Markets last week
It was an eventful week with many of the major central banks, including the US Federal Reserve (Fed), Bank of England (BoE) and the European Central Bank (ECB), holding their final meetings for 2023.
Investor sentiment has been very strong since the end of October which has fuelled an equally strong rally across global financial markets. This continued last week as global equities were up 1.4% and global bonds returned 1.7%. Small and mid-cap companies outperformed large caps, continuing the trend of the last seven weeks. The mid-cap FTSE 250 was up 2.7%, whilst the large-cap FTSE 100 Index was up 0.3%.
The US equity market recorded its longest winning streak since 2017, finishing up for the seventh consecutive week. The VIX index of implied volatility, a good measure of fear in financial markets, often referred to as the “fear gauge”, fell to 12.28 – its lowest level since January 2020, indicating that investor confidence has not been as high since before the pandemic. The historic rally in US Treasury bonds continued, with the US 10-year yield falling below 4% for the first time since July, closing at 3.9% and having come down from a peak of 5% in mid-October (bond prices rise as yields fall). Credit markets performed well, with US high yield spreads reaching 3.36%, their tightest levels since April 2022.
Driving the strong performance and improvement in investor sentiment has been the shift in narrative around monetary policy; away from a fear of potential further rate hikes and towards optimism in expectation of rate cuts next year. This narrative shift has been catalysed by softer economic data, further disinflation and through subtle changes in central bank speak. Since mid-October, Fed Funds Futures have moved from pricing in two rate cuts in the US in 2024 to now pricing in almost six cuts.
Last week this narrative shift was justified and further intensified the market rally, as Fed Chair Jerome Powell surprised the market, revealing that the Federal Open Market Committee had discussed the possibility of rate cuts in its latest meeting. This “dovish pivot” followed November’s Consumer Price Index (CPI) and Producer Price Index (PPI) data released on Monday, suggesting that the core Personal Consumption Expenditures (PCE) deflator, the Fed’s preferred inflation measure, was in the territory of the 2% target. Core PCE inflation is expected to persist around this level at least through early 2024.
Despite the Fed’s pivot, the Bank of England stuck to its guns, with no change to its guidance on the future path for interest rates, and with the same six-three vote split on the Monetary Policy Committee. The UK remains some way behind the US on subduing inflation, and economic activity in recent months has unexpectedly rebounded. This was evidenced again last week by the flash Purchasing Managers’ Index (PMI) data for December, showing that combined business activity in the services and manufacturing sectors is firmly in expansion. With continued economic resilience and without more progress on inflation, the Bank of England is unlikely to sound the all-clear on further policy tightening.
The ECB also left rates unchanged. President Lagarde pushed back on any suggestion of rate cuts by saying that the Governing Council had not discussed the matter, and still believe it’s too early to discuss it. With the progress on eurozone inflation and the relative weakness of the eurozone economies, the ECB has flexibility to cut rates in 2024. European equities returned 0.7% in GBP terms, in-line with the UK market last week.
The week ahead
Tuesday: Bank of Japan meeting
Our thoughts: There has been a lot of conjecture surrounding the Bank of Japan’s (BoJ) ultra-accommodative policy stance of negative interest rates and Yield Curve Control (YCC) in recent weeks. The Bank of Japan has been gradually moving away from YCC this year with small policy adjustments.
Recent words from policymakers, including Governor Ueda, have fed investor speculation that the BoJ will step away from these policies more quickly than previously anticipated. Investors have subsequently ramped up bets which have led to a steepening of the Japanese yield curve and a strengthening of the Yen.
Governor Ueda is well known for his careful messaging and long-term telegraphing of policy moves. Although Ueda has clearly begun this process, it is far from over, and while there could be further adjustment to policy this week it’s unlikely that he will make any drastic changes. The BoJ will also be less inclined to tighten policy, given recent data showing price pressures declining and consumer demand wavering.
Wednesday: UK CPI
Our thoughts: The BoE has made good progress on inflation in recent months, but economic activity seems to have rebounded in the fourth quarter, and the journey from 4% to 2% inflation could be more difficult as it is now the ‘stickier’ elements of inflation that will need to subside. Economists expect headline inflation to fall from 4.6% to 4.3% and for core ‘sticky’ inflation (excluding volatile food and energy prices) to fall from 5.7% to 5.6%.
The numbers for the week
Sources: FTSE, Canaccord Genuity Wealth Management