A personal view from Ian Stewart, Deloitte’s Chief Economist in the UK.

Asset markets have been on a rollercoaster ride since last January. Between January and October of last year the market was in so-called “risk off” mode. Fear of recession and inflation caused investors to switch away from assets whose fortunes depend on growth and low inflation. Investors stampeded from equities and government bonds into supposedly safer assets such as cash, commodities, utilities and pharmaceuticals.

That process has gone into reverse since 1 November. Riskier assets and government bonds have benefitted from a growing perception that inflation is near a peak and that interest rates may not need to rise as far as previously expected. China has dropped virtually all Covid restrictions, boosting hopes of a Chinese rebound and an end to supply chain problems. Meanwhile growth data has come in rather stronger than expected, especially in the euro area. If you’d bought euro area equities at the beginning of November, your investment would be up by 23% today. Chinese equities have done even better, rising 46%, turbocharged by the reopening of its economy. 

Expectations for inflation, interest rates and growth matter hugely for asset values. For most of last year markets were coping with higher than expected inflation and interest rates, and weaker than expected growth. No wonder investors switched out of riskier assets into cash, commodities and high-dividend equities. But better news on growth and inflation has triggered a so-called Santa rally from November that has extended into the new year.

Views vary on the sustainability of this rally. Sceptics note that valuations, especially in the US equity market, are high, that profits have further to fall and that bear markets are often punctuated by temporary recoveries. Optimists argue that markets have already discounted recessions and are now looking forward to recoveries later this year.

But as far as the real economy is concerned, the big picture is unchanged. The richer economies are in for a period of, at best, weak growth and, for many, recession. 

It’s worth looking in more detail at how assets fared in 2022 as a whole, treating the equity sell-off and the post-October rally as one. Despite late gains, the big picture remains of a flight to safety. Equities had a bad year as did government and corporate bonds. Shares in smaller companies, which tend to be more vulnerable to downturns, suffered more than bigger companies.

Tech stocks had a rotten year. Meta lost 64% of its value and Amazon and Netflix about half. Cryptocurrencies were hit by the fallout from the failure of FTX and other crypto-related assets. Bitcoin fell over 60%. The big car manufacturers were buffeted by supply shortages, higher costs and the prospect of weaker growth with shares in VW and GM dropping by over 40%. Growth-dependent sectors, like real estate, travel and leisure, retail and media suffered more than less cyclical ones like pharma.

Inflation erodes the value of government bonds that had one of their worst years since the 1980s. UK gilts suffered most, losing 26% of their value last year, with the panic triggered by large unfunded tax cuts in September’s mini-budget accounting for much of the damage.

Some assets did well. The UK’s FTSE 100 index prospered, in part due to the strong performance of UK banks, up 13% in 2022, and oil and gas shares that rose by 46%. The composition of the UK equity market, with low exposure to technology and heavy weighting in banks, commodity stocks and companies with dollar revenues, enabled it to outperform. Last Friday the FTSE 100 index closed at an all-time high of 7,844. This might seem odd given that the UK is expected to drop into a deeper recession than any of its peers this year, but the index is a poor proxy for the wider economy. FTSE 100 companies derive more than half their earnings from outside the UK and the composition of the index does not reflect the composition of UK GDP. Equity valuations are, in theory, forward-looking, capturing future prospects, not just current economic activity.

In currency markets the dollar was last year’s big winner, rising 5%. Investors want to hold dollars in uncertain times, especially when US interest rates are, as they were last year, rising rapidly. 

And what of the future? Markets have certainly perked up since October. If inflation falls faster than expected, and growth prospects start to improve, the Santa recovery could run on. But that’s not remotely assured. It could equally be snuffed out by a rebound in energy prices, a quickening downturn or unexpected rate hikes.

Economic forecasts and market sentiment warrant close attention. As a guide to the future, they are deeply fallible.

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