A Leap of Faith

Equities staged a strong bounce last week with global markets posting a gain of 5.6% in local currency terms. Strikingly, they are now up some 3% since Russia invaded Ukraine and 7% from their low on 8 March, although they remain down 7% from their early January high.

There has been no economic news to warrant this rebound with the Federal Reserve and the Bank of England both pressing ahead with policy tightening. The Fed raised rates 0.25% as expected to 0.25-0.5% and upped its forecasts substantially for further increases. It is now projecting an additional six 0.25% moves over the remainder of the year.

This was not a big surprise but if anything, Chair Powell was a tad more hawkish than expected. Indeed, Treasury yields have continued their upward march. They currently yield 2.15%, up sharply from 1.5% at the start of the year.

The BOE also raised rates by 0.25% to 0.75% but turned more ambivalent about the need for further moves. While it stuck to the mantra that some further modest tightening might be needed in the months ahead, it acknowledged there were risks on both sides.

UK inflation is now forecast to peak at 8% or even higher. This worsens the risk of a wage-price spiral but also will hit growth by exacerbating the cost-of-living squeeze – notwithstanding any additional support the Chancellor announces on Wednesday.

While these moves by the Fed and BOE echo the recent decision by the European Central Bank to bring forward its tightening plans, the People’s Bank of China is headed in the opposite direction. Chinese monetary policy has been out of sync with the West ever since the pandemic started and is now being relaxed.

Last week, the Chinese authorities promised moves to support both the economy and the equity market. However, this was not as positive as it sounds as it was only prompted by a surge in Covid cases, new lockdowns and a sharp fall in equities.

If not explicable by the economic news, the market rebound could possibly be put down to developments in the war in Ukraine, most obviously the continuation of peace talks. But this requires the belief that Putin is negotiating in good faith, which in itself is a big leap of faith.

There is also probably some relief that commodity prices have unwound part of their surge. The oil price is back down to around $110/bbl, having hit a high of over $130 at one point.

Even so, at the end of the day, the extent of the bounce in equities is hard to justify. Markets could easily re-visit their recent lows if the war took a further turn for the worse and triggered further sanctions, possibly this time including China.

Trying to time the market bottom in such circumstances is usually a futile quest other than for the very lucky. The more sensible strategy is to focus on the longer term, namely those asset classes which are likely to fare best in this new higher inflation world.

In this light, equities and other real assets such as commodities and some property continue to look attractive compared to cash and fixed income. Cash may now be paying a little more in nominal terms but is still losing money in real terms. As for conventional bonds, they are losing money outright with UK gilts down as much as 6% this year.

Equities, by contrast, should offer a fair amount of protection against inflation unless one heads into a recession which we are not expecting. Even though the deterioration in the economic outlook limits their upside, equities continue to look relatively well placed compared to most mainstream asset classes.

Chief Investment Officer