A fortnightly look at global financial markets

Market sentiment: Good. The S&P500 index of U.S stocks is near an all-time high, but it has been continental European companies that have seen the strongest gains so far this month. Stock market volatility (measured by the VIX) is at multi-year lows, suggesting confidence in the rally. Government bond yields are significantly down from their late-October highs, meaning that bond prices are up, while spreads on high yield bonds over Treasuries have narrowed.

The driving force behind the rally in both equities and bonds has been a growing consensus amongst investors that 1) inflation is indeed transitory, just as the central banks said it was in 2021 when it began. And 2) that this means the ‘higher for longer’ interest rate scenario, that was scaring the market during the autumn, is now less likely. Interest rates in North America and Europe appear to have peaked, and are likely to fall from mid-2024. This, in turn, means that 3) a soft landing for the global economy is likely, and in particular for the U.S (consensus forecasts are for around 2.7% global GDP growth next year, compared to 3% for 2023). A soft landing will in turn 4) protect corporate earnings, and dividends. 

European stocks have also benefited from news from China. The Caixin/S&P Global PMI (purchase managers index) rose to just above neutral in November, to 50.7. This was followed by stronger than expected export growth numbers. A commitment by the China politburo to support the economy, promising a ‘proactive fiscal policy’ and ‘effective monetary policy’, also helped sentiment. 

Central banks. The Bank of England, the ECB and the U.S Federal Reserve are all expected to keep interest rates unchanged when they meet this week. The market is confident that the peaks in the interest rate cycle have been reached, it is simply a question of when will the first cuts come, and how deep will they be. Wage growth is coming down, while the lagging effect of past rate hikes is showing in reduced economic activity in interest-rate sensitive sectors, such as construction. We are seeing consistent falls in PMIs in the major western economies, suggesting reduced business confidence. The effect is to reduce inflation, and the fear of a wage-prices spiral developing. This allows central banks to alter course.

The market’s expectation for the first interest rate cuts has been volatile in recent weeks. Two weeks ago, there was some speculation that the Fed may cut as soon as next March. This has since been tempered by warnings from Fed chairman Jay Powell, who has reminded investors that the last few percentage points of inflation are likely to be the hardest to tackle, and that the Fed has not actually ruled out further rate hikes. Yesterday’s 4% November core CPI inflation number (excluding food and energy) appeared to confirm this, with rents and service sector inflation remaining stubborn. June is now the most likely date for the first cut. Weak economic data, from the eurozone and the U.K, may lead to European central banks cutting ahead of the U.S.

What could go wrong in 2024? There is the perennial risk that central banks either keep interest rates too high, for too long, and so plunge the global economy into recession. Or that they cut too early, and inflation has a resurgence, for which the only solution is a return to interest rate hikes. The main geopolitical risk is perhaps the challenge to global stability, that would occur should Donald Trump regain the presidency, and then follow a policy of appeasement towards Russia and China.

In the financial markets, heavily geared sectors may yet come under stress as the lagging effect of high interest rates starts to bite. These might include private equity and property. But of course, interest rate-sensitive sectors will also outperform other asset classes, if central banks were to cut interest rates as sharply as they raised them. 

In the U.S, further share price growth for the Magnificent Seven tech stocks will have to be driven by increases in corporate earnings rather than an expansion of price/earnings multiples. Current valuations appear optimistic. For example, Apple is trading on a historic p/e of 31 times. Certainly this is lower than the December 2020 peak of 35, but it is well above the low teens p/e ratio that the stock traded in over much of the previous decade.  

Why the Bank of Japan matters. Last week’s meeting of the Bank of Japan hinted at interest rates to come. Unusually for a central bank, it is delighted to have inflation (of 3.3% in October), after almost three decades of a deflation problem. But voters think differently, and there is intense political pressure to reduce inflation, even as economic growth flatlines. 

Investors everywhere are keeping a keen eye on this story, as some fear that higher interest rates in Japan, at a time when the rest of the world is about to cut rates, could lead to a sudden rally in the yen. This may turn into a self-reinforcing trend, if Japanese investors in overseas assets (particularly U.S Treasuries), decide to sell and repatriate their money into Japanese bonds. The yen would be driven higher again. 

A mass sale of Treasuries by Japanese investors would exacerbate fears of a demand/ supply imbalance in the Treasury market, with potentially damaging implications for Treasury yields.

Oil prices. A contributing factor to falling headline inflation, and to reduced inflation expectations, has been the weak oil price in recent weeks. Following the October 7^th attack by Hamas on Israel, the World Bank speculated that oil could go to $140 a barrel if the conflict spreads and Iran blocks the Straits of Hormuz. That didn’t happen, and just this month Brent has fallen from $82 a barrel to a current price of $73. This reflects increased output from the U.S, Guyana and Brazil, that traders believe more than off-sets the reductions announced in November by the OPEC+ group. 

How should investors respond? Financial history tells us that investors should maintain exposure across a broad range of asset classes, regions and currencies, in order to achieve the best risk-adjusted returns. Balanced multi-assets funds help investors achieve this. 

