It’s been a very busy week in financial markets with three of the major central banks meeting, along with plenty of economic data, as a new month begins and we can say ‘good riddance’ to October, which was an unpleasant month for both equities and bonds
I wrote a few weeks ago about the substantial drawdown we have seen in government bonds as a result of yields rising to adapt to the higher (for longer) interest rates environment. October saw equities giving back some of their gains with the main US index, the S&P in a technical ‘correction’, down 10% from the recent highs in July. Small cap indices in the US and closer to home have seen even more pain. While most major markets have still made positive single digit gains this year in percentage terms, particularly looking further down the cap scale, and looking at Asia and Emerging markets, there are some indices in negative territory. Even in the US, where the S&P 500 is, in sterling terms, still up 9% for the year, outside the “Magnificent 7” stocks, the return for the S&P 493 (if there was such a thing) would be slightly negative. So, the narrow leadership in the US of the mega cap tech firms is masking wider underperformance. (Data from Refinitiv to end October).
It’s worth noting that market corrections are common; a 10% intra year drawdown happens in the US every 1.6 years on average, indeed since 1928, the average intra-year market decline has been 16%. The drawdown has come despite what has been a solid corporate earnings season so far, with earnings per share up 18% on a year ago, and only 2% off the record high in Q4 2021. The market pullback in the UK and Eurozone is more understandable in the context of mixed earnings and weaker economic data. In the US, we have seen companies that miss earnings expectations see notable falls in their share prices, but the overall earnings and economic picture remains relatively robust. In contrast to October’s market woes, we have seen a decent start to November in the past couple of trading sessions, with central bank pauses being taken as renewed confirmation that the peak in rates is here, and it’s a question of “when” and not “if’ interest rate cuts will come.
In terms of economic data, there has been plenty to digest. Let’s start with the eurozone, which published its GDP data for Q3 showing a decline of 0.1% which was weaker than expected. While Q2 was revised up to 0.2%, the picture is one of stagnation and an economy on the brink of recession. Germany, the engine of the eurozone, posted Q3 GDP of -0.3% versus Q2 and down 0.8% versus Q3 last year. Germany’s economy has been hit very hard by the energy crisis, with four of the last six quarterly GDP data points negative.
In the UK, the Nationwide Building Society reported a rise in house prices, which climbed 0.3% in October versus September, driven by a lack of supply. House prices are down 3.3% year on year, with mortgage data suggesting the market will take some time to recover. Mortgage approvals in September were at an 8 month low, and to give some context versus pre Covid and rate hike times, were down 35% on September 2019. The wider money supply data in the UK pointed to weaker supply and demand for credit, with the biggest contraction since 2012, down 3.9% year on year.
The PMI data has trickled out over the course of the past few days – we will see services data today and on Monday. The manufacturing data remained consistent with recent months in indicating a contraction across developed markets with the data notably worsening in the US, and to a lesser extent in the eurozone. We also saw the Chinese PMI manufacturing data slipping back into “contraction” adding justification to the stimulus announced last week. Today will see the monthly jobs report in the US published. The US labour market has proved very resilient and the job openings data published on Wednesday, for September, showed this continuing with an increase in available vacancies. There are 1.5 job vacancies for every unemployed person in the US; this is down from the peak, which was close to 2, but well above pre-Covid levels.
There were no major surprises from the central banks with the only policy shift coming from the Bank of Japan, who made the second adjustment to Yield Curve Control (YCC) in the past three months. This policy suppresses Japanese government bond yields, and keeping bond yields artificially low has required more and more intervention in a world where bond yields have risen substantially elsewhere. The policy will now allow 10-year yields to increase above 1%, redefining this level as a loose ‘upper bound’ rather than a hard limit. The Bank of Japan revised up their inflation forecast; they now see core inflation at 2.8% in 2024, versus their previous forecast of 1.9%. The Bank of Japan is very keen to see a healthy level of natural inflation in the economy after decades of deflation but is treading very slowly in terms of tightening policy. With interest rates still at -0.1%, policy is still incredibly loose compared with other developed markets, and this has impacted the Yen, which fell to a 33-year low this week, not helped by the lack of substantial policy change to YCC, which many had expected to be scrapped completely. Given the size of bond markets and the likely shifts as Japanese bond yield catch up with their international peers, it is no surprise the Bank of Japan continues to tread carefully.
In the US, the Federal Reserve kept rates on hold at 5.25-5.50% as expected but the markets interpretation of Fed Chair Jay Powell’s comments was that the Fed was unlikely to hike rates further from here. With rates on hold for the second consecutive meeting, Powell said that “slowing down is giving us a better sense of how much more we need to do, if we need to do more”. Powell noted that rising bond yields had tightened financial conditions, as well as the slowing in wage growth. He added that the tightening in financial conditions would need to be persistent for it to matter to policy and while “the stance of policy is restrictive” the Fed was “not confident yet” that they have achieved “a sufficiently restrictive stance”. It’s clear the Fed is happy to wait and see for now the impact of rate hikes already in the system, with Powell saying “the risks of doing too much versus too little are getting closer to balance” but rate cuts are not yet on the agenda, not least given growth is solid and inflation remains above target, with the slowdown in inflation having levelled off for now.
The Bank of England kept rates on hold at 5.25% as expected, with the Monetary Policy Committee (MPC) voting by 6-3 in favour of a second pause following 14 consecutive hikes. The Bank forecast growth to remain “well below historical averages” over the medium term while signalling inflation will remain more persistent than expected, with risks still tilted to the upside. Governor Andrew Bailey said the MPC would be “watching closely” to see if further hikes were needed and said “it’s much too early to be thinking about rate cuts”. The Bank expects Q3 economic growth to be unchanged, with growth in Q4 of 0.1%. 2024 is expected to see no growth at all, with a significant risk of outright contraction, with the Bank estimating that only half the impact from the series of rate hikes, that took rates from 0.1% in December 2021 to 5.25% today, has hit the economy. Despite the Bank pushing out their expectations for inflation to return to target, the market assessment of the meeting was that the Bank of England is highly unlikely to raise interest rates again, as the economy slows and with inflation expected to see marked falls in the coming months as the spikes in energy prices fall out of the data.
The strength in bonds and equities this week is a marked contrast to the prevailing mood last month of ‘higher for longer’. Investors seem more and more convinced that we’re at the top of the rates cycle in the US, eurozone and UK, and are focussing more on when the first rate cuts will come. Both the Fed and Bank of England, however, reiterated that they’re not even thinking about rate cuts right now, but history shows the first cut is often within six months of the final hike.
This week has seen the market mood improve on the basis that monetary policy tightening is over. However, we need to remain mindful we are yet to fully see the economic consequences of that tightening, with economic growth expected to be almost non existent in 2024, and significant reality checks are coming for any household or corporates needing to refinance. With that in mind, we continue to be cautious, but we do see opportunities in selected parts of the market, not least those areas that have been beaten up as we have transitioned back to a more normal rates environment.
