Financial Update from Brewin Dolphin - 20 January 2023

January 2023

The Weekly Round-up

Friday 20 January 2023

In his latest weekly round-up, Guy Foster, our Chief Strategist, discusses disappointing retail sales data and a strong start to the US earnings season.

There was a something of a cautious tone permeating through the markets this week. Some very weak retail sales data from the UK and US set the tone. Any reasonable assessment of the current state of the economy might suggest that consumers would have spent cautiously during December, not least because harsh weather buffeted both regions and the UK was stymied by strikes. However, these data were worse than anticipated – in fact, US retail sales have declined by more than had been expected for each of the last two months.

In the UK, this was the fifth consecutive disappointing retail sales report and it was cruel because forecasters had been sold a dummy by the more upbeat CBI retail sales survey, which suggested a surprising bounce in shopping.

At the same time, both consumer markets are still transitioning from a period of splurging on goods during lockdown, to one in which services spending is more important. Hence, any steer on the health of the consumer from these data should be taken with a pinch of salt. As a reminder, in the US wages have been rising faster than prices for the last few months.

Inflation remains challenging in the UK

This week saw an update on the UK labour market. Whilst there has been a slowdown in hiring, it remains positive. Wages have continued to accelerate. This will cause anxiety at the Bank of England, where a series of interest rate increases are due to impact the economy, but the Monetary Policy Committee will be reluctant to assume it has been successful in taming inflation until wage growth slows, the labour market softens, or both. Price inflation remains stubborn in the UK as well.

The challenge of setting monetary policy, immortalised by Milton Friedman in the early 1960s, is that “monetary actions affect economic conditions only after a lag that is both long and variable.” This means that it is difficult for a central bank to know the right time to stop raising interest rates. Housing markets in the UK and US have both ground to a halt due to the current interest rate cycle, but the labour market remains tight.

One positive was that the UK labour force saw the first consecutive declines in long-term sickness in two years.

Bad news becomes bad news

US retail sales are beginning to show some signs of weakness, which this week coincided with the release of a weaker industrial production report. The market’s reaction prompted some interest. Stocks fell while bonds rallied; this might seem a logical reaction, but in recent weeks bad news for the economy has been seen as good news for the market, representing an excuse for the Federal Reserve to slow its pace of interest rate increases.

Any investment involves spending money now to get more back in the future and, as such, it will have some kind of sensitivity to interest rates. For most bonds, with their fixed interest, this will be the only material factor driving their price. For stocks, prospective interest rates, and an extra return for bearing the risk of owning equity, determine the price. When good news is bad news it’s because interest rates are the biggest driver of equity returns. However, when investors decide they need more compensation for equity risk, that can be an additional headwind. In fact, that’s probably the biggest source of anxiety that investors will have about the coming year, and now it may be starting to be reflected in market performance.

US earnings season

Around 10% of companies have reported their fourth quarter earnings numbers and, so far, the picture is a familiar one. Most companies have issued surprisingly strong earnings and sales results. However, this reflects the fact that most analysts have lowered their expectations over the last few weeks. Overall, the consensus estimate for this earnings season is a decline in profits of 2.7%, representing the impact of higher costs and, in some cases, a moderation of demand. The focus of this earnings season will, however, be on the outlook as much as the lookback. Do they, for example, consider cost pressures to be ebbing as the data suggests? Is service spending holding up as well as hoped? Could there even be signs of recovery in the housebuilding market, as implied by the NAHB homebuilder sentiment index released earlier this week?

These messages will land at a time when stocks have staged a pretty significant rally from their October lows, but now they are facing some technical resistance. Some measures of sentiment are more bullish, which makes it harder for stocks to further progress, although they are not too extreme.

Japan – no change for now

One area in which investors have been particularly active is Japan. In recent weeks, we have discussed how Japanese government bond market participants have been complaining about lack of liquidity due to the cumulative scale of the Bank of Japan’s purchases. This led it to widen the boundaries of its yield target for the ten-year Japanese government bond (JGB) yield in December. Speculation is rife that a further relaxation will come, maybe even a total abandonment of the policy. This week, the Bank of Japan decided to leave the policy unchanged, but had to buy a lot of bonds in order to do so. It feels unsustainable to maintain the current upper threshold of the yield curve control corridor if doing so involves increasing bond purchases at a time when market participants are already expressing concerns about lack of liquidity.

The value of investments can fall and you may get back less than you invested. Neither simulated nor actual past performance are reliable indicators of future performance. Performance is quoted before charges which will reduce illustrated performance. Investment values may increase or decrease as a result of currency fluctuations. Information is provided only as an example and is not a recommendation to pursue a particular strategy. Information contained in this document is believed to be reliable and accurate, but without further investigation cannot be warranted as to accuracy or completeness. Forecasts are not a reliable indicator of future performance.