The Turning Point

Inflation, the war in Ukraine and China’s faltering growth have challenged global markets this year. GAM Investments’ Julian Howard examines each of these factors in turn and explains why he believes investors could be facing a crucial juncture again after eleven months of market volatility.

12 December 2022

In the BBC’s new drama SAS: Rogue Heroes, the British Army in Egypt is depicted as institutionally inept and slow to adapt to the far more dynamic Axis forces. But Britain’s eventual victory at El Alamein at the end of 1942 was seized on by Winston Churchill as a significant turning point in World War II. Strategically of course, Stalingrad was the far more significant event, but Churchill’s timing was correct as 1943 onwards saw a broad losing streak which the Axis powers never recovered from. Identifying such turning points is of course notoriously difficult. Indeed, it is no coincidence that the expressions ‘false dawn’ and ‘one swallow does not make a spring’ are part of our lexicon. But financial markets over the last few weeks have witnessed developments that may just give such a call legitimacy. Across three ‘fronts’, markets have taken a battering this year, namely from inflation, the war in Ukraine and China’s faltering growth. But in all three, profound underlying changes are starting to transform the calculus. Investors could be facing a crucial juncture again after eleven months of market volatility.

Taking inflation first, global indicators are starting to ease – factory gate prices, shipping costs, commodities and expectations have all printed lower than expected. In Europe, CPI for October came in at 10% on the previous year versus 10.6% the previous month. In the US, the same datapoint was 7.7%, the slowest annual inflation print since January for that economy and well down from the startling June peak of just over 9%. Crucially, the closely watched core measure that excludes food and energy softened by more than the economic consensus ahead of the release. Economists have been pleasantly surprised by all this and, while it is early days yet, the steady deceleration since June suggests the tentative emergence of a meaningful trend. For investors this is vitally important, because it gives the US Federal Reserve (Fed) breathing room to slow down its aggressive rate hike stance in the coming months. Already, the key rate-setters have begun to voice the possibility that the relatively steep path taken of 75 basis point (bps) incremental rises can be moderated. Minutes from the Fed’s early November rate-setting meeting stated that “A substantial majority of participants judged that a slowing in the pace of increase would soon be appropriate”, while Fed Chairman Jay Powell confirmed at the end of November that the next rate-setting meeting may only need a 50 bps hike. While this may not represent outright easier policy, it is surely a necessary first step on the way. Logically the rate of increases must slow before interest rates can be outright cut. For financial markets, any potential moderation in the trajectory of rate rises is therefore welcome news given that net present values (ie, prices) rely heavily on the prevailing interest rate.

Figure 1: The right way at last – US CPI starts to decelerate

On the war in Ukraine, military experience is surely not needed to appreciate that the tide has somewhat turned. Ukrainian victory in Kherson, Russia’s main prize in the war so far, has been a hammer blow to the invaders while the ensuing missile bombardment of Ukraine’s civilian energy infrastructure reveals increased desperation in response. Faced with Ukraine’s long range rocket capability, their imaginatively expedient military and a refusal to negotiate on anything short of full pre-2014 territorial restoration, it is increasingly difficult to see how Russia can pull off a strategic victory at this point. For the global economy, and by inference markets, this is increasingly positive as can be seen by lower volatility in oil and commodity prices. Even the gloomier scenario of protracted stalemate has its silver lining for investors. Just as the recent US mid-term election results will slow down the implementation of any radical legislative agenda and therefore reduce uncertainty, so too could a grinding war of attrition avert extreme retaliatory measures on the part of the Russians such as tactical nuclear strikes or biochemical warfare. Anything which can reduce uncertainty, whether imminent Ukrainian victory or the less palatable alternative of stalemate, should have a soothing effect on market volatility. The chart below demonstrates the well-established inverse correlation between uncertainty – as measured by researchers at policyuncertainty.com – and rolling returns for the S&P 500. The old adage of markets hating uncertainty is clearly backed by the evidence, and a more benign phase in the war in Ukraine could contribute meaningfully to lowering this.

Figure 2: ‘Markets hate uncertainty’ – it’s actually true

In China, a vicious combination of zero-Covid policy and a property market meltdown have conspired to curtail growth. The International Monetary Fund’s (IMF) latest World Economic Outlook now predicts GDP growth of just 3.2% for 2022 and 4.4% for 2023, down from a heady 6.8% in 2018. This decline cannot go on forever given that China needs a healthy growth rate to maintain social cohesion. As China’s economy has slowed, protests have duly broken out over mortgage payments for unfinished homes, while violent protests in the southern city of Guangzhou in November saw crowds of protestors escape a compulsory lockdown and clash violently with police, only for protests to spread across the country later in the month. Ironically the government was already loosening restrictions via 20 adjustments to its zero-Covid policy announced on 11 November, including reductions in quarantine periods, freeing up close contacts from being sent to hospital and banning mass testing until it is clear how infections are spreading in a specific area. Now, restrictions are being loosened further and local authorities have warned that excessive clampdowns will not be tolerated. At the same time, the central bank and banking regulator are enacting a plan which will encourage commercial banks to help finance stalled housing projects, suspend limits on banks’ exposure to real estate and urge them to extend the maturities of loans due in the next six months. New bonds issued by viable developers will also be approved. Collectively, these are not the actions of a government planning to ignore economic growth come what may, a fact not lost on investors who propelled the MSCI China Index in HKD terms over 8% higher from the 11 to 30 November.

Turning points are the key aspirational opportunity in the active investing world. Being able to call them has taken on a mythical status, both making and breaking careers along the way. But this very human desire to predict the future sits uneasily with the body of published literature on the subject which demonstrates that market timing is all but impossible. And examples of false dawns litter the investing world, inter alia: the end to Japan’s 30+ year stagnation, the meaningful return of value investing and the end of the US dollar’s de facto global reserve currency status. None of this invalidates the above analysis though. Long term investors still deserve to know and understand when the likelihood of a crucial market juncture is elevated, particularly after a hyper-volatile year like 2022. If the developments of the last few weeks do turn into a longer positive trend, they have the capacity to soothe frayed nerves, keep sound investment plans on track and offer a potentially positive opening for investors sitting on the sidelines with cash to deploy over a multi-year period. It may be too soon to say whether this is the market’s ‘El Alamein moment’ – the allies in early 1943 after all had yet to suffer major reversals at Arnhem and the Battle of the Bulge on their way to final victory. But after the torrent of bad news from all corners this year, the profound nature of the economic and market developments described suggests that a meaningful shift may soon be upon us.