Market Commentary
Economic Backdrop
Will they, won’t they? By how much, by how little? These were questions which dominated the limelight during the last 6 months, as investors, economists and market analysts alike tried to work out what the likely path for interest rates was. These were prevalent for most major developed markets, including the UK, US, Eurozone and Japan.
As a result, investment markets were focussed on economic data or rhetoric from central bankers which could provide an indication of their future direction. Markets reacted accordingly, which was particularly prevalent if the announcements took the market by surprise. In some instances, good news was good news. In others, good news was seen as bad news. For example, any economic data which suggested that interest rates may not fall as much as expected was seen as a potential negative for economic growth, with repercussions seen in asset markets.
In the UK, inflation fell below 2% during the period, with a reading of 1.7% recorded in September. This figure below the 2% target was expected to be transitory and that proved to be the case. Since then, we have seen consumer price inflation rise again, with a reading of 2.5% released in December. Much of the increase can be attributed to base effects and the pick-up was very much expected. All the same, there are elements behind the headline figure which are proving ‘sticky’.
The first is inflation within the services sector. Whilst goods inflation has been tamed, inflation here remains higher than the Bank of England would like to see. Secondly, we have wage inflation, which continues to run at an elevated level. The last reading, which was to November, showed that wage growth including bonuses stood at 5.6%. This is comfortably above the current rate of inflation and implies that the spending power of the UK consumer is improving. This is a positive for the economy, assuming of course that it is spent, rather than saved.
In the US the issues around inflation are similar. Whilst goods inflation has been contained, although it has recently seen an uptick, services inflation remains above a comfortable level. Wage growth again remains above the rate of consumer price inflation and jobs continue to be added to the economy at a fair rate. One area which could help see overall inflation come down is housing costs, or rent. This is very much a lagging indicator; however research shows that these are heading lower. This is a material component of the inflation basket in the US.
Still, for now, consumer price inflation continues to run above target at 2.9%. At the same time the economy continues to run hotter than others around the world, something which took people by surprise through 2024. As a consequence, the expectation of interest rate cuts has been pulled back. The last dot-plot issued by the Federal Reserve (the Fed), a summary of interest rate expectations by voting members, suggested that 4 could be seen through 2025. The market however, now expects no more than 2. At their January meeting the US central bank left rates on hold at 4.25%-4.5%, with Chair Powell commenting that the Fed is in no hurry to lower interest rates and that they are keen to see further progress on inflation first.
In the Eurozone the ability to cut interest rates has been greater and the European Central Bank (ECB) has acted accordingly. Since their rate-cutting cycle began they have now cut 5 times, with the deposit facility rate now standing at 2.75%. Whilst inflation remains above target at 2.4% the ECB remains confident that it will move towards the 2% level. The central bank is conscious of weakness within the economy, with an industrial recession, high energy costs and weak spending by consumers. A stuttering Chinese economy has also acted as a headwind, a home for its exports.
At the end of January, the Bank of Canada took the decision to cut it’s interest rate by 0.25% to 3%. This means that they have had 2% of rate cuts since the cutting cycle began in June 2024. This recent change was in line with market expectations and comes despite the central bank forecasting that economic growth will pick up in 2025. They forecast that the economy will grow by 1.8%, which is an improvement on the 1.3% growth which is expected to be finalised for 2024. Despite this improvement the central bank also took the decision to end quantitative tightening and they announced they will restart asset purchases in March, with the aim of supporting the traction of that economic growth, whilst also ensuring liquidity.
What for the future? The latest forecast from the International Monetary Fund (IMF) released in January saw a marginal improvement from their October forecast. They now believe that the global economy will grow by 3.3% in 2025, a pick-up of 0.1%. Whilst they saw little change as a collective, it is emerging market and developing economies that are expected to post the highest levels of growth at 4.2%. At the individual country level, it is China and India which are expected to be the driving forces, with growth figures of 4.6% and 6.5% respectively.
