Global stock markets are not enjoying the increasingly favourable macroeconomic outlook for the U.S. and the global economy.
The S&P 500 is down 3% since the start of August and the NASDAQ is down 5%. The UK, Eurozone and Japan are also down around 3% in both dollar and local currency terms.
Why? Perhaps because investors in risk assets see fixed income markets responding to ‘higher for longer’ interest rates and to bond yield fears, and are weakening in response. We have long warned of this scenario.
At first glance, the macro-economic environment is highly supportive of risk assets. Inflation is falling everywhere, even ‘sticky’ core inflation measures. This was confirmed in Friday’s US CPI inflation data release, which showed core falling to 4.7% (headline CPI rose a little, to 3.2%, but on account of year-on-year base effects).*
There is increasing confidence that central banks are nearing the end of their interest rate cycles: after Friday’s U.S. CPI inflation data release, markets placed a 91% probability of no change in the Fed rate at next month’s meeting, for the second month in a row. The Bank of England and the ECB undoubtedly have further to go, but are probably close to peak rates given falls in core inflation throughout Europe. (We will know more about UK inflation on Wednesday, when July’s data is published).
In addition, second quarter corporate earnings results have generally exceeded expectations in North America and Europe. They have been helped by continued strong household consumption, with ‘revenge spending’ leading to surprisingly strong earnings for travel and other discretionary consumer sectors. As we reported last week, global economic organisations have been increasingly optimistic over the prospects for global growth over the coming twelve months.
But…while fear that central banks will need to create recessionary conditions in order to squeeze inflation have receded, it has been replaced by another fear.
That is, the fear of a prolonged period of higher-than-expected interest rates and bond yields. This may well be what higher longer term Treasury yields are telling us. From a recent low of 3.4% in early May, the 10-year Treasury yield now stands at 4.2%.
Why is the 10-year rising?
There are probably two factors at work. First, ongoing fear of embedded inflation. Many economists question if wage growth can really fall to levels commensurate with the 2% CPI inflation targets of most major central banks, given continuing tight labour markets, and relatively weak labour productivity growth (of around 2% in the U.S.).
The U.S., for example, now has real wage growth (i.e., wages growth exceeds inflation), which means an increase in the affordability of goods and services, which in turn may stimulate price rises.
Second, there is a real fear that an over-supply of Treasuries, and political shenanigans, deter investors from buying Treasuries – this was highlighted by the recent Fitch downgrade of U.S. Treasuries to AA+. Still higher yields may be needed to attract investors into long term government debt.
Bloomberg talking heads fret over whether businesses, and sovereign governments, can live with 4% plus 10-year Treasury yield, on a multi-year basis.
Higher interest rates and long-term yields will impact company profits in several ways, principally through reduced customer demand and higher financing costs. Furthermore, the relative attractiveness of a company’s stock is likely to weaken if the return on risk free assets – such as Treasuries and bank account cash- rises.
Consensus from analysts is that investment grade companies can get by in a world of 4% plus on the 10-year, because they have plenty of cash in their balance sheets and demand for their goods and services is supported by strong employment numbers.
Governments that issue debt in their own currency need never default, so the question regarding Treasuries is entirely political, i.e., will politicians in Washington choose not to repay investors? Investment grade spreads over Treasuries may fall, if investors start demanding a higher premia for the political risk of holding government debt, and supply concerns.
This environment may persist…all eyes on wage growth
It may take several more months for the implications of the ‘higher for longer’ scenario to sink in. The deciding single factor is probably going to be wage growth, with both bond and equity investors hoping to see weakness in the numbers.
Investors should remain diversified throughout the range of available asset classes and geographies, in order to achieve the best long-run risk-adjusted returns.
Source Material: * https://www.bls.gov/news.release/cpi.nr0.htm
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