The dominant theme for investors over the third quarter was a growing fear, from early August onwards, of a ‘higher for longer’ interest rate policy from the Fed, the Bank of England and other major western central banks.
By the end of September, an additional fear was apparent in fixed income markets: an oversupply of Treasuries that was pushing up longer dated bond yields.
The MSCI World index fell 3.5% in USD, 2.6% in local currency terms, as government bond yields inched higher (and their prices fell).
Optimism. The quarter started well. July saw growing confidence amongst investors that global interest rates were near peaking, inflation falling, and growing hope that the major central banks may be able to squeeze inflation out of the global economy without inducing a marked slowdown in growth. It seemed likely that the Fed would achieve a ‘soft landing’ for the U.S. economy, particularly when the IMF upgraded its 2013 GDP forecasts for the industrialised nations. The Fed raised interest rates by 25bp to a target range of 5.25% to 5.5%, where they remained for the rest of the quarter.
The S&P500 rose 3.1% in July, ending at 4,588, a level last seen in December 2021. The 10yr Treasury traded between 3.7% and 4.1%, with little sign of direction.
Uncertainty. August saw repeated warnings from Fed officials that achieving their 2% inflation target, while unemployment remained near cyclical lows, house prices were rising, and retail spending remained strong, would require a prolonged pause in interest rates before they could be cut. This ‘higher for longer’ warning was explicitly made by Fed Chair Jerome Powell at the Jackson Hole summit of central bankers, in the last week of August.
Persistent strength in labour markets has also characterised the industrialised economies of Europe and the Pacific region. It has given rise to fears of wage inflation stocking core inflation and risks becoming intractable as workers demand further wage growth to compensate for the inflation.
The S&P500 fell 2%, despite a rally in the final week of August. The 10yr Treasury yield ended the month at 4.1%.
Fear. The ECB raised interest rates in September, hinting it may be their last. The Bank of England and the Fed put their rate hikes on pause. But all stated -using different words- that ‘higher for longer’ was now formal policy, with the need to create output gaps (i.e., unemployment) in order to reduce wage pressure on inflation. Investors did not like the message: the risk of a hard landing for the U.S. and global economy increases the longer interest rates are elevated.
A jump in the price of oil, following an output agreement between Saudi Arabia and Russia, together with on-going evidence of strong labour markets in the developed economies, heightened investors’ fear that interest rates may plateau for a prolonged period, before falling. Core CPI inflation, in August, rose unexpectedly.
The OECD kept its world GDP forecast for this year at 3%, but reduced its estimate for 2014 to 2.7%. The Eurozone looked increasingly at risk of a recession, while weaker-than-expected growth in China was pulling down Asian growth forecasts.
Government bond yields rose, not only on renewed fear of a sticky inflation problem, and of another rate hike from the Fed to come. But also, on fear of oversupply, due to large budget deficits, quantitative tightening policies by the Fed, the Bank of England and some other central banks. In addition, bond investors began to worry that the longer that inflation remains above target levels, the greater the risk of an increase in long-term inflation expectations and to the harder it will be to bring down wage growth.
The S&P500 fell 5% over the month, to end at 4,288. The 10yr Treasury yield ended September at 4.6%, last seen in the autumn of 2007.
Over the quarter as a whole, the S&P500 fell just over 3%, and the tech-heavy NASDAQ index was down over 4%. Small cap stocks underperformed in most markets, being more sensitive than their large cap peers to tightening financial conditions and weaker investor risk appetite. In the U.S., the Russell 2000 small cap index fell 5%.
The FTSE100 rose 1% in sterling terms, reflecting the more defensive composition of the UK’s main index (as well as the large weighting of energy stocks). It ended the quarter on a trailing price earnings ratio of 11 times, making it one of the cheapest stock markets in the developed world. Gilts had a less volatile quarter than Treasuries, the 10yr gilt yield began at 4.4% and ended at 4.5%.
The dollar strengthened over the quarter. This was in response to the prospect of ‘higher for longer’ interest rates, and the greenback’s traditionally defensive status during periods of investor stress. In addition, while the chances of a soft landing for the U.S. economy appear to have receded, any downturn in growth is likely to be much milder than that of other major economies. Sterling fell from $1.26 to $1.22, down 3%.
The prospect of a prolonged period on the plateau of peak interest rates has weakened investor confidence. The risk has increased of a hard landing for the U.S., and recessions for the Eurozone and perhaps the UK. This will hurt corporate earnings growth and dividend payments.
There is also an increased risk of something breaking in the global financial system, under the weight of prolonged high interest rates.
Investors in government debt won’t worry about a hard landing weak for the U.S. and global economy, if it brings down inflation. But fear of another U.S. rate hike, and the supply issues, mentioned above, may continue to push up global sovereign bond yields with a knock-on effect on spreads for commercial bonds.
Where is safe ground? U.S. dollar cash rates now exceed inflation, offering investors a welcome real return. Cash also offers ‘optionality’, the ability to quickly switch into other asset classes, should good buying opportunities present themselves.
But investors should bear in mind that, over most long-term investment periods, cash underperforms equities and bonds. Also, that timing entry into the markets is fiendishly difficult. Maintaining a balanced, multi-asset portfolio -across regions as well as sectors- is perhaps the best approach.
There will come a time when central banks cut interest rates and bonds rally. Cyclical sectors on global stock markets will attract investors, in anticipation of improvements to growth forecasts as the cost of capital falls. The early stages of such cycles are often dramatic, as animal spirits return. Those considering increasing cash holdings should be mindful of the risks.
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