Markets have started the year with a bang. The immediate catalyst has been an apparent easing of inflationary pressures, with CPI data coming in below expectations in the US, UK and Europe. However, recessionary pressures are not going away and the economic road ahead appears difficult. Against this backdrop, can the stock market hold onto its early gains?
Inflation numbers have certainly been encouraging. In the US, the latest data showed price rises running at 6.5%, down from 7.1% in November. Eurozone inflation is also dropping fast, though remained at 9.2% in December. In the UK, it is still above 10%, but was some way below market expectations. This has restored investor confidence, sending markets higher. The S&P 500 is up 5%. Asia, financials and technology have been particular winners.
However, there is still a potential recession in the mix. Jeff Schulze, investment strategist at ClearBridge Investments, believes a sustained rally in equity markets is unlikely until it is clear that the Federal Reserve is about to pivot – or even until some way afterwards. He says: “The time frame between the first cuts or pivot and the bottom of the market has traditionally been 14 months.
“What is different this time around is that there’s a lot more negativity that’s baked into the markets and really should help soften the blow to markets when that pivot eventually comes and that bottom is formed.”
He points out that if this were the bottom in the market, it would be the first time since 1948 that the market has bottomed prior to the start of a recession. Usually, the markets will bottom about two thirds of the way into a recession. That said, over the last 12 recessions, the market has bottomed in either month one or two after the start of a recession five times. Given the market has already started pricing for a recession, he believes this is the most plausible scenario.
This view is echoed by other commentators, many of whom believe that while markets may get better at some point this year, they have not yet reached an inflection point. Anthony Willis, investment manager in the multi-manager team at Columbia Threadneedle, says valuations are not yet at levels associated with a market bottom. He adds: “2023 may well see further downside – something that may be determined by the depth of the likely recession and the impact on corporate earnings. In this environment, returns look harder to come by.”
However, as Nick Train points out, all stock markets need is for selling pressures to dissipate. At that point, markets can move quickly. He said: “In November 2022 alone, the FTSE All Share was up 7% and for no apparent reason. But when any index or individual share price has been depressed or out of favour for a long period that’s what happens. Everyone who wants to sell has already sold, sentiment is terrible and there is attractive value everywhere you look. Suddenly and apparently randomly, prices rally.
“And prices can carry on rising for a long time, simply if the news is not as bad as expected—and investors’ expectations for the UK stock market are for terrible news. And if the news turns out better than expected – well, that is the stuff of multi-year bull markets.” Train is encouraged by some recent merger activity: in particular, the revelation that First Abu Dhabi Bank had given serious consideration to making a bid for Standard Chartered Bank.
As such, the liquidity backdrop is informative. Michael Howell, CEO of CrossBorder Capital, says that liquidity is currently at an extreme, at a point of “maximum pain” and can’t get very much tighter. This is normally the point in the cycle when something in the financial system breaks, which ultimately leads central banks to reverse course. He attributes the recent “shaking and cracking” – such as the volatility in the crypto markets – as an early symptom of this. In his view, global liquidity trends could soon start to improve.
He adds: “Normally around these inflection points you see problems coming out. Expect major failures, expect problems, expect more FTXs. But as liquidity builds and central banks put more money in, it’s going to be a much better investment environment. […] We think there’s an inflection point coming in 2023, but the next few months could be difficult.” He believes the Federal Reserve may be forced to inject capital into the treasury markets as liquidity wanes, in spite of its current stance on inflation.
Ultimately, expecting the recent rally to be the start of a longer-term bull market is probably optimistic. Schulze says he is expecting a “choppy, a bumpy trading range in the markets in 2023 until visibility is restored on: a) if we have a recession; but b) how deep that recession will be and what it means for the earnings picture?”.
This seems a more realistic appraisal of the current situation in markets.