The forecast economic growth rate for advanced economies is more subdued, at 1.9%. This represents a 0.1% uplift from the previous forecast given. Whilst the forecast saw little change at the top level there were some notable movers in terms of the underlying countries. US exceptionalism looks potentially set to continue, with the IMF now forecasting a growth rate of 2.7% for 2025, an uplift of 0.5% from October’s estimate. Reasons provided included strong wealth effects, a less restrictive monetary stance and more supportive financial conditions.
Conversely, we saw a write down in expectations for the Euro area. Whilst growth is still forecast to be seen in the power houses of Germany and France, their growth rate was reduced by 0.5% and 0.3% respectively. These changes were made to reflect weakness in manufacturing and goods exports, even though consumption saw a pick up thanks to a recovery in real incomes, with wages continuing to grow at a quicker rate than inflation. The UK economy is forecast to grow by 1.6% in 2025. This marks a 0.1% uplift from the previous forecast and a more marked uplift from the 0.9% which they estimate the economy grew in 2024.
Given the potential for geopolitical influences, however, there are some risks to the downside which lurk out there. One such risk identified could be if we see an increase in protectionist policies, such as tariffs, which could heighten trade tensions and have a negative impact on supply chains. As always there is a counter argument, in that economic activity could rebound if governments can forge new deals quickly. As always with forecasting, there will be many variables which can unexpectedly alter the outcome.
Whilst the pace of economic growth across countries varies and is expected to continue to do so, for now the challenge of trying to work out whether we will have a hard or soft landing appears to have disappeared. A no landing environment is now the most widely expected. There are expected to be pockets of strength, such as US exceptionalism, and pockets of weakness, but overall, for now, the global economy looks set to continue to grow.
Equities
There was a mixed performance from major equities during the period in local currency terms, as highlighted in the table below, although all those shown managed to end the period in positive territory. In sterling terms, which is ultimately what a UK investor would receive, there were some notable differences. For example, the return for the Hang Seng in these terms was higher at 20.80%. The return from the S&P 500 on this basis was also higher, at 13.07%.
Like in the previous 6-month period, the Hang Seng continued its rebound from its earlier lows. Whilst the economic outlook for China remains somewhat depressed, particularly at the consumer level, Chinese shares were trading at low levels not seen for some time. Despite the recent rally, they still continue to trade below longer-term averages. Whilst the Chinese authorities have continued to make incremental changes to support the economy, in the hope that this would flow through into the stock market, this time around they have held back implementing a ‘big bang’ method. Despite the rise seen in the equity market, investors still remain apprehensive around the economic outlook.
The US remained one of the strongest performing markets, although the rise was by no means a straight line. The stocks within the Nasdaq again remained key drivers, with the Nasdaq Composite outperforming the S&P 500 index. On the back of Trump winning the presidential election the Russell 2000, an index which covers stocks of a smaller size, saw a sharp upward spike. The promise by Trump to lift what he believed was cramping legislation was seen as a positive for domestic economic growth.
This favoured mid and small sized companies. This rally petered out, however, through December and January.
Despite economic weakness and woes continuing in Europe the Euro Stoxx 50 posted a strong absolute return, only a little behind the S&P 500 in local currency terms. After a strong previous 6 months the returns from UK equities was not as positive this time around. Large cap stocks were the strongest performing, although like other UK companies spent most of the period in negative territory, only climbing into the black in the second half of January. Mid and small cap stocks meanwhile remained in the red throughout the period. Concerns over the budget weighed on sentiment regarding economic growth, to which these stocks are more sensitive. With inflation ticking up the prospect for interest rate cuts was also dialed back. This was again seen as a negative for growth and could also mean that funding costs for companies stays that little bit higher for longer.
Japanese stocks, by reference to the Nikkei 225, managed to just scrape into the black for the period after what was a very difficult August. The index plunged more than 20% at the beginning of August, in what can almost be termed a flash crash. The catalyst was a surprise interest rate hike by the Bank of Japan. Whilst the size of the move was small, it caught investors unaware. A statement by the central bank following the announcement was also taken as meaning that there were more hikes to come. This came at the same time that the US Federal Reserve was still expected to be cutting rates and therefore the interest rate differential between the US dollar and the Japanese yen would narrow.
