19 Jul Could markets really be granted their wish for a ‘soft landing’?
The July Profile Reports are being prepared and should be with you in the next few weeks but at the risk of stealing some of our own thunder, we felt it might be sensible to provide a brief update ahead of their publication. After all, the first half of 2023 has been characterised by many of the same issues which plagued markets last year, yet stock markets have generally been much more sanguine. Why should this be so?
As we have said before, most of the world has been battling with an inflation problem for some time now. Investors had got used to virtually no inflation for more than a decade and with it, ultra-low interest rates. COVID changed all of that. The decimation caused to supply chains by choosing to shut down the economy and printing money like it was going out of fashion was always going to cause some kind of reaction.
Central Banks were generally slow to wake up to the reality of the situation, suggesting any inflation would be ‘transitory’, a term now long since consigned to the rubbish bin. Since then, they have been playing catch-up by jacking up interest rates pretty relentlessly. Equities and bonds both suffered in 2022 against this backdrop.
Inflation fears, along with adjusting to higher interest rates has now given way to the ‘will we, won’t we’ see a recession conundrum. Utopia for investors would be to see a marked reduction in inflation, accompanied by lower interest rates and little or no economic damage. A soft landing. Whether this is achievable might depend on which side of the Atlantic you are on.
The good news is that it’s looking a bit more likely in the US, which is where most eyes are focused. The latest inflation print came in at 3%, which provided some cheer, and the economy still seems to be holding steady. That is likely to mean interest rates are close to their peak, but we see perhaps two more quarter point rises before the year end just to finally choke off inflation. For 2024, the market is coalescing around the view that rates will be on a downward path in the Spring and around the 4% level by the year end. This is optimistic but not out of the question.
The picture in the UK is more tricky. Inflation has not tumbled in the same way it has in America. Today’s inflation reading of 7.9% will have led to a huge sigh of relief at the Bank of England, but it’s not ‘job-done’ just yet. Markets were fully pricing in another 0.5% jump in interest rates for August, but today’s announcement has made this less certain. We think there is still a 50:50 chance that the Bank of England opts for another half, rather than quarter, percent rise next month.
But whatever it decides to do, it will come on the back of a lengthy series of rate rises, which eventually are going to cause significant pain for mortgage holders in the UK. A large part of the fixed rate mortgage book in the UK is due to mature over the next 12-18 months and this means borrowers will face a cliff-face in terms of cost. This will inevitably cause many households to rethink their finances, so maybe the new car or the Caribbean cruise might have to wait. A more cautious consumer is precisely what the Bank of England wants.
What does this mean for investors who have had to endure quite the rollercoaster ride over the past few years? 2022 was a year most investors will be glad to see in the rear-view mirror because conventional diversification tactics were largely ineffective. Most asset classes fell, even those regarded traditionally as ‘safe havens’. For 2023, equity markets have generally been higher or tracked sideways so far, but it is again the lower risk part of portfolios that has acted as a handbrake. With higher interest rates, we have seen higher bond yields and when yields rise, prices fall. A year ago, a ten-year gilt in the UK provided a yield of 2%. The same bond now yields nearly 4.5%. This is a massive adjustment.
In the short term, we do like bonds because investors are now being rewarded with a higher yield. When inflation moderates, which it eventually will, rates will once again return to a downward path, and this will be very supportive for bonds, so we are in no hurry to lighten our exposure here. In fact, if yields edge up any higher there is a fair chance we might add.
For equities, the international side of portfolios is showing signs of life and as long as the 2nd quarter reporting season which gets underway this week, is not disastrous, we are optimistic. The UK market is slightly lower than where it started the year, but this is because it remains a few paces behind the US in the battle with inflation.
We have said before, markets anticipate what is likely to be happening 12-18 months ahead and the slightly more positive data emanating from the US and the realistic hope that the world’s largest economy could engineer a ‘soft landing’ should provide some encouragement for investors, both in equities and bonds. What we have witnessed so far in 2023, particularly in US stocks, is precisely that, anticipation in action.
We will write more fully in the Profile Reports, which will be with you soon.
Dr Andrew Mann