Global financial markets continue to be dominated by the unpredictability of inflation, interest rates and growth.
It seems too early to be bullish on cyclical stocks. We have yet to see the end of the post-Covid economic cycle, meaning it is premature to be buying into the next one. Growth stocks shouldn’t have performed as well as they have this year, given the ‘higher for longer’ interest rate environment, and appear fully priced.
Yields on investment grade bonds, meanwhile, are trending higher – in part because of the unpredictability of inflation, driven by ‘sticky’ core prices. Stagflation is a real risk to the U.S. economy and may already have become established in the UK.
One consolation is that real interest rates on cash are now positive in the U.S., and less negative than they were a year ago in the UK and Europe.
Investors should avoid over-concentration in any one asset class, or region. A balanced, multi-asset approach is strongly recommended.
Meanwhile powerful idiosyncratic themes are also at play, whether at sector or country/ regional level. These can make any top-down bets based on macroeconomic fundamentals look foolish.
For example, iron ore prices have risen by over 20% over the last month.* Large mining stocks have responded with good share price gains, with Rio Tinto -which owns the largest iron ore reserves- up 14% over the period.** A more than 10% rise in oil prices,*** thanks to an OPEC and Russia production agreement, has helped lift energy stocks. As a result, the FTSE100 index of large UK companies has delivered strong gains in recent weeks.
The semi-conductor designer ARM enjoyed a strong New York launch last week, up nearly 25% on its launch price.**** The stock benefited from the AI theme, which has helped drive much of the U.S. tech sector higher since the spring.
Neither rallies could have been anticipated from a top-down macroeconomic view.
A busy week ahead for central banks
The U.S. Fed and the People’s Bank of China (PBOC) will announce policy updates on Wednesday.
The Fed fund futures market suggests no change in the current 5.25%-5.5% target rate, despite rising energy prices and still reasonably strong labour market data. The Fed is often reminding the public of the lagging effect of rate hikes. Given that higher energy prices reduce discretionary spending elsewhere in the economy, it may be legitimate to ignore them. The Fed will also be conscious that households have largely exhausted their Covid-era excess savings and consumption may weaken as a result.
No changes are also expected from the PBOC. The generally weak economic environment in China, and near-zero inflation, might suggest the need for interest rate cuts but the central bank is nervous of further yen weakness.
The Bank of England (BoE) follows on Thursday, with a 25bp rate hike likely to be announced. This would take its benchmark interest rates to 5.5%. Services inflation is running at 7.4%, while private sector wage growth was 8.1% in July. These are disarmingly high numbers, given that the BoE was one of the first of the major central banks to start raising rates (in autumn 2021) and they suggest still tighter monetary policy is needed if the 2% inflation target is to be reached.
The sensitivity of the UK housing market to higher interest rates appears to be weakening, with further falls in fixed rate mortgages announced last week. This reflects the sharp inversion of the gilt yield curve, between the 1yr and 4yr yields, but raises questions as to the effectiveness of interest rates in reducing consumer spending.
The BoE is also expected to announce an increase in the pace of at which it shrinks its balance sheet, having shed £80bn in the last 12 months through bond sales (£34bn) and not re-investing maturing gilts (£46bn).
The U.S. Fed has reduced its balance sheet by about $1 trillion over the last year through not re-investing the proceeds of maturing bonds.
This reversal of quantitative easing, known as quantitative tightening (QT), involves literally delating the money that the central bank receives from the bond sales and/or maturing bonds. It is not thought to be having much effect on the bond markets, in part because of the sheer quantity of new issuance from the UK and U.S. governments to pay for large budget deficits.
A 25bp rate hike from the BoE would mirror last week’s 25bp rate hike from the ECB, which took its core benchmark rate to 4%. Both central banks face a more stubborn wage growth problem than the U.S., and peak interest rates for these central banks appears further away than for the Fed.
Indeed, there is a growing sense that the U.S. may be about to disconnect from the rest of the world, enjoying an economic soft landing while Europe (and possibly China) face recession. This would create a further level of macroeconomic uncertainty for investors.
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