Good news for economies is currently bad news for equities

Recent months have seen investors’ focus remain on central banks’ policy decisions and any data that might give sway to the direction of interest rates. It has been a story of weaker economic data being good news for financial markets and stronger data seen as bad news.

with Andrew Wyllie ] Forsyth Barr

The reason for this is that stronger economies point to the need for central banks to hike interest rates more aggressively in order to bring inflation down. That, in turn, is generally negative for equity markets as it often means that consumers and firms are less likely to spend, company earnings will slow, and stock values come under downward pressure. This trading pattern seems well established for now.

Growing optimism at the start of 2023 that global central banks could ease off interest rate hikes prompted a decent rise in stock market values. But better than expected economic data in February has prompted a re-think and seen market pricing for interest rate hikes shift significantly higher. This has offset some of the equity market gains seen in January.

Expectations are for central bank policy rates to peak at higher levels around mid2023. Beyond then, central banks are likely to keep policy interest rates on hold until they’re sure they have slain the inflation dragon. The big question for investors remains whether economies can navigate a “soft landing”, or if the extent of monetary policy tightening will be too much and push economies into a recession. At this stage, the market appears to be in the “soft landing” camp, but risks to the downside remain.

Negatives turning

Stepping back from the daily noise of watching inflation data, there are signs some that the major challenges in global economy and markets are starting to abate. It has been a turbulent few years.

After a strong bounce in the 18 months or so post the Covid crash, in 2022 we suffered the hangover from the withdrawal of substantial government and central bank economic support, rising interest rates to combat soaring inflation, a commodity supply shock after Russia invaded Ukraine, and China’s tight zero-COVID restrictions and property slump.

Several of these negative factors have now lessened or turned positive:

• Inflation appears to have peaked for most developed economies and, although it generally remains above central banks’ targets for now, it is now heading lower in most economies. The question is now, how fast can central banks get inflation back towards their targets (most countries target a pace of 2–3% inflation) and how long they will need to keep monetary policy restrictive in order to achieve this?

• There has been some relief from the commodity shock that hit after Russia invaded Ukraine. Energy prices in Europe have fallen back from being up +40% year-on-year to around +17% in January. European natural gas prices have returned back to levels seen prior to Russia’s invasion of Ukraine, aided by a mild winter and countries diversifying their energy supplies. Food prices have also declined from peaks seen last year (albeit, they remain above pre-war levels).

• China’s economic re-opening has been a significant positive since December and the expectation is that this will provide a decent demand boost for Australasian exports, especially in the near-term. The anticipation of increased economic activity in China has driven the price of industrial metals (such as copper, tin and iron ore) sharply higher in the past few months. The Chinese economy is now expected to grow by a solid 5.2% in 2023 based on the latest forecasts from the IMF, a big upwards revision from its previous forecast of 4.4% growth.

Remaining on the challenging side is the ongoing decline in global property markets in response to rising interest rates. Declining house prices remain a risk to household confidence and spending.

So far this appears to have been reasonably well offset by strong labour markets and pent-up demand and savings still flowing after post-pandemic lockdowns.

Maintain an even keel

After the rough ride through 2022, the first couple of months of 2023 have been more of a mixed bag. We kicked off the year with a roar but a more cautious tone has now filtered in.

There will undoubtedly be external shocks and some bumps in the road as markets manage the transition to more subdued growth and higher interest rates in coming months.

The potential for interest rates to start declining again from late 2023/ early 2024 could be helpful for equity markets, but it will depend on what drives interest rate cuts. Assuming inflation comes gently down and economies remain solid then, all else equal, that should be positive for equities.

The risk remains that inflation and interest rates get driven lower by a sharper contraction in economic activity which would be a negative for equity markets. As we’ve experienced in recent years, external shocks and surprising data can alter the investing landscape quickly. It remains important for investors to be flexible and prepare to navigate a range of potential outcomes in the year ahead.

This article was prepared as at 28 February 2023 and provides market commentary for the three-month period ending on that date. We appreciate that market volatility and economic uncertainty doesn’t make an easy backdrop for investors. To discuss your investment options please contact Andrew Wyllie, who is an investment Adviser and is Forsyth Barr’s Christchurch Branch Co-Manager. He can be contacted regarding portfolio management, fixed interest, or share investments on 0800 367 227 or andrew.wyllie@forsythbarr. co.nz This column is general in nature, has been prepared in good faith based on information obtained from sources believed to be reliable and accurate, and should not be regarded as financial advice.