deVere Group: Investment Outlook Oct 2023

Investment?Outlook

Tom Elliott

A fortnightly look at global financial markets

https://www.devere-group.com/international-investment-strategy/

12th?October 2023

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·?????????Treasuries rally as investors seek defensive assets

·?????????Have recent high bond yields done the Fed’s work for it?

·?????????Stock market investors see more evidence of a U.S soft landing

·?????????The oversupply of Treasuries argument

·?????????Sterling is hard to love

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Market sentiment:?Improved. Treasury yields have fallen this week (ie, their prices have risen), possibly marking the end of a bond sell-off that began in April. Risk assets have responded well to reductions in bond yields in recent sessions. A global stock market rally, that began last Friday following strong U.S payroll numbers, persists. The S&P500 is up 2.8% over the last five days, at 4,377. The FTSE100 is up 2.6%.?

Defensive buying in response to the Israel/ Hamas war, and a hope that high bond yields may help reduce the need for a further Fed rate hike, have perhaps put an end to the recent gloom surrounding Treasuries. If so, recent positive sessions for global bonds and stock markets may persist.?

But geopolitical risk is high, given the temptation Israel must feel to occupy Gaza, with unknowable consequences for peace in the region. And it is much, much too soon to know whether the increase in longer-dated Treasury yields seen over the last six months will actually modify Fed policy. Meanwhile, fear of over-supply of Treasuries casts an increasingly dark shadow over the asset class, and hence over the relative valuations of all assets.

Investors should remain cautious, invested in a broad range of assets across regions and sectors.?

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The bond argument.?The September non-farm payroll numbers, released last Friday, saw 336,000 new jobs created in the U.S last month. This was so far above the 170,000 consensus estimate that one suspects the forecasters (amongst them are Wall Street’s finest economists) of sleeping on the job. It re-enforced expectations of another rate hike from the Fed before it goes on pause, and of the ‘higher for longer’ interest rate theme that all major central banks are indicating will be their policy.??

The 10yr Treasury yield, at one point on Friday, reached a post-2007 high of 4.89%, the bear market in bonds that began in April showed no signs of letting up. But this may have been the low-point for the bond market in the current cycle.?

Since then, we have had a number of speeches by Fed policy makers, and written reports from Wall Street’s finest economists, which have moderated the negativity surrounding Treasuries. Their central argument is that high bond yields will help do the Fed’s work of squeezing inflation out of the economy, and a further interest rate hike from the Fed may not be needed after all.?

This coincided with the Hamas attack on Israel on Saturday, and a run for safe, liquid U.S dollar denominated assets – such as Treasuries. Given the weight of the Treasury market in the global financial system (there is around $33 trillion of outstanding U.S public debt), the improved view on the asset class has spread to other bond markets, both overseas and credit.

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The stock market argument.?Global stock markets have had a difficult month or so. They have been hurt by downgrades to global GDP estimates from the OECD and other organisations, by the chorus of ‘higher for longer’ interest rates that we heard from the major central banks in their September policy announcements, and by the persistent creeping higher of long-term bond yields.?

But investors read Friday’s strong U.S September jobs report as proof that a soft landing is still on the cards for the American economy. Indeed, the numbers suggest an improvement in the supply of labour, which will allow output to rise without adding to pressure on wages. Wall Street rallied on Friday, even as Treasury yields rose in response.?

The subsequent fall in Treasury yields has merely added to the pro-risk sentiment, with global equities and credit prices benefiting. It seems to have outweighed any negative effect on stock markets caused by the outbreak of the Israel/ Hamas war.

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The oversupply of Treasuries argument.?Meanwhile, fear of over-supply has been exacerbated by the recent government shutdown crisis. A shutdown was narrowly avoided. But it once again revealed a deeply dysfunctional political and budget-making system, and the solution amounted to little more than kicking the can a little further down the road.?

No major U.S politician appears willing to cut mandatory spending (such as welfare) or defence, which account for around 85% of the federal budget. Meanwhile, too many are urging tax cuts or increased government spending. This, when the total outstanding debt to GDP is around 120%, a peace-time high, and the budget deficit is around 5.9%, the largest of any major economy by some margin.?

What if the yields that investors demand are simply too high for the government to borrow at? Bond investors fear the preferred solution from Capitol Hill will not be budget restraint, but pressure on the Fed to cooperate in various ways. Either by buying the debt itself as it did in quantitative easing (‘monetary financing’ of the deficit). Or, as suggested by the U.S economist Charles Calomiris in a recent paper for the St Louis Fed, by changing the bank capital requirements of commercial banks.

The Treasury fears a Catch-22 situation developing, whereby large deficits increase the interest rate that the government has to pay on new debt. This, in turn, increases the deficit, which drives up interest rates on new debt.

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Sterling is hard to love.?The pound has climbed a cent since Friday, to $1.23. Supporting sterling was a warning earlier this week from the IMF, that at least one more rate hike from the Bank of England is required if inflation is to fall to 2%. In contrast, hope that financial conditioned in the U.S have tightened sufficiently to allow the Fed to pause at current levels, has helped to reduce upward pressure on the dollar.?

Near term, the defensive status of the dollar will help it should the situation in the Middle East deteriorate further. Gold, up 3% over the last five days to $1,880 an ounce, will also benefit.?

Longer term, the U.K appears more vulnerability to a persistent inflation problem than the U.S, given its lack of spare capacity despite very weak economic growth. Normally, this would mean higher interest rates in the U.K, to squeeze inflation and support sterling. However, the Bank of England does not want to cause recession, and may choose to compromise on interest rates and see sterling fall. Despite its fall from a recent high of $1.31 in July, sterling is hard to love.?

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Remain diversified, and stay well.