MARKET REVIEW 16/11/2023

Market sentiment: Improved. There is renewed optimism amongst investors that a soft landing for the U.S and global economy will be achieved. Bond and stock markets have had a strong fortnight, with investors confident that central banks have finished their interest rate hikes. Inflation is falling in all the major economies – and faster than expected in the U.S and the U.K. Markets are pricing in Fed rate cuts from June 2024, which will set the tone for lower short-term borrowing rates everywhere.

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The squashing of inflation has been done with relatively little damage done to the global economy. Indeed, the U.S grew at annualise rate of 4.9% in the third quarter, and the IMF last week upgraded its 2023 GDP growth forecast for China, the world’s second largest economy, from 5% to 5.4%. The most visible pain in terms of economic growth comes, perhaps, not from higher interest rates but from the weaker than expected trade volumes from China earlier this year. Germany and Japan, both big exporters to China, have felt the brunt of this. However, this week’s strong consumer spending and industrial activity numbers from China suggest that theme may be coming to an end.

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Corporate earnings growth may slow over the next year, with some over-indebted companies also hurt by the lagging effect of the interest rate hikes. However, compared to other end of economic cycles, the demise of this one -so far- may be relatively painless.

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A ‘soft landing’ – what does this mean for investors? The recent economic data confirms the picture of a soft landing for the U.S and global economy that we have described in previous Investment Outlook notes. That is, global GDP growth falling from around 3% this year to perhaps 2.7% next year, and then recovering. And with inflation falling to central bank target rates of 2%, or thereabouts, with inflation expectations remaining anchored.

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This scenario will be good for bonds, as investors will demand lower yields with lower inflation. Lower bond yields will, in turn, support the relative valuation of equities and other risk assets. A shallow economic slowdown will also protect corporate earnings, and so offer additional support to earnings.

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Given the uncertainties involved in investing, a multi-asset balanced fund is perhaps the best approach. By judiciously mixing bonds with equities and alternatives, better long-term risk adjusted returns can be achieved than by investing in any one asset class.

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The hesitation of central banks and inflation risks. While markets may be talking about interest rate cuts in the U.S, U.K and Eurozone from next summer, central banks are much more cautious in their language. Having been slow in raising interest rates when inflation took off in 2021, they do not want to make a similar mistake by easing monetary policy prematurely.

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Interest rate cuts next year, and a positive response from stock and bond markets, seems likely. But we should consider where do the risks to this scenario lie? ?

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The most obvious risk to inflation, and hence to the prospect of interest rate cuts, comes from oil. October U.S inflation, at 3.2% year-on-year, and U.K inflation at 4.6%, were both weaker than expected in part because of falls in energy prices, on a year-on-year basis. But Brent crude is $81 a barrel, higher than the price that existed for most of the March to July 2023 period. Unless it falls, it will be a contributor to year-on-year inflation from next spring for five months. The war in Israel and Gaza may yet expand into a regional conflict, pitting Iran and its allies against Israel, Saudi Arabia and their allies. If Iran chooses to block the Straits of Hormuz, the IMF recently suggested oil could rise to $150 a barrel.

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The second inflation risk comes from the still-tight labour markets of most industrial countries, which pushes up wages and so weakens the impact of higher interest rates by the central banks. European labour market rigidities exacerbate the problem, as do falls in the number of workers post-Covid. The Eurozone has near record-low unemployment of 6.5%, and the ECB estimate wage growth is running at around 5.3%. This is despite a slight contraction in demand (the third quarter saw the region’s economy shrink by an annualised -0.2%). U.K economic growth is flatlining, and yet restaurants still struggle to find staff, and wage growth is around 8%. Wage growth is lower in the U.S, at around 4.1%, thanks in part to better demographics: it has a relatively fast-growing labour force.

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Whenever wages are higher than inflation, as they are now in most major economies, they fuel demand growth and risk causing further inflation.

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Meanwhile, the fall in bond yields and the rally in stock markets since the end of October has loosened financial conditions, and so may actually hinder the interest rate cuts that markets are expecting. For example, U.K interest rates are transmitted into the real economy in part through mortgage rates, and a swathe of large lenders -including HSBC and Halifax- earlier this week reduced their lending rates, in part because of reduced gilt yields. If this stimulates the housing market, and so white goods, and demand for tradesmen to install them, it will add to wage pressure and to inflation.

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Geopolitics and U.S resolve. Perhaps the biggest single question for investors regarding geopolitics is the ability and willingness of the U.S to be the policeman of the world. If Trump wins a second term as president, would he support military intervention abroad? It seems unlikely. And could America afford it, even if a President Trump, or Biden, wanted to intervene? Given the current 5.7% of GDP budget deficit, bond investors may baulk at lending the U.S government still more money, when it seems politically unable to raise taxes, or cut spending, even during a period of solid economic growth.

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China, Iran and Russia are being drawn together by a shared envy/resentment of U.S power and ‘liberalism’. Three fronts (eastern Europe, Middle East, and Taiwan) may erupt simultaneously, and by design, if the countries’ leaders perceive weak U.S resolve to help its allies.

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Sterling – don’t bet on it. Sterling appears hamstrung by weak U.K economic growth (limiting foreign investment inflows), the prospect of Bank of England rate cuts next year, and a relatively large current account deficit of -2.5% of GDP. Its current value of $1.24 reflects these themes, and in addition the strong dollar theme that has been a feature of the financial world for two years now.

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While the dollar may weaken as investors begin to look forward to a new economic cycle, and an upturn in growth in Europe and Asia, the U.K-specific factors that hold sterling down are unlikely to go soon. Do not bet on a surge in sterling.