December Market Update: Inflation falls but so do stock markets

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What's moving markets

Santa didn’t get the memo. Hopes of a year-end rally for investors faded as Christmas passed, though there was cause for optimism in the CPI numbers as we kicked off 2023. The US saw a decrease from 7.7% in October to 7.1% for the 12 months ending November. Month-on-month, the CPI climbed by 0.1% compared to 0.4% the month before. This news sparked a rise in stocks and government bonds as investors bet that the Federal Reserve may not have to continue its aggressive rate-rising to bring inflation under control.

In response to the falling inflation rate, the Federal Open Market Committee slowed its pace on rate hikes by increasing the FED fund rate by 0.50%. With a range of 4.25 – 4.50%, this was the 7^th hike of 2022 and the highest FED fund rate in 15 years. Despite the reductions in October and November, Jerome Powell warned that “it will take substantially more evidence to have confidence that inflation is on a sustained downward path.” Consensus forecasts are that interest rates will remain elevated throughout 2023, with a terminal rate of 5.00% – 5.25%.

In the UK the latest data for December shows for the 12 months up to November, the inflation rate fell to 10.7% from the 11.1% recorded in October. An ease in in the rise of petrol costs was the factor in helping to bring the inflation rate down from a 41 year high. Month on month, the CPI also slowed with a rate of 0.4% recorded compared to the 0.7% in October.  Goods prices have led the declines, but service price inflation remains level. In December, the Bank of England raised interest rates by 0.50%, bringing the UK Bank rate to 3.5%.

The UK economy, saw a bounce back in the latest data with GDP rising by 0.5% in October, following a fall of 0.6% in September. Despite the recovery seen in October, the data for November and December is likely to show a contraction, and with it a second quarterly GDP decline signalling the technical definition of a recession. The headwinds experienced by the UK economy throughout 2022 seem likely to continue throughout 2023.  

In Japan, policymakers surprised the markets by tweaking the country’s long-standing yield curve control. The policy, aimed to pin the 10-year government bond at around 0% to stimulate the economy – had its target widened from 25 bps either side to 50bps. The move was intended to bring life back into a dormant bond market, but other markets were sceptical. The Yen surged against the dollar following the announcement, while stocks fell.

China is experiencing a surge in Covid cases following President Xi Jinping’s wide raging relaxation of the zero Covid policy after mass protests in the country and a weakening economy. It will take time to see what impact a spike in Covid cases has on production, but the latest Manufacturing PMI numbers in China fell to 40.9 in December, the lowest point since September.

Asset class implications

The rally in government and corporate bonds came to a halt in December. Despite positive news on inflation, central bankers’ mission to dampen its rise is far from over. Rates may need to go higher than initial expectations, albeit at a slower pace. The volatile year in bonds continued until the end, but despite the headwinds of 2022, the outlook for bonds in 2023 is far brighter.

In sterling terms, all major equity markets were in negative territory over the month, with the FTSE USA delivering the weakest performance, declining by 6.80%. The large cap tech stocks that dominated performance over the past decade had a year of reckoning. Markets have continued to assess the valuation of these stocks in a higher interest-rate environment. The question now is: how will profit margins fare with higher capital and input costs? Time will tell whether markets have priced in an earnings compression.

The UK, Europe and Emerging markets continued to price in the impending economic downturn throughout December with less severity than the US. Valuations in these regions now look attractive from a historical viewpoint. China bucked the equity declines with the FTSE China index rising by 4.15% over December, following the news that China was ending their zero Covid policy and reopening to the world. 

The outlook for growth stocks remains uncertain, and the likes of oil and gas companies could well outperform over the shorter term as supply remains tight. Companies that own tangible assets and pay dividends are also likely to hold their own, as their stable revenue streams and cash generative qualities look more attractive in a higher interest and inflationary environment.

Weakness in UK property persisted as interest rate rises continued, along with valuation adjustments and a decline in transaction volumes. Where property was typically valued on a monthly basis, we’re now seeing this move to fortnightly. This may increase volatility across the asset class, and with government bonds now yielding more than 3%, the attractiveness of property income may diminish further.

This article is for financial professionals only. Any information contained within is of a general nature and should not be construed as a form of personal recommendation or financial advice. Nor is the information to be considered an offer or solicitation to deal in any financial instrument or to engage in any investment service or activity.

Parmenion accepts no duty of care or liability for loss arising from any person acting, or refraining from acting, as a result of any information contained within this article. All investment carries risk. The value of investments, and the income from them, can go down as well as up and investors may get back less than they put in. Past performance is not a reliable indicator of future returns.