As we moved into the final quarter of 2023, it felt like many of the concerns for financial markets were little changed. The direction of inflation and interest rates continue to drive market movements. While there is more clarity, and less concern, over interest rates than earlier in the year, inflation is not yet firmly under control.
Global growth is likely to remain a little below trend. While US growth has remained robust, higher interest rates have taken their toll in the eurozone and UK, and China has disappointed the markets. The consensus remains for a soft landing for the global economy. Where countries fall into recession, it is likely to be short-lived and shallow.
Stock markets have been volatile, lacking any sustained good news that might steady the ship. Though there may be better times ahead for stocks. There is greater stability around interest rates, inflation is trending lower and the main adjustments to this new environment have been made. Most major economies are at or near the peak in interest rates and hoped-for cuts in 2024 are still possible. There is scope for stock markets to make progress, but they require careful consideration and investors should be prepared for volatility.
These are the four key headwinds and tailwinds for the next few months.
Rising bond yields
Investors now appear to have accepted that interest rates are likely to be higher for longer. While inflation is coming down, there are a number of technical factors pushing bond yields higher. The Federal Reserve (Fed) and other central banks are trying to unwind their vast balance sheets through quantitative tightening. At the same time, there are fewer foreign official captive buyers for government bonds.
The impact on the broader economy and growth is still unclear. Credit standards have been tightening and there is rising credit stress. However, many companies and consumers have adapted by securing longer dated loans at low rates during the Covid-19 pandemic. Also, a strong labour market has helped to limit the impact of rate rises. However, some economic uncertainty prevails.
Higher energy prices
Energy prices have started to rise again. This is largely a result of manoeuvring on the part of major oil producing states restricting supply. OPEC cut production in April, and in October, Russia and Saudi Arabia announced they were continuing with voluntary cuts. The US strategic petroleum reserve has been cut to levels not seen since the and will need to be refilled, creating additional demand. We believe that oil-producing countries will aim to keep prices in the $80-$100 per barrel range.
The BRICS bloc has become a force on the global stage. Previously limited to Brazil, Russia, India, China and South Africa, six new countries have recently joined. Three of them – Iran, Saudi Arabia and the UAE – are significant energy producers. As a result, the bloc is starting to coalesce around fossil fuels. Many of these countries are concerned that the US could implement similar sanctions to those that they placed on Russia. The bloc’s members are more likely to trade in local currencies, which could challenge the US dollar’s (USD) position as the world's dominant reserve currency.
Buffers against high interest rates
There are a number of defences against higher rates. Labour markets have been strong, and in many countries there has been a reduction in hiring without any subsequent rise in unemployment. This is good for central banks and supports hope for a soft global economic landing. Equally, there has been ‘smart borrowing’ by consumers and corporates securing long term deals at lower rates, helping to cushion the impact of higher rates.
Artificial Intelligence boost to the global economy
The global economy has yet to fully realise the productivity improvements of artificial intelligence (AI), although this is starting to be seen in areas such as manufacturing. CEOs increasingly recognise that they need to invest in AI to remain competitive.
Corporate pricing power boost to profit margins
Pricing power remains strong. In recent results, we have seen company profit margins continue to improve in spite of the cost of living crisis. For multinational businesses , for example, sales growth has remained strong in nominal terms, even though volume growth is negative These large companies continue to seek out profits where they can and are thriving in spite of consumer weakness.
Equities over bonds
Our main proprietary indicators suggest the world economy is in a recovery phase. This is usually good for stock markets and we retain a preference for equities over bonds as a result. Bonds remain vulnerable to the ebb and flow of central bank policy.
Stock market valuations remain undemanding, particularly outside the US. In the States market leadership is broadening, moving beyond the ‘magnificent seven’ of AI-related stocks that have dominated year-to-date. The number of companies in the S&P 500 with positive returns is still below average, but higher than it was six months ago.
Keep an eye on valuations
Although our preference is for equities over bonds, we are cautious on valuation grounds. In terms of sectors, financial, materials and communication services are relatively cheaper, while interest rate-sensitive sectors such as real estate look expensive relative to their earnings growth. Asia offers better value than other regions, particularly given the growth it offers.
Managing volatility with themes
Identifying long-term themes can help to manage stock market volatility. Areas of structural growth and megatrends, such as technology, and demographic change, are less vulnerable to the economic cycle and periods of weakness. In energy, for example, we see less investment in new oil and gas fields, as capital has been diverted into clean energy projects, while OPEC reduces supply to keep prices high.
Short-dated bonds for lower risk
The Fed has reduced market expectations on interest rate cuts in 2024. Longer dated government bonds have reacted to this ‘higher for longer’ environment. Yields have risen and prices fallen. The US economy has been robust, which could support higher inflation and consequently higher interest rates. The fourth quarter is likely to be weaker, with student loan repayments restarting. However, we still see greater risk on longer dated bonds which are more sensitive to changes in interest rates. This leads us to shorter dated bonds, which are also less correlated to equites.
US dollar depreciation
We had expected the USD to depreciate, but a strong US economy and high interest rates have supported the currency since the start of the year. Nevertheless, the US Government continues to borrow more and more money and is reliant on foreign investors to provide funding. If global growth moves higher, the USD should dip because it is a counter-cyclical currency. The USD looks expensive versus most major currencies, and we believe there is capacity for it to weaken from here.
To conclude, despite the threat of higher interest rates for longer, global growth is holding up. In the current climate, where the possibility of a mild recession in developed markets is already being factored into investors’ expectations, this could provide investment opportunities, as well as risks for investors.
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