A recap of this year so far

After one of the most challenging years on record, investors cheered the turn of the year as surely 2023 would herald a new start. Even in the run-up to the new year, there was a sense that inflation, which had so blighted markets during 2022, was beginning to abate.

In the UK, Consumer Price Index (CPI) data showed headline inflation falling, although food prices remained stubbornly high. It seemed that authorities were finally beginning to get a handle on it, with US central bank, the Federal Reserve, perceived to be only a few interest rate rises away from ending its hiking cycle. Moves like this helped the beleaguered bond market to perform well at the start of the year, with yields falling (and prices rising) for both government and corporate bonds.

European equity markets also continued their rebound as the twin forces of inflation abating and China reopening its economy after the pandemic, a major export market for European companies, began to offer hope on the continent. A warmer winter, and hence a more limited strain on Europe’s gas and oil reserves, was also a key underpin of equity market performance. US equities enjoyed a fairly solid January too. UK equities, although gaining ground, underperformed other global equities over the period.

However, February saw government bond yields rise sharply again as fears resurfaced that central banks would have to go much further in raising interest rates as concerns about inflation bubbled up again. And those hoping for a quieter end to the quarter were sorely disappointed as the revolving door of big news stories had one last surprise for investors. First there was the news that US regional banks, Silicon Valley (SVB) and Signature, had collapsed, then that Swiss banking giant, Credit Suisse, was also on the same trajectory. Thankfully, authorities were quick to react to contain the events. The Federal Reserve announced it would guarantee all SVB deposit holders, and there was the shotgun marriage of Credit Suisse with great rival UBS. This reassured investors that this shouldn’t spark anything reminiscent to the 2008 financial crisis, at least for the time being.

The move to shore up not only the financial sector, but also investor confidence, does seem to have been successful, with the final week of March seeing global markets continuing on their upward trajectory.

What’s next for inflation and interest rates?

Despite inflation rates slowing, core inflation (taking out volatile sectors such as petrol and food prices) is remaining stubborn just now, meaning that many central banks will be forced to continue raising interest rates for a while longer. That said, we believe that rates in many countries may peak lower and earlier than previously forecast. For example, we expect the Federal Reserve to increase rates to 5.25% this quarter, before cutting them at the end of the year.

The picture in the UK is slightly more complicated. In the Spring Budget, Chancellor Jeremy Hunt gave a positive update on the rate of inflation, announcing that the Office for Budget Responsibility expected it to drop sharply, fairly quickly, to 2.9% by the end of the year. But worryingly, March’s inflation figures showed that the UK remained the only country in western Europe with double-digit inflation. Whether that will have an impact on how soon and how quickly the Bank of England will start to lower interest rates again remains to be seen.

Is a recession still on the cards? 

In short, yes. Although global economic activity has been resilient at the start of this year, we expect the cumulative effect of interest rate hikes to push many major developed countries, including the US and UK, into recession this year. However, on the flipside, following the lifting of its zero-Covid policy, the Chinese economy is likely to continue to rebound. This should have a positive knock-on impact on other Asian economies, although the effects will be less intensive than in previous years, with emerging markets more widely caught in the crosswinds between Chinese growth and a US recession.

What does all of this mean for investments? 

A recession is never a good environment for equities. Some companies are likely to see downgrades in earnings and profits because of the difficult economic environment that’s likely to develop over the rest of the year. Currently, analysts are too sanguine on recession risks, with earnings in aggregate only expected to fall around 5% year on year. That means there’s further room for earnings to fall and also for downward movement in some share prices in the shorter term.

There will though be opportunities in some sectors and regions, with our focus being on defensive stocks - those that have more potential to continue to deliver earnings and returns during economic downturns. Alternatively, domestically focussed Chinese stocks which are geared to the reopening rebound should outperform their developed market peers.

While the outlook for equities isn’t overly positive, the opposite is true for bond markets. After last year’s bond sell-off, we expect bond yields to continue to rise to attractive levels for investors. Within our portfolios, we’ll be looking at higher-quality corporate bonds, as well as government bonds. We prefer to avoid higher-yielding bonds issued by companies with lower credit ratings.

Finally, on currencies, the Japanese yen is expected to become very attractive as the global economy enters into recession. The Bank of Japan is highly likely to move away from its policy of buying government bonds and other financial assets to keep bond yields at a certain level, leading to a de facto increase in interest rates as the year progresses. As mentioned earlier, we believe the US Federal Reserve will start to cut interest rates from the end of this year, which should work in the yen’s favour as the gap between interest rates in Japan and the US narrows.

There’s support if you need it

Not sure how market and economic events may affect your investments? Then think about speaking to a financial adviser. If you’re an abrdn client, get in touch with your financial planner. If you don’t have an adviser, see how our financial planning services could help you.

The information in this article should not be regarded as financial advice. Please remember that the value of investments can go down as well as up and may be worth less than was paid in. Information is based on abrdn’s understanding in April 2023.