The major stock and bond markets were unsteady last week, as investors took on board the implications of stubborn core inflation in the U.S. and Europe and the implications for interest rates.
However, thanks to a rally in both asset classes at the end of the week, major global stock markets recorded small gains over the week and bond market indices -such as the Bloomberg Global Aggregate- ended broadly flat.
Investors are nervous: what, they ask, is required in terms of interest rates to bring down core inflation? Market expectations for the terminal Fed funds rate have gone from under 5% a month ago to around 5.4% today.
This matters for stocks as much as it does for bonds. The tougher the inflation nut, the bigger the interest rate hammer has to be to crack the nut. And with that comes an increased risk of over-kill by central banks and recession, which will hurt company profits.
We should not expect a resolution in the near-term, given the continuing strength of labour markets in most developed economies. This props up spending on goods and services, which make up core inflation. Investors should remain invested in a diverse selection of assets that will protect them from downside risk.
It was the gyrating U.S. Treasury market that dominated market discussions last week. The 2yr yield, which stood at 4.1% as recently as February 23rd, reached 4.94% a week later on Thursday. This is a level last seen in 2007. The 10yr yield also rose, breaching 5% on Thursday.
The last time a negative spread was so large was in September 1981, months after one of the longest recessions in post-war history had started (16 months). Indeed, the negative yield curve has proven to be a reliable concurrent/forward indicator of U.S. recessions.
The Fed’s PCE inflation data triggered the sell-off in Treasuries from February 23, which we discussed in last week’s note. The key worry lies with rising core inflation, which is predominantly services. It is climbing on both year-on-year and month-on-month measurers. In addition, labour market data remains surprisingly strong.
Last week saw a stronger-than-expected services PMI reading of 55.1, confirming fears in the market that ‘higher for longer’ interest rates will be needed to weaken demand, weaken the labour market, and so bring down core inflation.
Some relief came from an unexpected fall in February’s consumer confidence index, which has now fallen for two months in a row, but remains reasonably strong by historical standards. Friday’s new jobless data that was broadly in line with expectations. These data items may explain the move down in bond yields at the end of the week.
Most investors who bought into investment grade fixed income at the start of this year, when the 2yr Treasury yield was 4.37%, will be nursing losses. But if a U.S. recession is to happen later this year that drives core inflation and then interest rates down, then-current Treasury yields surely look attractive? (This is a rhetorical question, not advice to buy).
Meanwhile, in the Eurozone, its inflation problem increasingly resembles that of the U.S., as energy inflation gives way to stubborn consumer spending. Last week, Eurozone inflation for February was reported at 8.5%, down on the previous month but higher than the 8.2% expected. The ECB’s 2.5% benchmark interest rate looks inadequate, with perhaps two more 25bp hikes to follow, looks increasingly inadequate.
In contrast, Andrew Bailey of the Bank of England said last week that interest rates may have peaked at 4%. Inflation of 10.1% in February is forecasted to fall sharply over the coming months. Consumer confidence is at the weakest levels since the index began in 1974. Retail sales were down 5% year-on-year in January, their tenth successive fall.
The decline of the L.S.E…has the City peaked?
We have recently had more evidence of the ‘hollowing out’ of the London Stock Exchange (LSE), that is of increasing concern to U.K. businesses. Last year the Paris stock market overtook London regarding the market capitalisation of listed stocks.
The value of listings on the LSE has steadily shrunk since the early noughties. Buy-outs, and a shrinking number of new listings, have reduced the number of listed companies. Meanwhile, the valuation attributed to the largest U.K. companies has been held back due to the ‘old economy’ value bias of the major firms. Since 2016, a clearly identifiable Brexit valuations discount has been applied by investors on U.K. firms, compared to their overseas peers.
U.K. institutional investors, meanwhile, have been re-weighting their equity exposure to international markets. U.K. pension funds have also sold equities and increased their fixed-income exposure over the last twenty years following accounting changes.
CRH, one of the world’s largest building materials companies, and Flutter, a gambling company, have both announced plans to move their listings to New York. ARM, the U.K.’s only major microchip designer, will list in New York when it is sold by its current owner Softbank. In February, Shell revealed it had considered moving its London listing to New York.
The preference for New York reflects the deeper capital markets of the U.S. (i.e., it is simply easier to raise money). Higher valuations are often applied to U.S. share prices than in London (Shell believes their p/e multiple might double on an NYSE listing). And the U.S. offers a comparatively easier regulatory environment.
The decline of the U.K. stock market is not a worry per se to investors, who have increasingly easy access to the global stock market and bond funds. Rather, it is indicative of a steady downsizing of London as a major financial centre relative to competitor cities, with implications for jobs, tax revenue and investment in the U.K. Arresting the decline will require a degree of commitment by the government to the financial services sector specifically and to business more generally, that it has eschewed since the Brexit vote.
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- No Investment Advice: This financial commentary is for informational purposes only and is not intended to be, and should not be, construed as an offer to sell or a solicitation of an offer to buy any security or financial instrument or invest in any equity or investment strategy. It should not be used to form the basis of any investment decision.
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