Market Commentary: Week to 20 December 2022

The week started well enough, with the publication of American data showing that the pace of inflation had decelerated more than expected in November. US petrol prices had fallen during the month, while food and rent inflation both moderated. Investors were jubilant all over the world. This was the long-awaited evidence that inflation had peaked, and markets seemed set for an easy run-in to the end of the year. The “Santa rally” was on.

Not for the first time this year, however, central bankers sent markets into a tailspin, although this time it was a one-two punch from the US Federal Reserve and, the following day, the European Central Bank. The Fed raised interest rates by 0.5% as expected, but the tone of Chairman Powell in the press conference afterwards was particularly aggressive towards inflation and unsympathetic to markets. Powell focused on the labour market in his comments, which is still growing robustly, rather than other, weaker aspects of the American economy. Not only did the Fed raise its expectations for where interest rates will end up, but the strong degree of unanimity from the members of the governing committee surprised investors. Moreover, the committee raised its expectations for the trajectory of inflation, confounding economic forecasters who had just witnessed the rate of inflation begin to decline.

The recent rally had been built on hopes for a so-called pivot in interest rate policy towards fewer rate rises, and these hopes had seemingly been confirmed when inflation data did begin to recede in recent weeks. Predictably, therefore, stock markets did not like the Fed’s message at all. The S&P 500 Index fell by 4% over the two days following the news, but European and Asian markets march to an American beat and share indices, globally, were dragged down by a similar amount. The reaction of American bond markets, however, was much calmer. After an initial wobble, they rallied and ended the week holding onto a noteworthy gain. This is an important development for investors as it marks a clear departure from the beginning of the year when nearly all asset classes were falling together, and portfolio diversification became less effective. Now it seems that what is bad for equities could be good for bonds, putting portfolios that are diversified across both asset classes in a much better position.

Unfortunately, the same cannot be said of European bond markets, whose recent good run was ended by the European Central Bank’s own pivot towards higher rates. The ECB raised rates by 0.5% as expected, but also raised its forecasts both for the path of inflation and, also, interest rates, to significantly above the market’s current expectations. This came completely out of the blue, about as shocking as Saudi Arabia beating Argentina in the World Cup finals. For good measure, the ECB also announced the start of quantitative tightening in March, which will involve running down its stock of government bonds. Commentators and analysts were stunned and saw in the ECB’s statement, and subsequent press conference, a sea-change for a bank hitherto regarded as being highly sensitive to economic weakness, as well as to the bond markets’ sensibilities. Given that the Fed had already abandoned its support for markets, where do investors look for sympathy now?

The weekly Market Commentary will return on 10th January in a new format. Merry Christmas and Happy New Year!?

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