Market Update 27th February 2023
(Out of) Puff the Magic Dragon
Having begun the year with such enthusiasm, it was inevitable that markets would run out of puff sooner or later. It is an inelegant truism that, in the short-term, markets act as what Benjamin Graham described as a ‘voting machine’ (The Intelligent Investor, first published in 1949). As 2022 morphed into 2023, the votes were being cast in favour of what was equally inelegantly called ‘the Fed pivot’. If we take away the jargon, this meant that American interest rates were expected to fall. That is a good thing, especially if you happen to be American. As we travel headlong into March, these votes have been recast, this time predicting what is called ‘higher for longer’. To perform the same culling of the jargon, this means that everyone now expects American interest rates to keep on rising. And that is self-evidently not such a good thing.
Sometimes this really is as complex as markets get. We have argued for some while that the world needs to turn upside down before we should have confidence that markets have actually turned a corner. What we need to see is a string of data showing that the pace of economic growth in the United States has meaningfully slowed, or even reversed. The Federal Reserve’s medicine is intended to slow the economy and it will only start to think about stopping raising interest rates when there is evident pain. Thus far, the American economy has only given an occasional ‘ow’ or ‘ouch’, and has perhaps blown its nose. It is stubbornly resisting the flu. For markets wanting to bet on lower interest rates by the year end, good news is bad news.
The hope that the Fed may change course was not the only tailwind for markets. It was nicely complemented by the very real change of policy in China. If we come back to truisms, it is important to remember that the Chinese Communist Party retains unchallenged power by keeping most people happy most of the time. It is a restive country and the Communist Party is constantly on a tightrope. As 2022 progressed, it became increasingly clear that President Xi’s policy of zero tolerance to covid was about as popular as, er, a dose of covid. The country was starting to revolt; either the policy had to change, or Xi was toast.
As we know, the policy changed, virtually overnight. Contrary to some alleged expectations, this does not appear to have caused a healthcare collapse and the outside is looking to China for a resumption of manufacturing and the easing of frozen global supply lines. In contrast to the Fed’s pivot, the signs are that this is really happening. This has to be good. Unsurprisingly, when it comes to financial markets, there is a hitch. Once everyone clocked that zero-covid really had been abandoned, money flooded into Chinese-linked investments. The MSCI Hong Kong Index rose by 40% in two months (although to be fair this only recouped the fall on the previous three months). The markets already know that China is going to have a much better year in 2023.
We seem to be dealing in truisms this week. Let us now move onto why sentiment (exuberance and despair) is such a reliable indicator of what has already happened. Investors are always the most excited, the most optimistic, the most ‘bullish’ about things that they already own. This is the simple reality that underlies why markets peak when sentiment is at its most optimistic. That is when the last buyer has bought. And when the last buyer has finally bought, there are no more buyers. And that, in our simplistic language, is a bad thing. The reverse of course happens on the way down: when the last seller has capitulated in a slough of despair, there are no more sellers and prices will rise.
This is a long-winded way of arguing that the second positive driver of markets – the re-opening of China – has also run out of puff. As we said at the outset this week, this pause for breath was coming and is probably healthy. To come back to the second half of Benjamin Graham’s aphorism, in the longer-term, markets act as a weighing machine: meaning that value and quality will ultimately prevail over the noise of the ballot boxes. The gains in both equities and bonds from last year’s lows mean that the pockets of value we were seeing may not be quite as appealing as they once were, but they do not negate the arguments in their favour.
Jim Wood-Smith – Market Commentator and Head of Climate Transition
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