26 Sep 2023
Markets have had a more challenging third quarter as investors realised the strength of the US economy and that a so called ‘soft landing’ would not lead to a rapid reversal in US Federal Reserve policy, highlighting that rates would stay elevated for longer than markets expected. Bond markets re-priced at the longer end of the curve as market participants realised that even when the Fed stopped raising rates, cuts were not likely to follow quickly. For most of the quarter, equity markets ignored the valuation impact of rising nominal and inflation linked (real) yields, but during the second part of the quarter came under pressure as bond yields rose close to the 4.5% level in 10-year debt in the US.
The US economy has remained robust with unemployment numbers still hovering around the 3.5% level despite interest rates being raised by 525bp since the Fed embarked on its monetary tightening. With inflation in the US falling (the recent rise in energy costs has yet to hit), the consumer has remained in fine fettle and service sector spending remains strong. Earlier perceptions that the US would be the first central bank to cut rates have evaporated this quarter and with the UK and European economies showing more signs of economic slowdown than the States, the US currency has seen strong gains during the third quarter. This has also provided challenges to the emerging market universe, although other fundamentals within the developing world by and large remain positive. China, however, is a separate story.
Within the Eurozone, businesses have reported falls in activity over the last couple of months. A more difficult economic outlook in Europe has resulted in the Euro falling versus the Dollar and while lower levels of economic activity should be a positive for inflation, if currency weakness persists, there remains a risk of inflation staying stubbornly strong despite the likelihood of economic growth forecasts being downgraded. The ECB have indicated that the current 4% interest rate may not need to be raised further but is likely to be held at this level until there are clear signs that inflation is falling back to the 2% level.
The third week of September saw the latest US central bank meeting and the Federal Reserve commentary and changes to the SEP (Summary of Economic Projections) showed the Fed remained absolutely committed to returning inflation to the 2% level. The Fed announced policy rates were being left unchanged at this meeting, but most participants are forecasting an additional increase in rates before the year end.
The Federal Reserve continue to believe that a soft landing is possible but recognise this is not easy to deliver. To date, the economy has seen some level of slowdown without a negative impact on levels of employment. The Fed clearly want time to assess further economic data and there are also several short-term issues which could affect US economic growth including the car worker strike, a potential government shut down, the resumption of student loan payments, higher long-term interest rates and the recent rise in the oil price. Powell was very up front about the difficulties of forecasting in an economic environment where there has been supply side shocks cause by Covid-19 and Ukraine.
In the third week of September, the Bank of Japan Governor Ueda once again surprised the markets by stating he had ‘yet to foresee’ inflation settling at the target level of 2%. Once again, market expectations that the central bank was close to ending its ultra loose monetary policy stance were confounded, sending the Yen tumbling. Japan continues to have the world’s only negative interest rates and the comments on inflation surprised the market as consumer price growth has now exceeded the 2% target for 17 straight months with core inflation around 4.3% in August. A huge interest rate differential between the US and Japan has naturally weighed on the exchange rate with the Yen declining significantly over the past 24 months. Japan has also not made any adjustments to its yield curve control policy (YCC) in 2023. Persistent currency weakness has had a significant effect on stock and sector performance in Japan. Domestic businesses previously viewed as high quality, often having some input costs in overseas currencies, do not benefit from a weakening currency, either through exports or currency translation from overseas subsidiaries. Many of the stocks heavily exposed to movements in the Yen Dollar rate are cyclicals and as a result value stocks have continued to outperform this year in Japan.
August/September proved a challenging month for many multi-asset portfolios due to the positive correlation between bonds and equities in a rising rate environment where concerns over inflation have driven market moves. The May through July period saw equities rally despite bond yields edging up as optimism mounted over the ability of the US Federal Reserve to engineer a soft landing, or in other words economic growth expectations improved despite rising rates. Since August, bond markets have continued to remain under pressure, but the last four weeks have seen equities also pull back as higher levels of both nominal and real bond yields weighed on equity market valuations. To date, the pull back in equities has not been in the main driven by concerns over economic growth or falling profitability, although higher rates have led to some investors worrying that this year’s recession is merely postponed until 2024.
In the US, economists have not forecast a single recession since records began in 1970, but investors entered 2023 expecting equity markets to suffer from the consensus view of an impending recession. At the back end of 2022, economic forecasters as a group gave a probability of a recession in the US at 60% but as John Maynard Keynes once warned, ‘The inevitable never happens. It is the unexpected always’. As a result, investor positioning in equities at the start of 2023 was relatively cautious and as economic growth and corporate profitability held up, conditions were favourable for a rally in equity markets in the first half.
