The Federal Reserve is now projecting just three rate cuts of 0.25% in 2024, and market expectations have converged on this, with cuts expected to begin in June or July - a far cry from the much more inflated hopes at the start of the year. It’s possible that expectations for rate cuts will be pushed later still: the economy does not appear to need urgent or aggressive stimulus at this point. But as inflation has fallen against static interest rates, real interest rates have therefore ratcheted higher - perhaps unnecessarily so: rate cuts at this stage of the cycle could be a helpful reduction on the brake pedal rather than a dangerous thrust on the accelerator.

Markets expect the ECB and the Bank of England Monetary Policy Committee to begin cutting rates this summer too, with the ECB potentially the first of the three to cut. Several emerging market central banks have already started cutting rates, including Mexico, Brazil and Czechia, and China has undertaken a range of policy stimulus steps. The Swiss National Bank became the first of the major western central banks to cut rates in this cycle, reducing its policy rate by 0.25% in March. The Fed’s first cut may be later than previously hoped, but as long as investors feel they can look forward with some confidence to cuts on the horizon, markets have remained buoyant.

The Bank of Japan is in a different cycle, having increased interest rates just above 0%, thereby ending eight years of negative interest rates. There may be a long way still to anything resembling “normality” - Japanese interest rates have been below 1% since 1995, and the Bank’s policy remains ultra-easy, but investors should be considering the implications for global capital flows if the enormous pool of Japanese savings could again access meaningfully positive rates at home.

The market’s reappraisal of the prospects for interest rate cuts has buffeted fixed interest this quarter, with bond yields rising across the board: the yield on 10-year US Treasuries rose from 3.9% at the end of 2023 to 4.2% at the end of Q1 2024 (and has pushed higher in early April). This meant negative returns for most government bonds, especially longer-maturity bonds, which tend to be most sensitive to higher yields. The global aggregate bond index was broadly flat for the quarter, with interest income partly offsetting capital losses and modest gains from the riskiest bonds - high-yield debt issued by the weakest corporate borrowers and Dollar-debt issued by emerging market borrowers - offsetting losses in Treasuries, Gilts and other government bonds.

Many investors see the appeal in the possibility of “locking in” medium-term yields well over 4% in government bonds or over 5% in high-quality corporate bonds. Yields are high enough now for bonds to be again considered part of the toolkit for a well-diversified portfolio, and the highest quality bonds offer scope for capital gains if yields fall in a future recession. However, credit spreads are narrow, and the continued rally in low-quality, high-yield bonds leads some to question whether investors are sufficiently compensated for the risks of losses in an environment where corporate defaults are climbing - and forecast to climb further.

Equities had rallied alongside rallying bonds in late 2023; over the past quarter, as equities have shrugged off the dampened expectations for rate cuts and rallied in the face of weaker bond markets, it seems that this correlation may be shifting, consistent with investors’ shift in focus towards prospects for growth in the economy. As so often, geopolitical concerns have dominated news flow and buffeted oil prices but had little impact so far on equities: stocks have enjoyed bumper returns again this quarter.

Global equities made new all-time highs in March, gaining 9% in the quarter. US stocks slightly outperformed, gaining over 10%, also reaching new all-time highs, but there are signs of broadening participation in this bull market. European stocks lagged only slightly, gaining over 8%, but there were many bright spots: French stocks made new all-time highs, and Italian stocks gained nearly 15% in the quarter. Japanese stocks led the way, up 18% in Q1 (in JPY terms). Other Asian stocks were weaker, particularly Chinese equities, which fell in Q1 despite a rally in March on hopes of a cyclical recovery. UK equities lagged the rest of Europe, up just 3% (with small and mid-cap UK stocks lagging even further behind).

Investors had plenty of ways to participate in the rally. Growth stocks have continued to outperform the Value style but by a much narrower margin. It may be no surprise to see Growth sectors like IT and Communications leading the global equity market rally over the quarter, but we saw gains around 10% for Energy, Financials, and Industrials, often a hunting ground for Value investors. Bond-sensitive sectors (Utilities and Real Estate) were undermined by rising yields and lagged the broader equity market rally.

Gold also achieved new all-time highs in March, above $2200/oz, and has strengthened further in the first days of April. This is a striking performance in a world where the traditional drivers of gold’s performance appear lukewarm at best: inflation is falling, not rising; the US Dollar is strengthening, not falling; real yields are climbing, and the opportunity cost of foregone returns on cash deposits is as high as it has been in over a decade; and while geopolitical risks abound, it is not clear that these have driven gold’s surge. With Bitcoin also achieving new highs, above $72,000, some argue that the rally in non-financial assets reflects fears over understated inflation and long-term debt sustainability.

Oil prices rallied late in March to their highest levels for the year to date, around $83, and gained further in early April on fears over an escalation of the conflict in Gaza and tensions between Israel and Iran. The inflationist camp has focused too on some other individual commodities seeing sharp price rises - notably Cocoa, where supply concerns have driven prices above $10,000/tonne (more than double the previous all-time-high set in 1977) - but much less attention paid to a broad range of other agricultural commodities: soybeans, wheat, corn, and sugar are all showing significant year-on-year price declines.

The Dollar strengthened by around 3% against a basket of its major trading partners as it became clearer that the Fed would keep interest rates higher for longer than previously expected. Sterling was among the stronger major currencies, weakening slightly against the Dollar year-to-date but rising against other majors: this, of course, detracts slightly from unhedged returns for UK investors in overseas assets outside the US. Markets appear to be pricing in the potential change of the UK government this year with equanimity. The Yen weakened significantly again, approaching its weakest levels since 1990: in a world of higher-for-longer interest rates, even Japan’s final retreat from negative interest rates is not enough to support the currency. While this is a boon for Japanese exporters and positive for profits at Japanese companies, it detracts from returns for overseas investors holding Japanese equities - unless that currency exposure is hedged.

