March Market Update: inflation beats investors again

What’s moving markets

Markets in February were driven by a handful of data points right at the beginning of the month. Employment data in particular, but also the broad strength from services exposed the scale of market overreactions so far in 2023.

In January assets were broadly higher, with a ‘risk on’ for equities driven by expectations that the Fed would raise rates by less than they were indicating, and even end the year with two rate cuts. This had been the driver of bond market strength. But once again, markets underestimated the power of inflation and the threat to the interest rate policy.

After the US reported a 517,000 net increase in jobs for January (double the market expectation and last month’s increase), there were concerns that demand destruction and monetary headwinds weren’t having the desired effect of subduing growth and thus inflation. A huge bounce in the Institute of Supply Management (ISM) non-manufacturing Purchasing Managers’ Index (PMI) added to the employment picture, with last month’s figure rising enough to imply growth across service sectors.

Whilst manufacturing the developed world over is waving the red flag for recession, the labour market has been consistently at odds with this. The services sector has been more resilient, albeit declining, most major economies now see positivity here too.

February forced investors to re-evaluate their view that interest rates were on the cusp of being cut. Once again, inflation has been underestimated – the more persistent it becomes, moving from a supply side spike to being engrained in employment, the longer and more severe the monetary policy implications will have to be.

Closer to home, the Bank of England raised rates by 0.5%, with the ECB following suit days later. Some good news from Europe is the continuing fall in Natural Gas prices, which helps minimise cost push inflation and assist growth – the holy grail of current economic outcomes.

Asset class implications

Revised interest rate expectations has had the most direct impact on fixed interest and government bonds, particularly Gilts down over 3% for the month. Initially, the 10-year Gilt yield fell by 30bp to 3% in just one afternoon, following dovish comments from the Bank of England after their 50bp rate increase. However, the employment and services data out from within the US quickly drove the yield upwards, pushing it as high as 3.8% by month end.

Any asset class exposed to duration was similarly impacted, having benefited from falling yields in January. The whole yield curve shifted upwards in a relatively parallel fashion, implying a major shift in the markets view on monetary policy not just for now, but for years to come.

Monetary policy, or at least expectations of future policy also affected currency. After months of relative weakness, the dollar spiked in value following the positive employment and services data, reacting in its own way to the likelihood of further rate rises.

Elsewhere, equities gave back some of the gains achieved over the previous three months. Asia and Emerging markets saw sizeable losses, but this was from a position of relative outperformance gained in the earlier rally. Europe fared better, up in sterling and local currency terms. The fall in US equities was partially insulated through dollar strength over February, benefiting UK investors.

Looking more closely, there was no particular pattern of returns by sector, particularly at the global level. UK Equities benefited from Energy and Telecoms, but Basic Materials saw large losses. Interestingly, quality as a factor underperformed in the UK last month, while value and size were smaller headwinds for UK equities.