The primary reason for the benign market environment was expectations of a more modest (dovish) interest rate development on the back of more subdued inflation figures and estimates.
In addition, recession fears subsided. In January, the IMF adjusted its 2023 global growth estimate slightly upward, to 2.9% from 2.7%. I believe it’s fair to say that the market had expected another downward revision. I also note, however, that the much-heralded 2022 recession never materialised.
Quite a few financial research papers indicate that the real economy, both in the US and elsewhere, has become less responsive to interest rates over the past decades. A pessimist might conclude that interest rates will have to stay high for a long time in order to quell inflationary fires. An optimist might decide that the economy will weather the higher interest rates fairly well. One month into 2023, the market seems to side with the latter.
There is, however, no doubt that interest rates move markets. Out of curiosity I just regressed the monthly changes in the S&P 500 during the past couple of years on changes in the yield on 10-year US benchmark treasuries and the spread on US high-yield bonds (in excess of Treasuries). The results were inordinately significant, despite the small number of observations, for both variables. Approximately 70 per cent of the monthly movements in the S&P 500 were thus explained, or “explained” if you happen to be my old econometrics professor pointing out some obvious objections. I’d still say the figures illustrate a remarkably strong sensitivity.
No wonder: I used the relative changes in rates and spreads. While interest rates have been notably low until quite recently, the same is not true for relative changes. Last year, the 10-year yield increased by 156 per cent. We may surmise that relative changes will be lower going forward, but with the added risk of recession-inducing levels, I wouldn’t out the possibility of continued interest rate sensitivity in the stock market.
While daily volatility has been surprisingly modest, the bigger picture has been that of a market veering endlessly from sunny views to rain and back. January gave us the bright side of this seemingly random tottering. Interest rates provide a concurrent explanation, January being no exception. And the coming year will probably deliver further examples of veering and tottering.
In the meantime: Don’t forget that the long-term direction is up.
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