Quilter Cheviot|Weekly Comment

Bright start to 2023

Market Overview | Quilter Cheviot

By Alan McIntosh, Chief Investment Strategist

A positive reaction to a series of key economic releases saw global equities start the new year on the front foot, with the MSCI All Country World Index gaining 2% in the first week of 2023. Europe (+6%) led the way, supported by data showing inflation is slowing, and there were also solid gains for the UK (+3.3%) and US (+1.5%). These moves were underpinned by a sizable decline in bond yields, as the German 10-year bund fell 36 basis points to 2.21% for one of its largest weekly declines in years. The US 10-year Treasury followed a similar path, dropping 32 basis points to end at 3.56%, while 10-year gilt yields in the UK dropped 19 basis points to close Friday at 3.47%.

The first US nonfarm payrolls release of the year was the most anticipated event of last week, showing 223k jobs added in December. Although this was the smallest increase in two years, it still represents a strong figure and topped consensus forecasts. The unemployment rate dropped back to its joint-lowest level in decades at 3.5%, in another show of labour market strength. Given the current inflation dynamics, strong employment figures are not seen as particularly supportive of stock markets, but fears of higher price pressures were allayed somewhat by encouraging wage data which showed a significant cooling in average hourly earnings. For December the 0.3% month-on-month increase was lower than expected and the previous month’s figure was also revised down, lowering the year-on-year gain to 4.6% – the lowest level since September 2021.

There will clearly be a greater focus on employment data this year as investors closely watch labour markets for signs of weakness, but although there was a significant reaction to the jobs report, the larger market move came shortly afterwards when a closely followed services sector survey fell far more than expected. The Institute for Supply Management’s (ISM) index dropped into contractionary territory for the first time since May 2020, due to a sharp slowdown in new orders. The reading of 49.6 was well below the 55.0 consensus forecast after a prior reading of 56.5. 50 denotes the line between expansion and contraction. There were mitigating factors around the big miss, such as the adverse impact of extreme weather in North America over the last month and seasonality due to the holiday period, but you would have thought these were reflected in consensus expectations.

The data sparked a large move in bond markets, with the US two-year Treasury yield experiencing one of its largest daily falls since the Federal Reserve (Fed) began its aggressive tightening campaign last year. Derivatives markets are now expecting a 25 basis point increase at the Fed’s next monetary policy meeting to mark the end of the current hiking cycle. Equities moved strongly higher into the weekend following the data as investors began to price-in a less aggressive Fed going forward.

There appears to be a near-term growing consensus among market participants that the central bank can achieve a “soft landing”, whereby high inflation fades, and the economy avoids a significant recession. There does appear to be a rose-tinted element to the way investors reacted to Friday’s numbers, choosing to take the jobs report as suggestive of a strong labour market and the weak ISM figure, along with falling wages, as more likely to cause a less aggressive Fed. An alternative, more pessimistic, take would be that the labour market remains close to the tightest levels on record and the economy is stuttering significantly, well before the full effects of restrictive monetary policy has fed through.

Eurozone inflation falls back

The latest eurozone consumer price data showed falling energy prices helped push inflation in the bloc back below 10%, following two consecutive double-digit prints. A reading of 9.2% was well below the 9.7% consensus estimate. The cost of natural gas fell back to levels not seen since before Russia invaded Ukraine and major stock benchmarks rallied, with Italy (+6.2%), France (+6.1%) and Germany (+4.9%) all moving strongly higher. While the headline figure was pleasing the core reading, excluding food, energy, alcohol and tobacco prices, was less so, rising more than expected to 5.2% – the highest level for this cycle.

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