Goldilocks has left the building… A Return to Normal …

2025 US Scene Setting – A change in Narrative:

Over the long term, the direction of financial markets is driven by fundamentals; over shorter term periods, sometimes lasting months if not years, it is driven by sentiment or ‘market narrative’. Last year, the’ Goldilocks Scenario’ was the narrative that drove the US Equity market higher and arguably kept bond yields in check. That was steady economic and corporate earnings growth, with inflation continuing to trend lower, allowing central banks to drop rates, keeping (pretty much) everyone happy! I have been arguing that the US economy was too strong to take those rate cuts for granted and that there was still a risk that inflation could reignite. Now, such a scenario is becoming the new narrative, namely healthy growth, with rates on hold and the jury out on whether inflation heads higher or lower from here. It doesn’t yet have a catchy name like ‘Goldilocks’, but I am sure someone will come up with something that market pundits endlessly recycle over the next few weeks. Bloomberg is headlining with a ‘Lose-Lose Market’, which I think is overdoing it. In actuality, I think we are just back to ‘Normal’ – rates roughly where they should be, and a Fed is equally likely to move rates higher or lower depending on how growth and inflation play out from here.

I happen to like the idea of a new ‘Normal Scenario’ – but it would seem investors currently don’t have the same enthusiasm. They have gotten quite attached to Goldilocks, and we are seeing equity valuations fall and yields head higher. I would be tempted to say that bonds and equities are merely ‘normalising’, a journey that could see the forward P/E on the S&P 500 shift to a (still pricey) 20x Earnings and the real yield on treasuries return to a typical 2%. Using simple maths, that would mean the S&P settles down around 5,500 (based on a $275 per share forecast), the US 10-year hits 5% (assuming inflation might stabilise at 3%), and Fed Rates around 4.25%-4.50% feels right. A drop of that magnitude would also ensure we get a reset of the Bull/Bear ratio, and I wouldn’t be surprised if it took us back into attractive contrarian territory of more Bears than Bulls if we get all of that. Yes, there is a bit of short-term pain as we give up some of last year’s froth, but it would be a healthy reset and set the scene for a continuation of this fledgling bull market that began back in October 2022, which could still have a very long way to run.

Last Week in the US

Whilst I understand the market reaction to the Jobs Data from the perspective of another nail in Goldilock’s coffin, as a long-term fundamental investor, I was delighted by the numbers. More jobs were created than expected, unemployment was heading down, and wage growth was in line with expectations. That’s about as good as it gets, and combined with the decent retail sales data we have been getting, it shows that the consumer and the economy are in a good place to drive higher corporate earnings this year. If earnings exceed expectations as they are in the habit of doing and we get healthy foarward guidance, then maybe the valuation of the market could justify the higher P/E we are currently on…we might not need to see the S&P 500 correct the 10% or so I factored into my earlier calculations.

Next week will give us a few more bits of the jigsaw puzzle as we get US CPI inflation data and the start of the earnings season with the Big Banks reporting. A higher CPI number could see the 10-year yield closing in on 5%; it’s currently hovering around 4.75%. I think equities will be able to live with a 5% treasury yield, providing earnings deliver…

2025 UK Scene Setting– oh Dear!

I really had hoped that one day I could write about the success and resilience of the UK economy. For just a brief moment in the first quarter of 2024, our economic growth led the G7 nations, and inflation fell fast. That seems like a distant memory in time as things have gone from bad to worse since Labour took office. That may sound like a political statement, but I can assure you that I have zero political bias in me; it is just a sad truth that Labour has misplayed its hand so far.

The first mistake was to ‘talk down’ the state of the country they had inherited, effectively increasing anxiety about what was coming and instantly curtailing business and consumer activity. They then compounded the problem by delivering measures in the Budget that were nearly guaranteed to boost inflation and hinder growth.

Now, I acknowledge that not all blame can be laid at the feet of Rachel Reeves and the new Labour Team. Global inflation has proved stickier, US yields have risen sharply, and a cold snap that will drive higher energy bills is outside their control. But come on! What did they think would happen when they raised national insurance contributions on employer contributions and the national wage? Wasn’t it obvious that this move would increase costs and inflation and reduce growth and investment?