The yield curve has been inverted - that is, yields on longer-maturity bonds are below yields on short-maturity bonds or cash - for an unusually long period. US 10-year Treasury yields dipped below US 2-year yields as far back as July 2022 and have stayed below since. This matters to investors because a yield curve inversion is typically seen as an early warning of recession. But, nearly two years on, no recession has arrived. We may need to tweak the framework for thinking about yield curve inversions: a more logical and literal interpretation is not that an inverted yield curve forecasts a recession - rather, the only certain inference is that an inverted yield curve is simply the market pricing in lower interest rates in future than today. Historically, recession has been the most common route to lower interest rates, but it is quite clearly not the only way. Rate cut expectations may be delayed and diminished further, but the market currently expects 3 rate cuts in 2024 and more in 2025, which would be enough to bring cash interest rates below today’s 10-year Treasury yields and unwind the inversion of the yield curve. Could that happen without a recession? 

Economic growth has remained particularly resilient in the US in this cycle. Inflation is moderating, and the path towards a soft landing seems navigable, although the risks of a misstep may increase the longer that rate cuts are delayed. With surveys and data indicating an increasingly broad-based reacceleration in the global economy and a resilient labour market supporting consumption, the Fed, in particular, remains very wary of stimulating a growing economy into overheating.

Purchasing managers surveys across key economies show that growth is gaining momentum. Manufacturing and services are both contributing to growth, and there is clear acceleration in the US, UK, Japan, and key emerging markets. China is seeing some recovery, helped by recent policy measures. The picture is more mixed in Europe, with France and Germany still lagging, but the local economies in much of the continent are now back in growth mode. Firms express more confidence in the future, as order books are improving, although some note stubborn cost pressures, particularly in services.

The health of employment in the US remains as crucial as ever, as one of the few factors that could break US household consumption. The labour market is typically a lagging indicator of changes in the economy - firms tend to cut other costs, before they cut jobs, but the picture remains quite rosy, without being so strong as to worry the Fed about renewed wage inflation risks. Job creation is still running at impressive levels and the unemployment rate has remained stable, fluctuating around 3.8% since August last year. Inactive workers are being tempted (or perhaps forced) back into the labour market, with the participation rate rising. But there are plenty of signs that this is not an overly tight labour market: payroll numbers are rising, but government and part-time jobs play a key role here; average hourly earnings are modestly above inflation (4.1% at the last reading), but this is the lowest annual increase in 3 years; there are a third fewer job openings reported than two years ago; and a downward trend in the voluntary quit rate suggests that Americans are feeling less confident about their ability to quit one job and walk into another at better rates of pay. It remains to be seen whether confidence in the labour market and earnings prospects will be the major factor in a tightly fought US election.

It may be difficult to foresee a significant economic slowdown while lead indicators from the corporate sector remain positive, but with equity markets pricing in an ever-more optimistic macro scenario, and the delayed effects of higher interest rates slowly working through the system as old debt has to be refinanced with new, we should remain watchful. Consumers are feeling a little less optimistic about jobs, savings rates have fallen and excess savings from the lockdown-era have been largely spent, consumer credit growth is slowing and interest payments are rising. Corporate bankruptcies are already ticking higher in the US and Europe, and ratings agencies expect the rate to increase further.

Fears of a second wave of inflation so far seem unfounded. The slight cooling of the labour market has helped reduce cost pressures in the service sector, and supply bottlenecks that propelled inflation in goods are largely in the past. Core inflation is falling perhaps more slowly than hoped, and bumps in the monthly data are still a risk, but the trend towards lower inflation seems intact. It is increasingly difficult to see what could drive a second round surge of inflation, even in a world of sharply rising oil prices: it’s worth noting that shifts in energy supply are already having a huge impact. Electricity prices continue to fall across Europe: in Spain, wholesale electricity is at record lows, with prices down 96% YoY as generation from solar and wind has been so strong. The situation is not as extreme elsewhere in Europe, but France, Italy and the UK have also seen very substantial falls in electricity pricing.

Inflation may be falling more slowly than hoped and rate cuts may be arriving later than hoped, but central banks remain clearly biased towards cuts. While that bias remains, and the economy continues to evolve towards a soft landing, perhaps investors are right to feel relaxed about the pace of cuts: the Fed may well delay further than markets are currently expecting. Periods of sharp interest rate cuts in the past have often been associated with significant volatility in equity markets, as stocks react to the harsher growth conditions that have necessitated rapid rate reductions. Let’s be careful what we wish for! 

The straight-line rally in equity markets since October leaves many commentators concerned that investors are becoming complacent. Valuations have become more demanding, skewed particularly by the expensive valuations for AI-related stocks, which can be justified only by optimistic assumptions about future sales and margin growth. Strongly growing corporate earnings - and more comfortable valuation levels outside the high tech segment of the market - arguably provide vital support. Continued resilience in the global economy alongside the beginnings of a well-managed rate cutting cycle could spur investor demand more widely, to cyclicals, small-caps, value stocks and emerging markets. However, with market bullishness at high levels - close to peaks that have been associated with profit-taking and modest corrections in the past - investors would be wise to think about how well-diversified they are and examine the case for protection in more defensive and less expensively-valued assets.

N.b. All content is based on data at the time of writing on 12th April 2024.