Q3 2023 reflection
Q3 2023 in summary:
- Stocks and bonds lost ground over the summer
- “Higher for longer” interest rates forced longer-term bond yields up…
- … draining liquidity, raising the cost of debt and undermining equities
- Strong Dollar and high income on short-term bonds cushioning diversified investors
- Interest rates - near or even at the peak, as inflation eases
- Recession deferred but still a risk - beware the lagged impact of rate rises
- End of the hiking cycle to bring relief - and risks
Stock markets have stalled through the summer as investors struggle to digest the reality of “higher for longer” interest rates. A stronger Dollar and rising oil prices have curbed liquidity and planted seeds of doubt as to whether inflation has really been seen off. Hopes of a peak in rates, and impending cuts, have been continually pushed back. Perhaps, now, we stand at the threshold - at or close to the peak, with more central banks signalling a pause or a shift in policy, as they gain confidence that their work is done on inflation. The US Federal Reserve made only a single rate hike in the quarter, +25bp in July, followed by a pause in September; the Bank of England paused at 5.25% in September, and although the ECB made a tenth-consecutive rate hike, it signalled a likely end to its hiking cycle. The key question for investors is whether a turn in the interest cycle really will provide relief for markets - or whether lags between rate hikes and the impacts of tighter policy in the real world mean that the resilience of the global economy is finally about to falter.
On the plus side, inflation readings are clearly in a falling trend. The process is slower than ideal in some economies, notably the UK, which still shows the highest annual inflation rate of the major western economies, at 6.7%. Notably, the US core PCE inflation index (the Fed’s favoured measure of inflation) rose at 3.9% in its latest reading, the lowest increase since May 2021. Inflation pipeline pressures have waned: supply bottlenecks have eased, core goods and services prices in the US seem now to be trending towards 2%, wage settlements are moderating (again, less so in the UK than other major economies) and wholesale prices are in deflation across Europe. Global food commodity prices have eased from last year’s highs, and electricity prices in the UK and Europe have fallen 60-70% year-on-year, although this hasn’t yet fed through to households. A resurgent oil price could undo some of this progress - the dangerous and distressing escalation in the conflict between Israel and Hamas carries risks in that regard - but the broad range of indicators suggests inflation continues to trend lower. Markets have been thinking the peak in interest rates is imminent for months: we might finally be there - or just a step away.
Many forecasters have expected that policy tightening would mean inevitable recession: not immediately, as it takes time for higher interest rates to bite, and high levels of US government spending have softened the pain. But the burden is felt as debt costs rise, making new borrowing less attractive and adding significantly to the cost of maturing debt that has to be rolled over - as UK mortgage holders coming off a fixed rate deal can surely attest. Leading indicators and surveys in most economies point clearly to slowdown: for services now as well as manufacturing. Job creation in the US appears to be trending lower and unemployment ticking up, company bankruptcies are rising sharply exacerbated by the higher cost of corporate debt, commercial real estate is suffering from escalating borrowing costs and shifts in tenant demand, household savings have been eroded and high mortgage rates threaten both the housing market and consumers’ ability to maintain current spending.
But the economy has remained surprisingly resilient - so far. While the odds of a recession materialising remain quite high, 2023 will likely have been a year of modest growth in the US, UK, Japan and Eurozone aggregate (despite Germany experiencing a recession). Just like expectations of the peak interest rates, forecasts of recession have been deferred - or even cancelled. The Fed has joined in, announcing on July 26th that it was no longer forecasting a recession as its central scenario, raising the possibility of mission accomplished: inflation back under control, without a major downturn - could they have navigated the narrow path to an elusive soft-landing?
Fed committee members don’t think they are quite done: they still project one probable further interest rate hike this year, before two cuts in 2024. Markets disagree, thinking we have seen the last hike of the cycle, pricing in only a 40% probability of a hike in December - but the gap between the Fed and the market is no longer the gulf that existed earlier in the year. As recently as May, futures markets had been pricing in a rate cut in summer 2023, and at least one more by the end of the year. That shift in expectations - towards a higher rate peak and much slower, later cuts on the other side - has been a lot for markets to digest. Of course, not all agree that the peak is nigh: the CEO of a leading Wall Street bank raised the possibility - not a forecast - that rates could hit 7% and suggested that borrowers consider how they could survive such a scenario.
This reappraisal led to losses for bonds, as markets priced in higher rates not just for the short term but stretching out into the future. With yields rising above 4.5% for the ten-year bond, US Treasuries lost just over 3% in the quarter (taking a small gain at the half-year stage to a small loss for the year-to-date). Yields have risen even higher since the quarter end. Longer-dated bonds, which are more sensitive to changes in yield, saw far bigger losses: the US 20-year Treasury lost over 13% in the quarter. High quality corporate bonds and inflation-linked bonds also lost money as yields rose, but short-dated and floating-rate bonds made small gains. Lower quality corporate bonds (high yield, or junk bonds) made money too: they tend to be short-dated, so are less sensitive to rising bond yields, and prices have been supported by narrowing credit spreads: perhaps surprisingly, in the face of higher interest rates, tight financing conditions and sharply rising corporate bankruptcies, investors are demanding less additional compensation for holding these riskiest bonds. It seems clear that credit markets are not pricing in a hard landing and may have to reprice significantly if recession does indeed arrive.
The grind higher in bond yields was a tough backdrop for stocks too: it is often hard for stocks to perform when bond yields are surging. The quarter-end yield of 4.5% for US Treasuries may be the highest seen in 16 years, but it is unremarkable over the long-term (in fact it’s close to the average yield seen since 1970). However, the rapid rate of change creates risks and puts questions in the minds of investors. A rise in government bond yields forces a reassessment of valuations across all markets: what’s the right price for equities, or indeed for any other asset, in a world where cash on deposit or in short-term bonds can make 5%? Or where long-term investors can secure a yield to maturity of perhaps 6% in high quality corporate bonds?
