Risk assets have shown surprising stubbornness this year, in the face of repeated increases to interest rate expectations. Can this persist? Not logically.
As we discussed a fortnight ago, * much of this year’s stock market ‘strength’ has been focused on Big Tech. But narrow-based rallies are particularly vulnerable to changes in investor sentiment. Higher interest rate peaks are now expected in the U.S., the Euro zone and the UK, than when we wrote that note – and the outlook for long-duration risk assets must logically have deteriorated further.
Fortunately for investors in multi-asset funds, such portfolios are regularly rebalanced to prevent any outsized positions developing through ‘drift’ (i.e., holding on to stock market winners irrespective of their prospects). Multi-asset funds are also exposed to a wide range of asset classes, including government bonds. These will benefit from an eventual vanquishing of inflation and are relatively impervious to the recessionary conditions that may be needed to do so.
Meanwhile, the Bank of England’s tough talk on interest rates has helped lift sterling, even as short-dated gilts fall in price on fear that an embedded inflation problem may be developing.
We can ignore the Fed’s interest rate pause last week, it was expected and priced in. But the risk of still higher interest rates -Fed chair, Jay Powell, speculated that two may be needed- will have further damaged the investment case for ‘jam tomorrow’ tech stocks.
Valuations on tech stocks and other growth sectors, are peculiarly sensitive to the rising cost of capital, given their need for investor capital and patience while new products are being developed.
And how expectations have changed! A month ago, market expectations were that the hikes had finished, now the Fed’s own ‘dot plot’ chart suggests a terminal rate of 5.6%, up from the current target range of 5% to 5.25%. Over the same period the tech-heavy NASDAQ index is up 8%.
The ‘higher for longer’ scenario for interest rates is also found in Europe. Last week, ECB president Christine Lagarde warned of more hikes to come due to stubborn core inflation, after raising rates by 25bps. This week, economists expect the Bank of England to say much the same as it raises rates by at least 25bps. Some are pencilling in a 6% terminal rate, a significant jump from the 4.5% today, given the weak state of the underlying economy.
And the risk of recession has grown
As the ‘higher for longer’ scenario turns into reality, the risk of recession in the U.S. and UK increases, something that Germany is already experiencing.
This risk is to be seen in the recent widening yield spread between two and the ten-year Treasuries, which is currently at -0.97%. A negative spread suggests a recession lies ahead, the current spread is near the figure seen in March, during the mini-banking crisis. This was the lowest since September 1981.
The next upturn in global economic growth is likely to be pushed out to early next year, as and when the Fed begins to cut rates. The risk that the Fed will be cutting interest rates as the economy goes into recession has increased.
The UK’s special problem
Short dated government yields have been rising everywhere over the last month, as the prospect of ‘higher for longer’ interest rates is taken on board. But in the UK, the calming influence on the gilt market that prime minister Rishi Sunak and his chancellor Jeremy Hunt, brought when they took over has faded and the jump in gilt yields has been particularly severe over the last month. Two-year gilt yields, at 5.06%, are now higher than during the Liz Truss’s premiership last autumn. Why?
Analysts have identified several factors.
First, it appears that the UK economy cannot grow at all without creating inflation: first quarter GDP growth was 0.1% (quarter on quarter), but core inflation rose between March and April, stimulated by pay growth of around 7% annualised. The numbers reflect a shrunken workforce (discussed in our previous Taking Stock commentaries).
Second, policy solutions to the lack of labour and to low levels of public and private investment spending (which might help make up for labour shortages), are not in evidence. Indeed, the government appears anxious to reduce migrant labour, in order to meet a commitment on immigration levels.
Third, the Bank of England’s governor, Andrew Bailey, has announced a review of the Bank’s failure to forecast, and then control, the current inflation. He can be credited for candour, but it suggests an impotent central bank.
The result is a rise in gilt yields, which has triggered hikes in fixed term mortgage rates and will intensify the political pressure on the government to ‘do something’. The Treasury has denied it is considering subsidising mortgages.
However, unlike last autumn, sterling has not been weakened. Then, the Bank of England had ‘wobbled’ on interest rates. This time, robust talk from the Bank -as it preps the market for more hikes- has been a key support. Sterling stands at a six-month high of Euro 1.17, and a fourteen-month high of $1.28.
June 6, 2023 Brite USA: Taking Stock: “An artificially intelligent market’”
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