Trevor Hubner, Investment Manager at MKC Invest, explains why the US continues to dominate market movements, despite geopolitical events, and looks at the outlook for interest rates.
After a strong first half of the year, asset markets saw a distinct slow down or reversal in Q3 as investors digested inflation and economic data and attempted to predict central bank policy for the coming months. When looking for direction it is generally the case that you use the US as the main indicator, as it is the world’s dominant economy and tends to lead the global cycle. While this remains broadly the case and certainly most central banks will be influenced by decisions made by the US Federal Reserve (the “Fed”), recent geopolitical events have driven some retraction from the open, globalist economy of the past decade and as such economies find themselves in very different situations.
The Fed not ready to pivot yet
The US economy continues to be surprisingly robust, reflected by GDP growth of 2.10% and a very tight employment market (meaning more jobs are available). While inflation has eased considerably, now standing at 3.70%, policy makers are concerned this economic strength means the battle against inflation is not over and, most significantly, it also gives them the room to continue with their restrictive monetary policy.
The much awaited “Fed Pivot” from raising rates to neutral and then, eventually, cutting them again has been pushed back over the course of the past year. At the start of 2023 many felt that we would have lower interest rates by now, but current consensus is that this will not happen until perhaps Q2 2024. The Fed have been saying that they will keep rates higher for longer for several months, and in September the bond market started to believe them, with bond yields rising to reflect this. Bond prices move in the opposite direction to bond yields and so they fell in this period, leading to low or negative returns for most bond funds.
Factors that could influence the Fed’s decision
There are, however, several factors at play that could feasibly change this narrative and central bank policy.
Firstly, rises in interest rates and the cost of borrowing are known to take time to filter through to the broader economy, a fact acknowledged as recently as January by Federal Reserve Governor, Christopher Waller, saying that policy moves have an impact in 9 to 12 months (source: Reuters). Most economists believe the lag to be more like 18 to 24 months, but in both scenarios the effect of the interest rate hikes have yet to be felt. As has been the case since the start of this inflationary episode, the danger is that the Fed (and others) overtighten policy and these additional borrowing costs will cause businesses to fail leading to unemployment and recession. Were this to happen there is a valid argument that monetary policy would have to be loosened more rapidly with rate cuts needed to stimulate economic growth.
A second factor, unique to the current situation, is that the Federal Reserve estimate that US households accumulated in the region of $2.3 trillion in excess savings in 2020 and 2021. This additional cash has been a large contributor to the resilience of the US consumer, but a recent report by the Federal Reserve speculates that these savings have now been exhausted in 80% of households (source: Bloomberg) and this is highly likely to dampen demand and slow growth.
US government debt: how high could it go?
The third issue is the growing recognition of the size of the debt issued by governments around the world and how the cost of servicing this has risen dramatically because of interest rate hikes. The standard measure for this is the Debt to GDP ratio – meaning how much does a country owe compared to how much it produces – and this figure in the US is running at 129%, having been around 107% pre-pandemic (source: Trading Economics). While not an ideal long-term position, in itself the figure is manageable, but the problems arise if the ratio continues to move higher and investors lose faith in the creditworthiness of the government. Clearly the US is the world’s largest economy and the dollar still the world reserve currency, meaning that there should always be demand for its debt. But in September bond yields rose as the so called “bond vigilantes” started to question this rhetoric and sold US treasuries.
The concern is not only that ‘higher-for-longer’ rates means more interest being payable on their debt, but also the that the level of borrowing shows no signs of abating. The situation in the Ukraine and tensions with China increased the need for the US to be self-sufficient in energy production and to accelerate the development of renewable sources. The Inflation Reduction Act (IRA) is intended to encourage investment in both these areas (and others) but at a substantial cost, estimated to be in the region of $1.2Trn. The CHIPS act is designed to reduce reliance on Taiwan (and China) for the manufacture of semiconductors, again encouraging investment in these industries on home soil, but also at considerable cost. The US debt ceiling is a debate that comes up frequently and although legislation passed in July pushed the next deadline back to January 2025, there will be interim debates and political horse trading over the issue which is likely to cause market volatility in the near term
Could UK inflation have peaked?