The Fed’s positive change of outlook in late July, removing recession from its forecasts and deferring expectations of rate cuts, actually marked the peak of equity market optimism for the quarter: the positive of avoiding recession outweighed by the implications of debt costs staying higher for longer.
After a bonanza first half of 2023, with the Nasdaq index recording its best-ever start to a year, the daily drumbeat of new highs in the Treasury yield undermined stocks: global equities lost almost 3.5% in the quarter, with growth stocks - the leaders at the half-year stage - falling 5%. The IT and Consumer Discretionary sectors, both fell over 6%. Value stocks were more resilient, falling a little over 1%. European and Emerging Market stocks fell 3-4%, digesting not only the global interest rate rises, but also facing clearer evidence of slowdown in China and Germany. Equity sectors that are historically very sensitive to bond yields - Utilities, Real Estate and Consumer Staples - were the biggest fallers, down 6-9%.
There were a few brighter spots: Energy shares rose 13% in the quarter, boosted by rising oil prices and Financials, which sometimes benefit from higher interest rates, were broadly flat on the quarter. Japanese stocks continued to appreciate, rising over 2% in the quarter in local currency terms thanks to shareholder-friendly reforms, low valuations and a much looser monetary policy than other major markets, although the falling Yen took the shine off this for unhedged investors. UK stocks were the pick of the bunch, gaining over 2%, helped by high exposure to oil companies and with their high exposure to overseas revenues benefitting from Sterling’s weakness: the Pound fell from $1.27 to $1.22 over the quarter, unwinding almost all of its gains in the first half of the year.
With global stocks and Treasuries both losing over 3% in the quarter, multi-asset investors had little chance of avoiding losses. Corporate bonds, EM debt and linkers all lost money: diversification within bonds didn’t help much last quarter - though shorter-maturity and high yield bonds provided useful returns, and many investors will now be looking at bonds with a much more sympathetic eye, seeing current income levels as a meaningful cushion against further upward pressure on yields, and attracted by the scope for government bonds to make capital gains in a slowdown or recession. Broad commodities indices made modest gains, thanks to rising oil prices as OPEC and Russia reduced supply, and concerns grew about low stocks in the US Strategic Petroleum Reserve. After a dip at quarter end, the dangerous escalation of the conflict between Israel and Hamas has raised concerns of potential impact on Iranian supply: oil prices could remain very volatile as the conflict develops. Gold and metals prices generally weakened, with gold trading down to $1848/oz by the end of September, close to its lows for the year. For Sterling-denominated investors, overseas currency exposure was a key benefit, with the Pound falling 4% against the Dollar and down slightly against the Euro. Portfolios with a high proportion of unhedged US Dollar exposure could have side-stepped the worst of the losses on underlying assets thanks to the currency move.
We wondered last quarter whether stocks had run too far, too fast in the face of rising bond yields. Perhaps they had, but perspective is important: after a 15% surge in global equities in the first six months of the year, a modest retreat might be seen as acceptable volatility, and global stocks have still delivered returns of nearly 20% over the last twelve months. A handful of giant technology stocks have helped drive the US index higher, boosted by optimism over future AI-related growth, but there has been more to the rally than this: over the past year, European, Japanese and even Latin American equities have all seen stronger gains than the US (in local currency terms). Despite the rise in real bond yields, which might be expected to compress valuations, equity valuations remain demanding for headline indices: perhaps less so outside the US (and especially outside the technology giants). Valuations may be rational if investors expect renewed profit growth in the coming year; but again less so if the long-heralded recession finally arrives, and corporate earnings come under pressure.
The peak of Fed interest rate hikes has been a critical point in past economic cycles. In the inflationary economic cycles of the 1970s and 80s, recessions began within a couple of months of the last rate hike, and rate cuts followed quickly after the peak: in effect, the rate hikes continued until recession was upon us. In more recent cycles, slowdowns typically took longer to arrive - rate cuts too. Forecasters are divided, and have had to constantly revise and push back calls for recession they have been making over the past year or so, but many are still expecting at least a mild recession in the US and UK by mid-2024, ultimately causing the Fed and other central banks to cut interest rates. It seems far from clear that many assets - including equities and riskier corporate bonds - have priced in this risk.
The peaks of tight monetary policy have been critical - and complex - for markets too: history helps investors make a case for both good returns and for volatility! On average, both stocks and bonds have delivered positive returns in the six and twelve months after the last hike of past Fed cycles. For bond markets, every cycle of Fed rate cuts in the last forty years has led to positive returns for Treasuries, as lower short-term interest rates pull down bond yields at longer maturities too. If a recession does follow the rate hiking cycle, it could be a catalyst for a change in Fed policy and a period of opportunity in bonds. Stocks have not got a flawless hit rate; although average returns after a Fed peak are high, in at least two of the past nine cycles, stocks have ended lower a year after the last Fed hike. And across all of those cycles, there has been meaningful volatility, with stock markets on average experiencing a double-digit correction sometime in the year following the last hike.
The end of a central bank tightening cycle, if we are there, could be an important step towards better times - but we should not expect a calm journey: the lagged effect of past rate hikes is still feeding through to companies and households, reducing liquidity and forcing up the cost of debt. Renewed fears over recession, hard-landing and corporate defaults could yet play a role. Investor sentiment is wary, with scope for volatility and for sharp market moves. A robust, diversified portfolio with a view to both long-term opportunities and short-term risks can help investors navigate these potentially choppy waters.
N.b. All content is based on data at the time of writing on 10th October 2023.