And guess what—inflation is trending up, and growth is slowing. That is a perilous position to have gotten themselves into, and the financial markets have spotted the danger of the rise in the UK’s public debt as the cost of financing it—gilt yields—is heading dramatically higher.

For now, investors seem unconvinced by Rachel Reeves’ plans to generate the growth necessary to tackle the UK’s towering national debt, which remains at a 60-year high near 100% of GDP, or to address stubborn inflation effectively. The scepticism is reflected in a significant market selloff, pushing bond yields higher and weakening the pound. This dual impact hints at a possible capital flight, drawing comparisons to the turbulent period preceding the 1976 sterling crisis.

The parallels with 1976 are particularly striking. Back then, concerns about unsustainable debt levels, a struggling economy, and inadequate policy responses led to a sharp loss of investor confidence and, ultimately, a bailout from the International Monetary Fund (IMF). While the UK’s situation today is not as dire, the underlying themes of eroded fiscal credibility and a reliance on foreign capital to finance deficits resonate with investors.

The sharp rise in gilt yields signals that the cost of borrowing is becoming an increasingly heavy burden for the government. This rise limits fiscal flexibility and threatens to crowd out spending on essential public services or infrastructure investments. Meanwhile, the pound’s depreciation adds to inflationary pressures by raising the cost of imports, further complicating efforts to stabilize the economy.

While the BoE is not expected to intervene in the market, it may have to demonstrate a renewed commitment to tackle inflation despite rising unemployment and stagnant growth. The BoE faces a tricky balancing act as it weighs its inflation-fighting credibility against pressure to ease policy fast enough to prevent a sharp economic slowdown. BoE Governor Andrew Bailey signalled last month that four quarter-point reductions would be about right for 2025, as policy would remain restrictive at that level. However, markets are currently pricing just two cuts to 4.25% by December, and there is some scepticism over the speed of cuts. The BoE will now watch financial markets carefully for signs of liquidity strains. It could use its emergency tools or even stop selling gilts under its £100 billion a year quantitative tightening program if necessary. There is a glimmer of hope that growth could surprise the upside and help solve the conundrum, and that is the fact that less indebted consumers are still spending and have enjoyed wage growth in excess of inflation for a while now.

Apparently, growth remains the top government priority, and the press office has said that the chancellor would leave no stone unturned in her determination to deliver it. But I am scratching my head to see where that might come from. I think we need closer ties with the European Union; Brexit probably got us in the mess in the first place. Maybe getting closer to China might help, but I don’t think Trump would look too kindly on the UK looking East for help. But Reeves is travelling to Beijing and Shanghai in the coming days in an effort to mend relations, and I wish her luck.

But what does all of this mean for UK investment? Strangely, it is not all bad news. A weaker pound boosts the overseas earnings of many of our FTSE 100 companies, and you can already see that large-cap stocks are starting to outperform smaller ones. Our equity market remains very cheap on the world stage, and with Sterling down sharply, it does make the UK equity and bond markets look even more attractive to USD investors or would-be acquisitors. I also think the UK is going to muddle through this near crisis, and the scene will be set for further rate cuts later in the year, making a UK 10-year yield of close to 5%, very, very attractive for cautious investors. Higher yields mean pension funds are better funded, reducing the risk of shortfalls. This increases the likelihood that retirees in DB schemes will receive full benefits. Don’t forget that retirees opting for annuities can lock in higher income. Within our AQ portfolios, we have been underweight Gilts for a long time, but at this level, I think they are looking attractive again, particularly at the short end where yields look likely to exceed cash returns for the first time in a long time.

UK Equity & Gilt Markets Year to Date

I apologise for concentrating exclusively on the UK and US this week, but that has been where most of the action happened. Other markets and asset classes will be considered as we move forward! After two good back-to-back years from equities, I wouldn’t be surprised if this one proves to be a little choppier, but I still see markets higher by year-end, and I am still firmly in the long-term bull camp. Despite the more cautious tone of this opening, Market Matters, I still haven’t dismissed the possibility of a melt-up scenario on the back of all Trump promises when he takes office on the 20th of January.

Wishing you all a very happy New Year!