Back to Higher Rate Fears…

Equity Markets Last Week

This is a fickle market, which seems to manifest the general uncertainty of investors. Are we going to get the immaculate disinflation, or is the economy simply too hot for the Fed to pause monetary tightening any time soon? Last week, the US ISM (Institute for Supply Management) index came in hotter than expected, hitting an expansionary 54.5 for August, playing in to the ‘rates higher for longer’ narrative. Unsurprisingly, investors reacted accordingly, sending bond yields higher and equities lower. The ISM is viewed as the US equivalent of the European PMIs, but there are subtle differences in the way they it is calculated, which can typically mean that the US index is more volatile and history suggests it tends to be more optimistic. I think the market’s reaction was probably a bit overdone and by close of play Friday, US indices seemed to have calmed down. If you look at the chart below, I would argue it looks like things are returning back to a normal trajectory, rather than we are about to see growth heat up again.

Global Economic Outlook

So far this year, there has been more economic resilience than expected but little evidence of overheating. In fact GDP growth in 2023 is expected to be the weakest since the global financial crisis, excluding the unusual circumstances of 2020 and I think we can expect sluggish growth to continue, as monetary tightening gradually hits household and corporate spending. That is a better outcome than most people expected and there are several factors behind this, including the continued spending by the US consumer, Europe’s capacity to withstand energy crises, and China’s swift emergence from pandemic restrictions earlier in the year, albeit that recovery now seems to be waning.

Looking further ahead, the impacts from policy tightening, tougher lending standards, and fiscal drag all look set to take a greater toll on the US economy, just as the depletion of households’ excess savings leaves a smaller shock absorber. But I think a soft patch, rather than a recession is most likely. As with the US, the full impact of lagged policy tightening is yet to be felt in Europe and the UK, but it does feel as if activity will ‘muddle through’ benefitting from easing energy and food prices over the next year or so. Very difficult to call here, but Europe might just skate over a recession that the UK will probably fall in to, but I expect that will only be shallow. The Chinese economic data for July indicates a broad-based weakness that may somewhat exaggerate the true state of the economy. However, it does suggest that the pent-up demand following the easing of zero-Covid restrictions has largely run its course. While stimulus measures have been recently introduced, significant and aggressive policy interventions are not expected. Instead, policymakers appear focused on stabilising growth and mitigating risks in the property sector. Anticipated Chinese GDP growth is projected to decelerate from just above 5% this year to around 4.5% in 2024, hardly catastrophic. On a more positive note, Latin America is expected to shine as less restrictive domestic policies are anticipated to drive a broad regional recovery in 2024. Slow and unspectacular is how Oxford Economics describes the outlook for world economic growth next year and I think that is probably an accurate description of what we can expect.

Global Economic Outlook

Inflation & Monetary Policy

Headline CPI inflation rates worldwide are on a downward trajectory, largely due to the expected easing of annual energy and food inflation, helped by a drop in ‘cost of shelter’ in the US, as rental costs look set to start trending lower. However, core inflation rates, which hold greater significance for central banks, are anticipated to decline at a slower pace – held up by wage inflation. The upshot is that headline inflation is likely to remain above 2% throughout 2024 in most major advanced economies, with concerns about prolonged high inflation lingering in regions like the UK and Australia. The eurozone stands as an exception, with negative energy inflation expected to keep headline inflation below 2% next year.

Nonetheless, core inflation is expected to remain above the target level. The idea of a swift and effortless return to target inflation, the ‘immaculate disinflation scenario’ is probably overly optimistic, expect stickiness between 3 to 2 %. Regarding interest rates, recent comments indicate a growing reluctance to raise them further among central banks, caveat the BOE which is expected to increase rates once more in September. It is probably likely that both the US and Eurozone have reached their peak policy rates (fingers crossed), but the key question in the coming months revolves around when and how quickly policy rates will begin to decrease and that probably holds the key to the performance of equities and bonds from here.

Traditionally, central banks have been hesitant to cut rates when core inflation significantly exceeded the target. However, they have been swift to loosen policy during periods of economic weakening or financial stress. The current situation, with relatively high starting inflation compared to past cycles, represents uncharted territory where previous rules of thumb may be broken to some extent. Assuming core and headline inflation continue their downward trends and pose more downside surprises to policymakers, central banks should gradually move towards less restrictive monetary policy. This aligns with evidence from Emerging Market central bank cycles, where rate cuts can quickly follow initial rate hikes.

As things stand, market expectations suggest that the Fed and the ECB will commence rate cuts around May, and by year end, market forecasts suggest reductions of 75 basis points and 150 basis points, respectively. In contrast, the forecast for the UK is that we will see just two 25-basis-point rate cuts in the second half of 2024. Here, I probably differ with consensus and feel that rates could come down much faster as the UK consumer struggles with the higher cost of debt financing including mortgages. The Bank of Japan might not even feel the need to tighten rates and will instead focus on adjustments to its yield curve control policy which it relaxed in July.

Implications for the major Asset Classes

Finally we have attractive yields available from fixed income investment, but we have not arrived at that point without significant pain for investors, just ask anyone that has held Gilts or even Sterling Corporate bonds over the last two years.

Not so long ago 10-year Gilts paid investors little more than 0.25% for the privilege of lending to the UK government, now that figure is a very healthy 4.5%. That might not look especially attractive right at this moment when cash rates on offer are above 5%, but once the BOE are done with rate hikes as the economy weakens, then I think a risk free 4.5% will look very attractive indeed. Same is true for 10 year US Treasuries, which hit a low of around 0.65% and now offer 4.25%.

If the economic picture we have painted comes half true, then as inflation drops and central banks commence easier monetary policy , expect yields to come down and capital gains from bond funds. It feels like it is probably time to start moving overweight this asset class or at least increasing duration (essentially raising beta) in portfolios. If inflation is stickier than expected, at least you are compensated by a yield over 4% and a little bit more with some credit risk in investment grade and high yield for the brave.

Equities should do just fine given a backdrop of modest growth and a more benign rate environment. The only problem is that a lot of that optimism is already baked into valuations, particularly in the US. I don’t know about any other regular Bloomberg watchers, but I can’t remember the last time we had someone on talking about how high P/Es have become or how expensive equities look in comparison to bonds. We might just breeze through the next couple of quarters and then see earnings power ahead bringing valuations back into normal territory. But for valuation reasons alone, I think it probably makes sense to be slightly underweight equities for the next few months until we get confirmation that rates have peaked and that growth will hold.

But further out, don’t get me wrong, I think equities could do very well over the course of the next economic expansionary phase of the cycle, particularly if the widespread adoption of artificial intelligence continues to gather pace. The greatest bull market of all time coincided with the arrival of the PC in the 1980s, which boosted economic activity whilst simultaneously reducing costs, in short bringing about massive productivity gains. It is too early to say definitively that AI will bring about a similar revolution, but the potential for that to happen is high. That would be a gamechanger for equity investors, and I don’t just mean holders of Nvidia, as if companies can successfully embed it in their eco systems it could simultaneously boost output and reduce costs, massively raising profits and alleviating the labour shortage problem along the way.