This led to the unwinding, potentially only partial, of the carry trade, whereby investors borrow in a low yielding currency to invest in a higher yielding currency. This caused the yen to appreciate notably. Investor behaviour for a long time has predicated that a stronger yen is a negative for Japanese corporate earnings and therefore share prices fell sharply. The Bank of Japan was quick to clarify that their statement had been misinterpreted and that whilst further interest rate rises may be seen, these would be measured and only as the economy dictated. The stock market subsequently saw a sharp recovery but was unable to make much headroom from their end of July levels.
Fixed Income
The returns from UK fixed income assets classes were mixed for the period on a total return basis. Yet again it was the high yield (non-investment grade) segment of the market which was the strongest performing. This sub-asset class is less sensitive to interest rate expectations and therefore escaped the higher level of volatility which was seen in the performance of gilts and investment grade corporate bonds. The pricing for high yield bonds is more sensitive to changes in the credit outlook.
Whilst the observation is clear that credit spreads, the amount of additional yield you receive above that offered by a gilt for taking on the credit risk, are tight, history has shown this can remain the case for extended periods of time. As long as economic and in particular corporate fundamentals remain positive, the cycle can continue, assuming we don’t see investor apathy. Any notable pick up in defaults on payments in the sector would be a warning light, but for now they are not a concern.
Source: FE Analytics
The performance of UK gilts and investment grade corporate bonds meanwhile is highly influenced by changes in interest rate expectations, which are of course driven by the economic and inflation outlook. Gilts enjoyed a relatively positive start to the period, with the UK Gilts All Stock index up c.2.5%. From the end of September to mid-January, however, gilts endured a period of weakness, with prices falling, and yields rising. Sterling corporate bonds followed a similar pattern of returns but managed to end the period in positive territory. This was helped by credit spreads remaining tight but also what credit spread there was contributing to a higher return.
There were two key reasons for the weakness. The first was related to the path of inflation. Whilst in the UK and US the level of inflation has undoubtedly come down, the current level is still above the preferred level of 2%. It was predicted that the ‘final mile’ would be the hardest, however it has proven a little harder to achieve than some may have expected. Wage inflation has proven stubborn in the UK and the US, and in the latter it has also taken longer for housing costs (rent) to come down, although this is very much a lagging figure.
Western central banks have made it very clear in their statements surrounding interest rate decisions that there is no set path moving forward. Any decision taking regarding such will very much be dependent on what is known to them at the time. Whilst economies are not necessarily booming, they certainly do not appear to be in a recessionary status right now. This has afforded more time to judge rather than jump. Also contributing to the inflation conundrum was Donald Trump. He made it clear throughout his campaign that tariffs would be coming. The introduction of such could prove inflationary as it would raise the cost of goods on which they were imposed.
The second factor impacting bond yields was bond supply. With governments continuing to spend their fiscal positioning continues to worsen. Current account deficits continue to expand. The larger this position becomes, the greater the amount of debt the Government needs to issue to fund it. This brings into question the credibility or credit worthiness of bonds issued and led to investors demanding a higher coupon for accepting that risk. In reality, for example, the UK or US government are highly unlikely to default on their bond coupon payments or capital repayment obligations. But that did not stop investors begging the question all the same. These fears were alleviated somewhat towards the end of January. The auction of 15-year gilts was well received by the market, with the amount being issued being covered many times over by bids received. The yield was clearly enough for fixed income investors. This helped both gilt and corporate bond prices tick up/yields fall as we reached the end of January.
This article is for information purposes only and should not be construed as advice. We strongly suggest you seek independent financial advice prior to taking any course of action.
The value of this investment can fall as well as rise and investors may get back less than they originally invested. Past performance is not necessarily a guide to future performance. The Fund is suitable for investors who are seeking to achieve long term capital growth.
The tax treatment of investments depends on the individual circumstances of each client and may be subject to change in the future. The above is in relation to a UK domiciled investor only and would be different for those domiciled outside the UK. We strongly suggest you seek independent tax advice prior to taking any course of action.
Sign up today!
You can unsubscribe at any time by emailing enquiry@lowes.co.uk or by clicking the ‘unsubscribe’ link at the bottom of each email.
Full details of how we use and secure your personal information and how to update your marketing preferences can be viewed in our Privacy Policy
