Investors saw good returns in major stock and bond markets over the first quarter, which is perhaps surprising considering the volatility of bond yields over the period and a mini-crisis in the U.S. and European bank sectors in March.
The outlook is for continued uncertainty for investors. Central banks in the U.S., Europe and Japan are all trying to tame stubborn core inflation with interest rates, but without raising rates so high that they trigger recession, or bring about another crisis somewhere in the financial eco system. It is a delicate balancing act.
The result may be a compromise, with central banks raising interest rates quietly ignoring their 2% inflation target in exchange for macroeconomic stability. This may lead to both inflation and interest rates being higher, for longer, in the medium term.
The first quarter saw strong gains made on global stock markets, with the MSCI World Index up 11% in USD, and 5% in sterling. Tech stocks did particularly well, with the NASDAQ up 16% in USD, benefiting from the fall in Treasury yields. The FTSE 100 rose a more modest 1% in sterling, reflecting its more defensive and cyclical membership.
There were two distinct periods during the quarter: January saw bullish spirits on stock markets, on hopes that central banks may not have to raise interest rates as much as had been feared. Inflation was falling and end-of-the-year forecasts for 2023 had been uniformly gloomy regarding the global economy. It was a period of ‘bad news is good news’. Bond yields fell back a little.
But persistent strong labour market data, particularly in the U.S., disturbed the view that central banks might end their rate hikes in the spring. January’s non-farm payroll numbers, released on February 2 was shattering: 517,000 new jobs created, against a consensus forecast of 187,000.
It was becoming increasingly clear that tight labour markets are supporting inflation in the services sectors throughout the developed world. The U.S., eurozone, the U.K. and Japan all saw core inflation rise during the quarter, even as headline inflation numbers fell on account of last year’s energy price rises falling out of the data.
Bond yields rose rapidly, as central banks continued to raise interest rates. Their aim has been to avoid persistent core inflation triggering a rise in long-term inflation expectations and so fuelling the ‘inflation busting’ pay hikes that be-devilled the 1970s. The ECB became noticeably more hawkish. Forecasts for terminal rates edged higher. Stocks lost momentum.
When the tide goes out
Warren Buffet, the legendary U.S. investor, once said that when the tide goes out, we see who has been bathing naked, i.e., when liquidity dries up because central banks raise intertest rates, things in the financial system tend to break.
And so, they have. Last year we saw special interest rate purpose companies (SPACs) burn, along with meme stocks and liability driven investments (LDI) in U.K. pension funds, as rising interest rates combined with investor unease over management and growth prospects.
In March, it was the turn of a number of small and mid-sized U.S. banks to be caught swimming naked, together with the Swiss giant Credit Suisse. The growth of money market funds in recent years has accelerated on account of the much higher deposit rates they can offer investors, than banks. This contributed to a crisis on the liability side of banks’ balance sheets, as deposits were withdrawn from banks deemed weak and poorly managed, or over exposed to a particular sector.
The U.S. and Swiss authorities moved quickly and stopped a series of idiosyncratic problems becoming a systemic banking crisis. Bond yields fell sharply, as investors sought safe haven assets and hedge funds that had bet on a continuing rise in bond yields had to cover their short positions.
Central banks faced a complicated balancing act at the start of January. How to reduce inflation without causing recession? In March, a further dilemma presented itself: reducing the risk of further failures in the financial system calls for a relaxation of monetary policy, not a contraction. Marrying the goals of price stability, growth and stability in the financial system has got complicated.
The recent decision by the OPEC+ group of oil producing countries to cut production by 1.1 million barrels per day adds a further complication (is it inflationary or deflationary?).
The likely approach of central banks is to have interest rates peaking at lower levels than previously expected. To trade the risk a persistent inflation problem for a reduced risk of further failures in the financial system. But this will delay inflation falling back to the 2% target set by central banks, delaying rate cuts. And as investors price in higher for longer inflation they demand higher for longer yields on their fixed income investments.
A good environment for commodities, defensive stocks and short dated bonds. Not so good for cyclical stocks and long dated bonds.
Tech stocks, and other growth sectors, should struggle in an environment of higher for longer interest rates and bond yields. However, the picture is slightly confused by the strong balance sheets of Big Tech in the U.S. Microsoft, Apple, Alphabet all have large cash holdings, making their investment and growth prospective less sensitive to the day-to-day cost of money.
Finally, sterling’s climb to $1.25, from $1.21 at the start of the year, reflects changes in interest rate expectations on either side of the Atlantic.
Slowing inflation, the recent slowdown in new jobs openings, and nervousness over further hiccups in the financial system, point to just one more rate hike from the Fed in the current cycle.
In contrast, better than expected economic GDP data and tax revenue in recent months from the U.K., and a surprise rise in inflation in February, have resulted in market expectations for two further 25bp rate hikes. The U.K. is also perceived to be under better government than in the dark days of late September, when sterling fell to £1.03.
The current exchange rate looks sustainable.
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