective.

US inflation did reduce slightly in January (6.4% y/y), and while this is below the peak of 9.1% y/y from June 2022, it is still three times more than the Fed’s targeted inflation rate of 2% and continues to suggest a broad-based increase in prices.

Given the inflation data, almost all Federal Open Market Committee (FOMC) participants agreed that it was appropriate to raise the target range for the federal funds rate by 25bps at the first monetary policy meeting of 2023. However, a few officials favoured raising it by 50bps. This recent decision has pushed borrowing costs to the highest since 2007. All committee members continued to anticipate that ongoing increases would be appropriate until data provided confidence that inflation was on a sustained downward path to 2%, which would likely take some time.

Another element of the US economy that is likely to lead to more persistent inflation is the strength of the US job market. Currently, there are 1.9 jobs available for every unemployed person. Even in the mid-2000s economic boom, there was less than one job available for every person searching for employment.

A tight labour market will keep wage-price inflation high, with Federal Reserve Chairman Jerome Powell commenting that employment trends suggest the fight against inflation could last “quite a bit of time”.

Given the interest rate environment, it is unsurprising that 2022 was the worst year for global bond markets in over a century and marked the end of a four-decade-long “golden age” for the asset class. Global bonds lost 31% (United Kingdom (UK) bonds losing 39%), the worst annual performance for fixed income in data stretching back to 1900.

This performance sharply contrasts with the “reliable” returns that bonds recorded between 1982 and 2021. During those years, the World Bond Index annualised a real return of 6.3%. Those investors expecting bonds to provide them with a safe haven during the equity market sell-off last year had an unwelcome surprise waiting for them.

Some investors have started buying bonds to mitigate the effects of an anticipated recessionary environment in 2023. However, when reviewing market history, the point at which the Fed starts easing interest rates tends to be a better timing indicator for fixed income investment.

In inflationary cycles, interest rate reduction typically only happens after the start of the recessionary period. Investors may point to the 2000 and 2008 cycles, as in both cases, bond yields started to fall before the recession, but in those cases, the Fed also began to ease rates before the recession.

Instead, a more appropriate period for comparison with the current environment is the 1970s and early 1980s. Rates were kept elevated well into the recessionary period, and interest rates and bond yields only started falling when the Fed began to reduce rates.

The Federal Reserve Bank of New York’s Centre for Microeconomic Data recently issued its Quarterly Report on Household Debt and Credit. The report shows an increase in total household debt in the US, with an increase in credit card debt, auto loan balances, student loans and mortgage balances.

The increase in total debt in 4Q22 is the largest nominal quarterly increase in 20 years. Also rising are delinquency rates. The delinquency level still appears relatively low but has increased more significantly in auto loan and credit card debt, particularly for younger borrowers.

Rising interest rates are an obvious contributing factor to the increasing level of delinquency. Auto loans in the US tend to be on a fixed rate basis, so only newer auto loans feel the effect of increased rates; however, credit card debt is variable.

The other potential factor driving increasing delinquency is inflation. Admittedly, the two (interest rates and inflation) go hand-in-hand. Americans have been facing higher prices on all items, including purchases they may be putting on their credit cards. Increasing prices and, correspondingly, increasing debt service payments may be cutting borrowers’ balance sheets and making it more difficult for them to make ends meet, mainly as real disposable income fell in 2022.

The US is, of course, not the only country to be experiencing more “sticky” inflation. German inflation rose to 8.7% y/y in January, with the main contributors being “cost of living” components, namely, housing, water, electricity, gas, and other fuel.

Inflation in February rose 7.2% y/y in France and 6.1% y/y in Spain. European government bond prices have fallen sharply and yields across the Eurozone have risen. Therefore, it is unsurprising that the European Central Bank (ECB) has maintained its hawkish tone and is likely to raise rates by a further 50bps in March. A March increase would take the rate up to 3%, which is quite a reversal from negative 0.5% last year. European money markets are pricing in a 4% interest rate by the end of the year.

General Conclusion

There is no doubt that the macroeconomic and market environment remains challenging. It is increasingly clear that what was initially marketed as “transient inflation” due to Covid-related supply chain disruptions has become a more entrenched phenomenon. With their inflation-targeting mandates, central banks have no alternative but to raise interest rates to slow and reverse some of the inflationary effects.

A sharply rising interest rate cycle differs from the conditions markets have experienced recently. Increased rates feed into the pricing of multiple financial assets, particularly when assessing the present value of future prospective cash flows.

Rising interest rates also impact non-financial assets by slowing credit lending by the banks and increasing delinquencies. As borrowing costs increase, companies needing re-financing may choose to curtail their expansionary ambitions.

Therefore, the macroeconomic environment impacts both financial markets and the “real economy” in various ways, increasing the risk of economic slowdown and reducing appetite for what are perceived as riskier assets.

14 March 2023

General Market Commentary Q1 2023
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