A fortnightly look at global financial markets

• Confidence returns to stock markets

• Bond investors are more sceptical

• Tech stocks are surprisingly robust

• UK inflation, interest rates, and a temporary rally in sterling

Market sentiment: Stock markets are calm, and enjoying a month-long rally. This suggests that confidence in the outlook for profits and dividends growth is returning. And yet core major bond markets continue to be marked by inverted yield curves, which suggest recession is ahead. However, the apparent discrepancy maybe a timing issue: stock market investors already placing bets on the economic recovery, that will follow any recession. 

Investors should remain diversified, perhaps making use of multi-asset funds. These funds reduce the amount of risk (ie, volatility) suffered per unit of return, by spreading themselves widely across a range of low, and un-correlated, assets. 

The outlook for interest rates is for one more 25bp rate rise from the Fed, on 3rd May, taking the target rate to 5%-5.25%. In the U.K, a further two 25bp rate hikes are expected, which would take the key rate to 4.75%. The next Bank of England meeting is on May 11th.

The positive message from stock markets. We have seen solid gains on all the major stock markets, over the last month. Fear of a further crisis in the financial system has subsided, and investor risk appetite has returned. Furthermore, stock market volatility has fallen, with the VIX index of implied volatility on the S&P500 at 17.8, near an eighteen month low. Warnings of a fall in first quarter company earnings, perhaps of around 8% in the U.S over the same period last year, have been shrugged off (judging from the earnings results so far released, the 8% figure is unduly pessimistic). Investors appear to be seeing beyond the current interest rate cycle, and its likely impact on company earnings, and looking ahead to the next upswing in the economic cycle.

In contrast, the bond market is very much focused on the interest rate cycle, with yield curves inverted in the U.S, U.K and Eurozone. Longer term lending rate are below the overnight rates set by central banks. This reflects fear that the final rounds of interest rate hikes, from the major central banks this spring and summer, may tip economies into recession. The IMF, never an organisation to a glass half full, recently supplied a number of arguments as to why recession might occur. They included reduced real wages (because of inflation), low investment spending, and the need for governments to repair their finances after Covid-era deficits. It now estimates that average world real GDP growth over the next five years will be just 3%, in contrast to the 3.8% seen over the previous five years. 

Tech remains surprisingly robust. Despite the sharp rise in the cost of capital over the last year, tech and other growth sectors have shared in the broader stock market gains since the start of the year. This is surprising to many market analysts. A rise in interest rates is often associated with weakness in jam-tomorrow growth stocks, as investors favour money market funds and other products that benefit from rate hikes. While some of the not-yet-profitable tech companies have been hit by this effect, in aggregate the quoted tech sector looks resilient. 

A combination of factors is probably at work. First, the largest U.S tech stocks sit on large cash piles, reducing their need to borrow money to fund investment and growth. Second, falls in bond yields over the last six weeks, triggered by the Silicon Valley Bank crisis, have helped reduce funding costs for smaller growth companies. Third, in an era of weaker long-term GDP growth, investors may be searching out -and willing to pay a premium for- the sectors that will show earnings growth.

Indeed, investor confidence in the sector remains strong. Despite last year’s share price falls, the trailing price-earnings ratio on the NASDAQ index of U.S tech stocks is currently 25 times (ie, investors are invited to pay $25 for the right to own $1 of last year’s earnings). This is down from the pandemic-era peak of 29 at the end of 2021, but it is still well above the 21 times at the end of March 2020. 

U.K inflation, interest rate expectations and a temporary rally in sterling. March’s U.K inflation numbers, released last week, were disappointing. Headline CPI fell to 10.1%, higher than the 9.8% consensus forecast. Falls in petrol prices were offset by rising food inflation. Meanwhile core inflation, which is what the Bank of England believes it can influence through interest rates, was unchanged at 6.2%. Strong private sector wage growth, of 7% in January year-on-year, reflects a particularly acute labour shortage. This is fuelling inflation in the service sectors (a similar story can be found in most other developed economies).

Money markets are pricing in two further rate hikes from the Bank of England, which has supported sterling against the dollar. This trend may persist over the coming weeks, particularly if the U.S rate hike expected on 3rd May is followed by a pause, and then cuts, as the market anticipates. 

However, other fundamental factors regarding sterling work against it. One is relative growth. Despite some better than expected growth data in recent months from the U.K, the IMF still expects the U.K to be amongst the weakest of the major economies this year. GDP will be below pre-pandemic levels at the year-end, in contrast to the U.S and the euro zone economies, which have more than made up for the lost ground. This reduces the relative attractiveness of the country’s domestic-facing companies to inward investors, and lowers the amount of public and private investment spending that will contribute to future growth. 

The second is a deteriorating export sector, which reduces overseas demand for sterling. Exports in January of goods were down 9.4% compared to the same month in 2018 (pre-Brexit, pre-Covid), while exports from other G7 economies averaged a 3.8% gain over the period*. Exports to the euro zone have been hampered by the bureaucracy that Brexit helped delivered. 

It is hard to see sterling return to the $1.50 level in the near future, given the weaker economic fundamentals of the U.K, compared to the U.S.