Stay well, and best wishes for 2024.Market sentiment: Good. The S&P500 index of U.S stocks is near an all-time high, but it has been continental European companies that have seen the strongest gains so far this month. Stock market volatility (measured by the VIX) is at multi-year lows, suggesting confidence in the rally. Government bond yields are significantly down from their late-October highs, meaning that bond prices are up, while spreads on high yield bonds over Treasuries have narrowed.

The driving force behind the rally in both equities and bonds has been a growing consensus amongst investors that 1) inflation is indeed transitory, just as the central banks said it was in 2021 when it began. And 2) that this means the ‘higher for longer’ interest rate scenario, that was scaring the market during the autumn, is now less likely. Interest rates in North America and Europe appear to have peaked, and are likely to fall from mid-2024. This, in turn, means that 3) a soft landing for the global economy is likely, and in particular for the U.S (consensus forecasts are for around 2.7% global GDP growth next year, compared to 3% for 2023). A soft landing will in turn 4) protect corporate earnings, and dividends. 

European stocks have also benefited from news from China. The Caixin/S&P Global PMI (purchase managers index) rose to just above neutral in November, to 50.7. This was followed by stronger than expected export growth numbers. A commitment by the China politburo to support the economy, promising a ‘proactive fiscal policy’ and ‘effective monetary policy’, also helped sentiment. 

Central banks. The Bank of England, the ECB and the U.S Federal Reserve are all expected to keep interest rates unchanged when they meet this week. The market is confident that the peaks in the interest rate cycle have been reached, it is simply a question of when will the first cuts come, and how deep will they be. Wage growth is coming down, while the lagging effect of past rate hikes is showing in reduced economic activity in interest-rate sensitive sectors, such as construction. We are seeing consistent falls in PMIs in the major western economies, suggesting reduced business confidence. The effect is to reduce inflation, and the fear of a wage-prices spiral developing. This allows central banks to alter course.

The market’s expectation for the first interest rate cuts has been volatile in recent weeks. Two weeks ago, there was some speculation that the Fed may cut as soon as next March. This has since been tempered by warnings from Fed chairman Jay Powell, who has reminded investors that the last few percentage points of inflation are likely to be the hardest to tackle, and that the Fed has not actually ruled out further rate hikes. Yesterday’s 4% November core CPI inflation number (excluding food and energy) appeared to confirm this, with rents and service sector inflation remaining stubborn. June is now the most likely date for the first cut. Weak economic data, from the eurozone and the U.K, may lead to European central banks cutting ahead of the U.S.

What could go wrong in 2024? There is the perennial risk that central banks either keep interest rates too high, for too long, and so plunge the global economy into recession. Or that they cut too early, and inflation has a resurgence, for which the only solution is a return to interest rate hikes. The main geopolitical risk is perhaps the challenge to global stability, that would occur should Donald Trump regain the presidency, and then follow a policy of appeasement towards Russia and China.

In the financial markets, heavily geared sectors may yet come under stress as the lagging effect of high interest rates starts to bite. These might include private equity and property. But of course, interest rate-sensitive sectors will also outperform other asset classes, if central banks were to cut interest rates as sharply as they raised them. 

In the U.S, further share price growth for the Magnificent Seven tech stocks will have to be driven by increases in corporate earnings rather than an expansion of price/earnings multiples. Current valuations appear optimistic. For example, Apple is trading on a historic p/e of 31 times. Certainly this is lower than the December 2020 peak of 35, but it is well above the low teens p/e ratio that the stock traded in over much of the previous decade.  

Why the Bank of Japan matters. Last week’s meeting of the Bank of Japan hinted at interest rates to come. Unusually for a central bank, it is delighted to have inflation (of 3.3% in October), after almost three decades of a deflation problem. But voters think differently, and there is intense political pressure to reduce inflation, even as economic growth flatlines. 

Investors everywhere are keeping a keen eye on this story, as some fear that higher interest rates in Japan, at a time when the rest of the world is about to cut rates, could lead to a sudden rally in the yen. This may turn into a self-reinforcing trend, if Japanese investors in overseas assets (particularly U.S Treasuries), decide to sell and repatriate their money into Japanese bonds. The yen would be driven higher again. 

A mass sale of Treasuries by Japanese investors would exacerbate fears of a demand/ supply imbalance in the Treasury market, with potentially damaging implications for Treasury yields.

Oil prices. A contributing factor to falling headline inflation, and to reduced inflation expectations, has been the weak oil price in recent weeks. Following the October 7^th attack by Hamas on Israel, the World Bank speculated that oil could go to $140 a barrel if the conflict spreads and Iran blocks the Straits of Hormuz. That didn’t happen, and just this month Brent has fallen from $82 a barrel to a current price of $73. This reflects increased output from the U.S, Guyana and Brazil, that traders believe more than off-sets the reductions announced in November by the OPEC+ group. 

How should investors respond? Financial history tells us that investors should maintain exposure across a broad range of asset classes, regions and currencies, in order to achieve the best risk-adjusted returns. Balanced multi-assets funds help investors achieve this. 

Stay well, and best wishes for 2024.