WeeklyWatch – Possible interest rate peak inspires continued market growth

7th February 2023

Stock Take

Inflation rates continue to rise

Surprises don’t sit well with markets. Thankfully, central banks met investors’ expectations and delivered the expected messages and rate rises last week.

The US Federal Reserve announced a 0.25% rise, which is a slowdown from earlier hikes. Elsewhere, rates were increased by half a percentage point by the European Central Bank (ECB) and the Bank of England (BoE). Tellingly, the BoE changed its prior guidance that rates will probably increase once more.

Jerome Powell, the chair of the Federal Reserve, said that the committee planned to tighten policy even further and that there was still “a long way to go” before declaring victory against inflation. The market response, however, implies that they are already motivated by the notion that inflation has reached its peak and the fact that the global economy would be slowed by the lagging impact of rate rises, requiring these hikes to be reversed later in the year.

Highs and lows for global stocks

Is that a light at the end of the tunnel for investors? Well, there’s certainly some positivity as global share markets have continued to rise. Despite a decline on Friday with the revelation that the US economy generated 517,000 jobs last month – more than double the consensus estimate – the S&P 500 Index is currently up about 8% in 2023. Investors believe that a weaker labour market will be crucial in bringing down the high inflation rate.

The STOXX Europe 600 Index is beginning the year with its strongest start ever. And the week came to a close with the FTSE 100 Index ending at a record high, boosted by optimism of declining inflation and that a weak pound will benefit UK businesses operating overseas. Energy and banking businesses, which make the majority of their money abroad, dominate the index.

In the wake of the ECB’s interest rate announcement, 10-year German bonds had their largest gain in more than a decade, while bond markets have also soared so far this year. This occurred despite early-week reports that the German economy suddenly declined in the fourth quarter.

Risk of market overconfidence

The possibility of markets moving too quickly and outrunning central bank policy actions before they have the chance to catch up could put investors at risk. Mark Dowding of BlueBay warned:

“In the short term, improving sentiment could lead to an outcome where it appears that higher interest rates are having relatively little bearing on the economy.

“Paradoxically, we might observe that the stronger the economy and markets at the start of the year, then the weaker the outlook for both will be later in 2023. Conversely, if things looked materially weaker now, then this could be more of a harbinger of a stronger second half of the year.”

The value of global equities has already recovered $4 trillion this year following a $14 trillion loss in 2022. Four calendar years, including last year, have seen the US stock market lose more than 15% since 1950. The market increased 12.9% on average in the year that followed each loss, however, highlighting the fact that strong years typically come after poor ones – and the significance of investors maintaining their composure.

2023 outlook for the UK economy

The International Monetary Fund (IMF) raised its projection on Tuesday for global growth in 2023, citing robust demand in the US and Europe as well as the reopening of China’s economy. But the IMF presented a gloomy picture for the UK, predicting that it will be the only advanced or developing economy to shrink this year.

High energy expenses, rising mortgage costs, more taxes and ongoing labour shortages were cited as reasons for the decline. This year, an estimated 1.7 million mortgages are anticipated to approach the end of their fixed-term rate, and the hike in rates is predicted to result in repayment increases of an average of £250 per month.

Unfortunately for those who want to save money, banks have not been eager to increase interest rates on savings accounts. Moneyfacts reports that the typical instant access account still only pays 1.73%. That may be the best-case scenario if interest rates truly are at or approaching their peak.

In corporate headlines, Alphabet, Apple and Amazon all reported poor earnings on Thursday, echoing Microsoft the week before. Facebook’s owner Meta resisted the grim technological trend, declaring better-than-expected results. The stock increased by as much as 26%, which was the largest one-day increase in almost a decade.

Economic effects of low work motivation and early retirement

Last but not least, the Bank of England warned in its statement last week of the long-term negative effects on the economy as a result of early retirees and those who have left work since 2020.

Lower productivity, meanwhile, is likely not just an issue raised by those who have ceased working. The setting of working from home may also play a part. BlueBay reported on data findings from Netflix, which found that the prime periods for streaming have changed from Sunday evenings to weekday afternoons. This raises suspicion of homeworkers who are disinterested or demotivated and may be ‘quietly quitting’.

Wealth Check

The UK tax system is anything but simple. It’s very easy to misread the rules, make some costly mistakes or get caught in one of the seemingly invisible tax ‘sinkholes’.

The 60% income tax trap is one prominent example. Due to the fact that it’s an unofficial effective rate of Income Tax, it’s not stated in any HMRC guidelines. The tax trap happens as a result of the personal allowance for higher earnings being reduced. The outcome? The tax rate for those making between £100,000 and £125,140 lands at 60%.

Even if this tax ‘sinkhole’ in particular doesn’t relate to your individual circumstances, it’s important to be aware that taxes can pop up in a variety of unexpected areas, sometimes covertly and undoubtedly by surprise. Melloney Underhill, Head of Marketing Insights at St James’s Place, warns:

“What the 60% rate represents is that these ‘sinkholes’ can appear anywhere – tax allowances change frequently, and those changes can affect you.”

Your annual income that is exempt from income tax is known as your personal allowance. The £12,570 personal allowance gradually decreases if you make £100,000 or more annually. Currently, it is reduced by £1 for every £2 you make over £10,000.

In concrete terms, this implies that for every £100 of income between £100,000 and £125,140, you keep just £40 after income tax and another £20 due to the personal allowance tapering. This results in a tax rate of 60%. And when your income reaches £125,140 or above, you are not eligible for any personal allowance.

But it’s not all bad news. With the right financial advice and careful planning of your financial future, you can alleviate and even steer clear of this sinkhole altogether. Underhill suggests:

“The quickest and simplest way is to pay more into your pension before tax-year end, so you reduce the earnings that fall into that bracket. This way, you save Income Tax and boost your retirement fund at the same time.”

The levels and bases of taxation, and reliefs from taxation, can change at any time and are generally dependent on individual circumstances.

The Last Word

“We need to stay the course, and in my view, the next step in the bank rate is still more likely to be another hike than a cut or hold.”

– Bank of England Monetary Policy Committee member Dr Catherine Mann gives her view on the likely direction of interest rates in the coming months.

BlueBay is a fund manager for St. James’s Place.

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SJP Approved 06/02/2023