2022 October Economic Review

  • Global stock markets were negative once again as investors became increasingly worried about the energy crisis, high inflation and slower economic growth.
  • Liz Truss was elected leader of the Conservative Party and succeeded Boris Johnson as UK prime minister, but resigned 45 days into her tenure following a disastrous fiscal plan.
  • Stock and bond markets were once again turbulent after a short period of positive growth in July.

Financial markets were highly turbulent once again throughout the past three months as concerns about inflation, soaring energy prices and slower economic growth continued to weigh on investor sentiment. The positive momentum seen in July turned out to be short-lived when it became clear that major central banks around the world, such as the Bank of England and the US Federal Reserve, were focused on getting inflation under control even if it meant tipping the economy into recession. Against this backdrop, stock markets were negative across the board throughout August, September and October.

Economic update

Overall, the economic picture in the UK, and around the world, is showing signs of weakness. Like many major economies, the UK continued to deal with inflation at 40-year highs and rising food and energy bills. While the economy has so far avoided a recession, gross domestic product, which measures the size and health of the economy, fell in August despite the economy expanding slightly in the month.

Commanding the most attention throughout the past few months were two major political and constitutional events. The first was the Conservative Party selecting Liz Truss to succeed Boris Johnson as party leader and prime minister, while the second was the death of Queen Elizabeth II and King Charles III’s ascension to the throne.

Shortly after taking office, the Truss government announced a radical fiscal package designed to promote growth. This proved controversial because it included billions of pounds of unfunded tax cuts that would require additional government borrowing, and was therefore poorly received by taxpayers and financial markets. The pound plummeted in value against several other currencies and briefly fell to an all-time low against the US dollar, while the cost of government borrowing went up.

The government’s fiscal package created so much market turmoil and frustration among the public that Truss was forced to make a U-turn and withdraw nearly all of its proposals. This did little to assuage anger within the Conservative party, however, and Truss announced her resignation after just 45 days in office.

These events took place during a time when the outlook for the UK economy looked gloomier than any other time in recent memory. Inflation spiked to more than 10% for the second time this year, reaching 10.1% in September, while retail sales fell in both August and September, according to data from the Office for National Statistics.

Perhaps unsurprisingly, the situation in Europe was broadly similar to the UK. Inflation in the eurozone reached 10%, driven primarily by energy and food prices, while the triple threat of high inflation, higher energy costs and economic uncertainty caused business activity to slow. Similarly, there was little in the way of let up in the US, where inflation came in at 8.2% in September. While this was down from a peak of 9.1% in June, it suggested the higher interest rates were not working.

Market commentary

Both equites (shares) and bonds fell during the past three months as the market volatility continued. A key feature of bear markets, such as the one we are experiencing right now, are sharp movements up and down as market sentiment changes. This is in contrast to bull markets, when prices move much more gradually, albeit in one direction: up. The positive movement that we saw in July was part of the overall bearish market climate we are currently experiencing. Investors briefly thought most of the interest rate hikes were behind them, but these hopes were dashed in August when the Federal Reserve reiterated its pledge to curtail inflation rather than support growth. This was the primary driver for falling stock and bond markets over the past three months as investors became pessimistic about the prospects of economic growth and corporate earnings in the months ahead.

During a time of negative stock market performance, there were few, if any, bright spots. Stock markets in Japan and the UK fared better than other major global markets, but were both down, followed by Europe, the US and Asia Pacific excluding Japan. China was the worst performer of the major markets.

Once again, global bond markets also fell as high inflation, rising interest rates and the ongoing negative geopolitical climate took their toll. With inflation remaining high and interest rates moving upward, investors are demanding a higher yield, or income from the bonds in which they are invested. Because bond prices move in the opposite direction of yields, this is causing their prices to fall.

The UK bond market was hit particularly hard in September due to the government’s ill-fated budget announcement. UK government bonds (gilts) fell sharply because investors felt the amount of debt required to fund the tax cuts would be difficult to achieve. The Bank of England attempted to steady the markets by buying gilts, while the government – as mentioned above – was forced to rescind its proposals. Bond markets do not usually react so negatively to the UK government’s budget deficits, but on this occasion, the central bank’s efforts to dampen inflation and slow down growth were at odds with the government’s attempt to stimulate growth.

With the Chancellor of the Exchequer’s unfunded tax cuts requiring a large increase in government borrowing, investors were sceptical that this was achievable, and prices fell, causing yields (in other words, the interest rate the government pays on its loans) to go up. When this happened, pension funds that hedge their positions with instruments known as derivatives suddenly needed additional collateral to cover their calls, triggering a widespread sell-off that caused liquidity to dry up and prompting the Bank of England to intervene.

Outlook

As the end of a very difficult year for investors approaches, we think the next few months will largely be the same as what we have seen so far. Inflation is unlikely to go anywhere any time soon, while interest rates will almost certainly notch upward yet again. The Bank of England and other central banks may slow down the pace of hikes if inflation falls back from its peaks, but markets are pricing in several further rises, and we see little chance of rates being cut before the new year.

It is difficult to predict how markets will behave in the months ahead as much of this relies on what happens to the global economy. It is possible that some countries will fall into recession, the magnitude of which will depend on how governments reduce the impact of rising energy prices and the soaring cost of goods on businesses and consumers.

The past few months were particularly turbulent for markets, with stocks and bonds delivering far more negative performance than was previously expected. This is not to be unexpected given the uncertain economic and market environment. During times like these, sudden shifts in sentiment can cause markets to move significantly in either direction. Given that the global economy is slowing down and the outlook for the UK and its trading partners is on the negative side, the likelihood of a recession remains high and markets will likely remain volatile.

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