There remain three potential outcomes for both the US economy and the world in general. The most positive outcome would be the so-called soft landing, although markets began to realise in August that even this had some level of downside. With employment remaining strong, there was no pressure on the US Federal Reserve to rapidly reverse course and cut interest rates, certainly not while inflation at the core level remains persistently and significantly above its 2% target rate. For the moment, the US still seems to be in a low no landing regime, or in other words a ‘growthflation’ environment with non-housing service sector inflation not significantly pulling back. Wage rises are not compatible with a 2% inflation target if persisting at current levels.
The oil price has rallied significantly and was further boosted when the Saudis indicated they had no intention of ending their temporary production cuts. Egged on by Russia, the two leading producers may well have targeted a $100 oil price. Reaching this level would represent a significant supply side deterioration to the global economy and would weigh on risk assets as fears of a 2024 slowdown increased.
China continues to see pressure on its growth rate with the real estate sector clearly seeing some levels of stress. More policy support from the government over time is likely, although the authorities in China will be unwilling to go down the route of using excessive leverage to boost economic growth. The leadership under Xi may well believe that it is better for the country to see some level of hardship now than continue relying on fiscal stimulus to deliver economic support if it is wasteful over the longer term. Xi seems focused on building up industries which are of strategic importance to China.
How stock markets progress over the next 12 months will depend on how markets perceive firstly the possibilities and then the eventual economic outcome delivered. In the early part of the rate tightening cycle, markets were focused and split between the possibilities of a soft or hard landing, although today a third scenario has evolved which can be described as no landing or ‘growthflation’ and is particularly applicable to the US. Over the last quarter it has become apparent that different regions of the world may well behave in a very different manner. Growth in the US is proving far more resilient than in Europe or the UK. China has seen its economy deliver a very tepid post Covid-19 recovery due to weakness in the property market, high levels of youth unemployment and a significant slowdown in manufacturing activity as consumer demand has shifted away from goods to services. These potential outcomes have not only reflected themselves in stock market movements, but also, or perhaps especially, in the currency markets. A year ago, most commentators expected a peak Dollar environment to soon emerge, but the relative strength of the US consumer has resulted in shifts in interest rate expectations favouring the US currency.
At this stage it is impossible to be definitive about how the cycle will eventually play out, but it’s clear that conventional economic models have not been able to forecast or predict the continued strength in economic activity in 2023, especially in the US. Sentiment to China remains very negative but the authorities still have plenty of levers to pull to ensure the economy does not collapse and fundamentally, China remains a very entrepreneurial society. We should remember that a year ago there were two big consensus calls: the first was for a recession in the US and the second was forecasting a strong reopening economic boom in China. China remains a world leader in many technologically driven industries, especially electric vehicles, and is still well placed in various fields ranging from AI to robotics. China has now surpassed Japan as the world’s leading exporter of EVs. With anti-China sentiment so high, any small mood change could see the market rally. The elephant in the room remains the property market which may well unravel further with land and home prices contracting at an annual rate of around 5%.
In the short-term, markets will be focused on the outlook for interest rates and the realisation that rates will remain high by post GFC standards for a long period of time. The oil price remains a threat to economic growth and falls in future levels of inflation in the developed world, and some emerging market economies such as India have always been vulnerable to oil price shocks. An upward move of 30% since June in WTI and Brent crude is not something to be ignored and would favour US economic growth over that of Europe. Europe faces a double whammy of a weak currency versus the US$ which oil is priced in and currency weakness if it occurred would put further pressure on the ECB on the interest rate front. At present, the most recent language of President Lagarde is that rates, while not having to rise further, will be held until there is definitive evidence that inflation is on its way back to the 2% target rate. Unlike the US, the ECB does not have a dual mandate and so is not focused on preserving full employment if inflation remains above mandated levels.
RSMR provides impartial, qualitative, forward-looking research for advice businesses.
Click here to head to the RSMR blog for market updates and a whole host of informative, up-to-the-minute content.
Click here to sign up to RSMR research where you can access RSMR fund ratings, fund profiles, factsheets, insights, market updates and event information.
This information is for UK Professional Advisers only and should not be given to retail clients.
The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.
Rayner Spencer Mills Research Limited is a limited company registered in England and Wales under Company Registration Number 5227656. Registered office: Number 20, Ryefield Business Park, Belton Road, Silsden, BD20 0EE. RSMR is a registered trademark