13 Feb 2023
Paul Niven, Fund Manager, F&C Investment Trust
Rising inflation and interest rates, in combination with geopolitical concerns concentrated around the war in Ukraine and zero-Covid policy in China, weighed on global equities in 2022. As we look ahead, it is clear that the outlook for inflation and interest rates will continue to be key market drivers in 2023. However, inflation appears to have moved past its peak and the focus is now turning to its persistence. This will inform how soon central banks shift from hiking rates towards a more accommodative stance.
The US Federal Reserve (Fed) is, of course, the most influential of the global central banks. And for the Fed, there is a view that inflation may well remain sticky unless there is meaningful weakness in economic activity and labour markets. Nervous about making a policy error, the Fed has stressed the need for a prolonged period of high rates to combat core inflationary pressures. For this reason, the key to the outlook for inflation is the labour market. Without clear evidence of labour market weakness, the Fed will likely remain hawkish. That said, we are already seeing a number of significant Covid winners such as Amazon and Meta (as well as Goldman Sachs) announcing job cuts.
In Europe, soaring energy prices have been the catalyst for inflation and the higher interest rates have coalesced discussion around the potential depth and length of recession. Nearly half of respondents to Bank of America’s December Global Fund Manager Survey1 said the biggest risk for 2023 was that impending recessions prove more severe than anticipated. This is in contrast to the US where a mild and short-lived recession has been widely accepted by market participants.
Fortunately, European natural gas prices appear to have been muted by an unusually warm winter in Europe, government support for consumers’ energy bills and high gas storage levels. Consumers being able to draw on excess savings built up during the pandemic has also helped to soften the blow to growth.
A global recession remains a clear risk on the horizon, however, with several leading growth indicators pointing to slowing economic activity. The downturn in the US housing market is perhaps the clearest bellwether for what is to come – home sales and building permits continued to decline in the fourth quarter of 2022.
Yet, there is room for some optimism that Europe, being a cyclical economy, should benefit from China’s re-opening. China’s zero-Covid policy has been a persistent geopolitical headwind. While the transitional phase will likely be bumpy, as cases surge and healthcare resources become stretched, the effect of Omicron in other economies around the world suggests there should be a sharp but short-lived impact on China’s economy. After cases moderate, we could expect a ‘V-shaped’ recovery in private consumption supported by high levels of savings accumulated since 2020.
The one wild card that remains, in any inflation scenario, is the potential for the war in Ukraine to escalate or enter a credible de-escalation. Either way this would have a major impact on the economic and market outlook for European risk assets.
Having suffered the worst annual downturn since the global financial crisis, driven by a compression in valuations, much of the froth has come out of equity markets. Highly priced growth stocks, in particular, have seen a marked reduction in valuations. Nonetheless, investors do not yet appear to have priced in the downside risks to corporate margins and earnings, particularly if recession unfolds in the coming quarters.
For F&C Investment Trust, we came into 2023 with relatively high levels of cash, low gearing and with reduced exposure to the expensive, growth, segments of the equity market. Near-term risks remain high in our view as investors digest the prospect of earnings downgrades and still high inflation, albeit falling rates of inflation. However, valuations in markets are more attractive and, while retaining our long-term focus, we expect good opportunities to emerge as we progress through the year.
1 Bank of America Global Fund Manager Survey – December. Published 13 December 2022.
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