The UK is in a slightly different position. Inflation is higher than many other regions and consensus was that the Bank of England (BOE) would have to continue hiking rates to control this, with the market seeing a terminal rate of 6 to 6.25%. However, data in August showed that inflation had unexpectedly fallen to 6.7%, giving the BOE room to leave interest rates at 5.25% with forward guidance that they felt we were at or close to peak rates. This caused a repricing of bonds and, although yields did rise alongside most regions during late September/early October, they remain well below the highs seen in August.
There was also an unusual episode during the quarter when the Office for National Statistics revised the figures for economic growth by nearly 2%, indicating that the country had recovered from the pandemic far better than previously thought and was in fact ahead of other big European economies rather than lagging them. While revisions are common, the size of this miscalculation was extreme and suggests a deeper problem with how data is collated. The actual figure for GDP growth at 0.2% is still anaemic, but it did relieve some pressure from both the chancellor and the BOE.
Eu rates likely to remain high
The ECB continued with its rate hiking cycle in September, rising for the 10th consecutive time to 4%, in what was described as a close decision. The issue for the ECB is as always that they are trying to get a policy to suit countries that are in very different situations, for example inflation in Germany is at 4.5% with zero GDP growth while Spain has 3.5% inflation and 0.5% growth. The forward guidance is that the ECB feels that policy is sufficiently restrictive but, in keeping with other regions, the suggestion is that rates will remain high for some time.
At or near peak rates in the US, UK and EU?
All the above are making it incredibly difficult to predict the future trajectory of interest rates with any real confidence. It seems highly probable that we are indeed at or very near peak rates in all three regions and so focus then turns to when rates move lower and at what pace. Earlier this year many commentators felt a soft landing was possible whereby higher interest rates cooled inflation without damaging the economy, but this outcome seems unlikely and the question is now the depth and length of any recession that we will see and then how central banks will react. Amongst the bond funds we hold there is a variety of opinion ranging from mild to quite severe and the managers have positioned themselves accordingly. We feel this is a sensible approach in a period of uncertainty.
What about China?
China continues to struggle and has not seen the post lockdown bounce of other areas resulting in GDP growth of 0.8%, far below its target of 5%. Youth unemployment is becoming a major problem – to such an extent that after hitting a record 21.3% in June they stopped publishing the figures – as is its aging population. Near term the main problem concerns its heavily indebted property sector with several of the biggest participants in the market thought to be close to default. It is estimated that the sector accounts for around 29% of GDP (source: Reuters) and is therefore of enormous significance to the Chinese Communist Party (CCP). In contrast to most other regions, deflation- not inflation-, is an issue and interest rates have already been cut twice this year.
China holds a large amount of US Bonds and for several years there have been concerns about what might happen if they started to flood the market with this debt. However, by some reports it has unwound around 10% of this holding this past year and the market has absorbed this with ease, even allowing for the recent uptick in bond yields.
Higher and lower demand drives oil prices
The price of oil fell during the summer and was trading in the low $70’s per barrel, well below the $80 to $88 range estimated by the International Monetary Fund and Goldman Sachs as the fiscal breakeven price needed by Saudi Arabia (source: S&P). To counter this the Saudis, together with Russia, announced a production restriction to lower supply, which pushed prices up above $90 per barrel. However, oil demand is closely linked to economic activity and a report from CitiBank suggested that a global slow down in 2024 would result in lower demand and they forecast that this, alongside an increase in the number of non-OPEC+ suppliers would see prices fall back towards the levels seen in the summer. Prices fell on this report.
The tragic events in Israel have reversed this over the past week and there have to be concerns that any escalation in the situation would again push the price up towards $100 which would clearly increase inflationary pressure globally.
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