May Market Update: Inflation trending down, but credit conditions tighten
What’s moving markets
Following widespread concerns in the banking sector in March, April was calmer. Volatility across equity and bond markets dropped considerably as the initial panic faded. There’s no room for complacency though. More US regional banks are likely to face trouble, as we saw First Republic’s worrying earnings update at the end of April after depositors pulled money out. Regulations for these banks will become more stringent to avoid further stress to the banking system. Across the board, banks have become cautious in their lending and this, coupled with an economic slowdown, will lead to tighter credit conditions. As a result, we may start to see a rise in corporate insolvencies.
During April, the OPEC+ alliance announced a surprise oil production cut, equivalent to 3.7% of global demand. Whatever the political or economic motive, initial concerns were of renewed inflationary pressures globally which could mean that interest rates need to stay higher for longer, dampening growth further.
As it turned out, oil prices stabilised around $80 per barrel, and inflation data from major economies appears to be trending downwards, albeit at different speeds. In the US, core CPI for March was in line with expectations, with shelter prices rising less than expected. Services inflation continues to prove sticky but slowing wage inflation should help offset this. UK CPI also fell in March to 10.1%, but this was more than the 9.8% expected. Looking ahead, the overall fall in energy prices should feed through to utility bills in the coming months, as will the fall in food prices. As a result, some of the price pressures on UK consumers may ease off by the summer. It’s a similar story in Europe, where headline inflation is falling due to lower energy prices, although core inflation in services is still proving stubborn.
The overall message is one of moderating inflation, but what’s clear is that there are some elements in the data that are persistent. Central banks aren’t ready to pause on their interest rate hikes. Both the Federal Reserve and the Bank of England are now expected to raise rates by 0.25% at their May meeting, while the European Central Bank are on track to raise rates by another 0.50%. The latest narrative from the Fed suggests rates may stay higher for longer, but analysts predict that US interest rates may actually fall by the end of the year, due to the worsening credit conditions. To reinforce this downbeat view, the latest US GDP figures for Q1 came in at 1.1%, well below the 1.9% expected. It’s clear consumer spending is tailing off, and that future layoffs, tighter credit conditions and corporate failures could start to take a further toll on overall growth.
Asset class implications
In stark contrast to March, UK equities rebounded in April. It was the strongest equity market performer during the month, with the FTSE All Share rising by 3.35%. followed by European equities which saw the FTSE World Europe ex UK rising by 2.26%. As markets gained comfort that March’s banking issues were not systemic, these financials heavy markets saw investors return and take advantage of lower valuations. It was also a month where ‘value’ style investing returned to provide a tailwind to these markets, whereas ‘growth’ type markets like the US continued to struggle, delivering a return of -0.32%.
Government and corporate bond markets saw yields rise over April on the news that core inflation in major economies remains higher than central banks would like. That means interest rates are likely to continue rising and stay higher than initially expected. This is a headwind for longer dated government bonds and led to a fall in the FTSE Actuaries UK Conventional Gilts All Stocks index of -1.66% during April. Meanwhile the ICE BofA Global Broad Market Index, home to some good quality credits on some very attractive yields also fell -1.10% over the month.
Asia and Emerging Markets struggled to keep pace with some of its developed counterparts during April. This was largely due to the ‘higher for longer’ narrative from the Fed on their interest rate cycle. Higher US interest rates have a spill over effect on these markets as it means liquidity shrinks while credit conditions tighten, leading to higher borrowing costs. In turn, this leads to a bleaker outlook for earnings and potentially lower profits for some companies. Once the outlook for peak rates becomes clear, visibility should improve for these markets, at which point there should be a turnaround in performance.
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