Financial markets have started to see the light at the end of the inflation tunnel, but central banks aren’t ready to declare victory just yet. Jesmond Mizzi Financial Advisors’ Head of Wealth Management Colin Vella sheds light on how financial markets ended 2022 and what to expect this year.
- What have the main takeaways been from the last quarter of the year?
October and November saw markets rebound quite strongly, before erasing some of the gains in December. In general, however, I would say things started to look up during Q4, with numbers indicating that inflation may be starting to slow.
The quarter’s developments suggest that September’s declines - mainly driven by the prospect of a difficult winter due to the ongoing energy crisis - may have been the bottom of this bear market.
Most of these concerns seem to have been somewhat alleviated and Europe has secured enough natural gas to meet most of its demand this winter, especially if it continues to be a relatively mild one.
Markets saw that the worst-case scenario they were bracing themselves for will likely not develop and reacted accordingly.
Another consideration is that after a year of drastic interest rates hikes, markets are expecting that sooner or later central banks will start to ease off.
- And what if inflation remains high?
Even if inflation remains high, it is unlikely that interest rates will increase indefinitely. If anything, we’re more likely to find ourselves in a situation where central banks start to cut rates in spite of high inflation.
This is especially true when considering that the labour market has remained strong and has even continued to see salary increases across various sectors, further fuelling inflation.
You currently have a lot of uncertainty about what next year is going to be like. The expectation is that there will be some sort of recovery, but at the same time, it is difficult for anyone to say with any certainty that this will be the case. So, while we hope that inflation will start to come down, it is equally hard to believe there won’t be any more surprises.
What we definitely hope to avoid is a situation in which inflation remains high and unemployment rises, since it would make a recovery all the more difficult and most likely be the start of a global recession.
- Why did we see markets decline again in December if things are looking up?
December’s declines were mainly due to a misalignment between the market’s expectations and what we heard from central banks.
Key indicators in October and November showed that inflation was starting to be brought under control, leading to an expectation that central banks would start to signal a move away from monetary tightening and possibly announce a cap on interest rate hikes. EU inflation figures dropped to 10.1% from October’s high of 10.6% - the first slowdown since June 2021. In the US, we saw headline inflation decrease from 9.1% to 7.1%, still well above the 2% target, but showing signs of recovery. Meanwhile, in the US, headline inflation continued to slowdown from the 9.1% peak in June, to now reading 7.1%, albeit still well above the Fed’s 2% target.
Though markets expected it, it was never really on the cards. Central banks are still conscious of the prevailing instability they would continue to keep all options open, and that is pretty much what we heard in December: “Things are looking better, but uncertainty remains and we’re not taking any options off the table for the time being”.
Based on how things are currently looking I would describe December as more of a speedbump on the way to recovery, rather than indicative of some major systemic problem. There will be more bumps along the way, but we appear to be on the road to some sort of recovery.
- Has the recovery been the same across different markets?
We’ve actually seen a stronger recovery in Europe, which is primarily a reflection of its proximity - both economically and geographically - to the crisis in Ukraine.
As we’ve already mentioned, the energy crisis has been one of the biggest causes of uncertainty so any improvement in this regard will impact Europe more than other economies like the US.
That said, energy isn’t the only factor and if you were to exclude both it and food from the equation inflation would still be running at some 5% - more than double the 2% target set out by the ECB.
European markets have in fact fared better not just through the December turmoil, but have managed to register stronger gains over the last quarter of the year, with most markets registering double-digit gains. This compares to a somewhat more muted performance for the quarter across US markets, with an overall lagging performance in the tech-based Nasdaq 100 index. This was also reflected on a full-year basis, despite still ending the year in negative territory. Equity markets across the two economies on the other side of the Atlantic ocean have had distinct performances, with the average European market holding quite strongly when compared to the US markets, with the former registering low double-digit losses, as opposed to around a fifth of the market value being shaved off from the S&P 500 index in 2022.
On the fixed-income side, the performances recorded aren’t very far off from what we have witnessed on the equity side. To a certain extent, some segments within fixed-income have even performed worse than any other asset class – in particular, low-coupon, and high duration bond investments, which were the most sensitive to the high inflation and high-interest rate environment we have experienced through 2022.
- Are there any particular asset classes one should be looking at?
Investors should be considering companies with consistent cash flows operating in sectors that will remain in high demand, such as healthcare and insurance, for stability in their portfolio.
They should be looking at their portfolios and assessing the performance of their investments over the past year and whether any rebalancing is in order. They might also consider buying into their portfolio to reduce the average price paid per share or unit of investment.
The key is determining which equities saw declines purely due to circumstance and the prevailing high inflationary environment and which ones were overvalued to begin with.
We’ve seen this quite clearly in the local market where you have many companies which we know have strong fundamentals and prospects for the future, but which have registered declines as a result of inflation.
On the bond side we’ve seen the return of good yields as we have now entered a new year. This will cushion one’s portfolio if volatility persists throughout next year while also providing a higher income. Highly rated government bonds are today returning considerably more than the 1% or less they were just a year ago, presenting investors with a good opportunity to add quality to their portfolio while also shielding it from any potential future interest rate changes.
At the end of the day, if a portfolio lacks stability, this is what should be prioritised. If it is already quite well balanced, then I would say the priority is looking out for opportunities in other segments of the market.
- Would you say there is cause to be optimistic going into 2023?
Despite the uncertainty I expect it to be a better year. If anything, now it has created good opportunities, both in the bond and equity markets. The hope is that we will continue to see good opportunities while the market moves to a more stable state.
Going forward we will probably have to get used to a new reality in which markets must adjust to a new, higher, interest rate environment.
And when I talk about markets adjusting, I don’t only mean the bond market. It is very likely that this new reality will be reflected in several companies’ valuations. We saw declines in certain growth companies that were the result of the fact that their valuation assumed future interest rates would remain at 0%, which we now know won’t be the case.
Even if we start to see some monetary easing, any future earnings will be evaluated at this new interest rate level, so we won’t see a full recovery in every sector. We’re very likely to have companies see a drop in their valuation despite continuing to register healthy profits and growth.
That’s why it is important for one to be selective with one’s portfolio, not only with regards to the ratio of bonds to equities, but also the type of asset and sector.
This interview does not intend to give investment advice and the contents therein should not be construed as such. The Company is licensed to conduct investment services by the MFSA under the Investment Services Act and is a Member of the Malta Stock Exchange and a member of the Atlas Group. For further information contact Jesmond Mizzi Financial Advisors Limited of 67, Level 3, South Street, Valletta, on Tel: 2122 4410, or email colin.vella@jesmondmizzi.com