It’s the most wonderful time of the year. All the more wonderful because an equity market rally means the ‘Santa rally’ is here already.
The idea of markets advancing through advent is a strange phenomenon. While there are explanations abound for its existence, my view is that there is about as much logical evidence behind it as there is for flying reindeer. After the last 12 months, perhaps I should not be complaining about anything that can raise markets, whether real or imaginary. But to be honest I much prefer my rallies to be based on the former rather than the latter.
On which note, I can report that change is in the winter air. Having previously been concerned that Jerome Powell was asleep at the wheel with his foot on the interest rate accelerator, market participants see this as much less of a risk now.
The long-established dynamic is that central banks write between the lines and markets read between the lines. Recently, that hasn’t been required. While giving clear credence to the fact that the labour market is red-hot and inflation remains well north of target, Powell specifically said it is unlikely that rates are going to increase at the same breakneck+75bps a meet speed. In a rare outburst of slightly-more-precise guidance, he highlighted “the time for moderating the pace of rate increases may come as soon as the December meeting.” That means +50bps next time is now the bookies’ favourite.
The fact inflation has shown signs of abating has only added weight to that argument. October’s data showed the annualised rate of price increases, while still sharply positive, undershot expectations. While we’ve since seen a similar trend in the eurozone, and UK inflation forecasts have retreated in recent weeks, one swallow does not make a summer. Until inflation is firmly in a downwards trend the champagne should remain on ice. However, if one believes consensus forecasts, the trend should be an investor’s friend from here. The rate of US CPI is expected to have dwindled to more like 3.5-4.0% by the middle of 2023.
That will not only ease the pressure on the consumer, it also implies an earlier-than-feared-peak to the interest rate cycle. Consensus has US rates peaking in May at 4.9% at the midpoint, before falling back to 4.4% by the end of 2023. The threat of a widespread recession, the Chinese only reopening after Covid at a glacial pace and the war in Ukraine raging on are just three reasons we are clearly still in troubled waters. However, the prospect of inflation abating and roughly 0.5 percentage points of US rate cuts in the second half are reasons for optimism. The war in particular has consequences far greater than its effect on markets, but from a purely financial perspective it is hard to look past uncertainty around the rate cycle as being the biggest overhang on 2022’s disappointing market performance.
That leaves me looking into 2023 with cautious optimism. That positivity is only enhanced by the fact that valuation is generally much less demanding now than at the time 2022’s new years’ resolutions were being drawn up. The PE on the leading US benchmark is 17.7, as opposed to 20.8 a year ago. In the UK it is 10.1 vs 12.3. Balance sheets provide assurance too. The uncertainty that has lingered since the onset of the pandemic has nudged many management teams to make prudent capital allocation decisions, leaving debt levels far from the levels associated with panic stations. The net effect is there are now many innovative companies with outstanding long-term track records available at knock-down prices. I am confident that the value that we are now seeing in both equities and bonds will provide good returns over time, so long as we all have patience.
On that cheery note, I conclude with this week’s teaser. Fill in the blanks: XXXX has topped the UK Christmas charts in each of the last XXXX years?
George Salmon – Senior Investment Analyst
All charts and data sourced from FactSet
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