Inflation dominated investor concerns over the past couple of years and into 2024, and a renewed inflation scare, had sparked meaningful market volatility in the spring of this year. Investors - as well as central bankers - are clearly gaining in confidence that the inflation threat is now subdued. Broad and core measures of inflation remain on a broad and steady trend back towards central bank targets on both sides of the Atlantic - in some cases already undershooting, notably in some Eurozone countries. Companies still see some price pressures in their supply chains, but the alarming bottlenecks and soaring prices for key components and raw materials that were seen in 2022 are nowhere to be seen: finally, perhaps belatedly, and certainly well after a host of other central banks, the Fed finally sees enough margin of safety on inflation to begin cutting rates.

While the first half of the year saw dramatic shifts in investor expectations for interest rates, the third quarter saw a crystallisation of certainty around a first Fed cut in September, with investor speculation centring more on the size of the cut than its timing. A 50 basis point initial cut in September - an unusually large step outside periods of market stress or collapsing economic growth - perhaps signals a recognition that the first step in this new cutting cycle is arriving a little later than it could have, and a desire to get ahead of the curve. Economic data - the US jobs market in particular - seem resilient enough for now to point to 25bp cuts rather than more dramatic moves, but the easing cycle is at last underway.

With the ECB, Bank of England and many central banks across developed and emerging markets starting rate cutting cycles ahead of the Fed, and the People’s Bank of China embarking on a potentially powerful range of stimulus measures in September, investors now face a world of significant and coordinated global policy easing: we’ve already seen 21 rate cuts from the major central banks so far in 2024, a number exceeded only in the wake of the 2008 Global Financial Crisis and the 2020 Covid pandemic. The Bank of Japan may remain on its own path, slowly increasing interest rates - prompting a rebound in the weakened Japanese Yen, and shocking markets into a brief wobble and a reversal of some leveraged trades in August - but internationally, central banks are very clearly in easing mode.

That this broad and decisive loosening of policy comes at a time of with global stocks near all-time highs, with credit spreads close to cycle lows and corporate default rates now falling, and with lead indicators of economic growth still pointing towards expansion is a clear shot of adrenaline for financial assets.

Almost every significant move in financial assets through the quarter can be traced back to the emerging clarity on central banks’ policy intentions, against a backdrop of moderating inflation and steady economic growth. Global bonds gained 4% in Q3, with yields falling along the curve as investors priced in more certainty about the rate cutting cycle. Global equities gained 6.5% in Q3 (now up almost 18% year-to-date in US Dollar terms, a second year of stellar performance); this despite a brief growth scare in August and a bout of sharp volatility prompted by the Bank of Japan’s rate hike and a counter-trend bounce in the Yen. It’s worth noting in passing that the US equity market’s 20% gain year-to-date is its strongest-ever showing in the first nine months of an election year.

Equity markets’ strong performance showed a markedly different picture to that of the past year or two. Investors are used to large-cap growth, AI and a magnificent-few dominant technology companies leading the equity market charge higher. Q3 showed a significant broadening and rotation within the market: global Tech stocks (big winners year-to-date) gained just 2%. It was time for cyclicals and for sectors most sensitive to falling bond yields to lead the way: Utilities rose 18%, Real Estate stocks 17%; Financials and Industrials gained 11%, both making new all-time highs in the period. Energy stocks were slightly negative for the quarter, although gained strongly into early October, driven by sharply higher oil prices after Iran’s missile attack on Israel.

While the Growth investment style that has dominated the last few years still leads Value by a little year-to-date, Q3 saw a sharp narrowing of the gap, as Global Value stocks gained 10%, well ahead of a 4% gain from Global Growth. Small and mid-cap stocks - often beneficiaries of looser financing conditions - outperformed large-caps in both the US and UK, but elsewhere the geographical picture at first glance seems somewhat muddled: UK and European stocks both gained only 2% in the quarter, despite having high exposure to strong performing sectors like financials, industrials and utilities, significantly lagging US stocks, with their heavy technology weighting. When we take account of currency, the picture is clearer: UK stocks gained only 2% in Sterling terms, but Sterling gained 6% against the Dollar. So, measured in comparable currency terms, British stocks clearly outperformed American - a rare event in recent years. Similarly for European stocks: they gained only 2% in Euro terms, but the Euro’s gain of 4% against the Dollar puts European equities on a par with US equities over the quarter.

Asian markets diverged sharply: Japanese stocks lost 5% in the quarter, although a rapid 12% rise in the Yen clearly outweighed these losses, for investors with unhedged FX exposure, who gained far more on the currency than they lost on the underlying stocks. Chinese stocks languished until mid-September, when an extraordinary two week surge was sparked by policymakers’ package of stimulus measures. Chinese equities gained 23% in the quarter, dragging emerging market equities as a whole to a near 9% gain for Q3.

Central bank action drove bond markets too. Ten-year US Treasury yields fell from 4.4% in June to 3.8% at quarter end, pricing in greater certainty about the rate cutting cycle: that drove healthy gains of 4.7% for US Treasuries as a whole in the quarter, with longer-dated bonds - which are much more sensitive to changes in yields - gaining as much as 8%, thereby outperforming equities for the period. Yields fell perhaps surprisingly little in the Gilt market, where investors have been pricing in only a very gradual series of rate cuts: Uke government bonds made just 2% in the quarter, with yields dropping only slightly to 4% - the highest yields on offer now of all the major developed government bond markets. Lower yields (i.e. higher prices!) may superficially reduce the attractions of bonds going forward but investors will have taken heart from the performance of bonds in the market’s brief growth scare in August: in contrast to the inflation scare in the spring, when both stocks and bonds sold off, bonds rallied during the brief bout of equity volatility in August - a powerful underlining of the potential benefits of holding high quality fixed interest in a diversified, well-balanced portfolio.

Better quality (“investment grade”) US corporate bonds were one of the stronger sub-sectors, making almost 6% in the quarter, benefiting both from lower government bond yields and continued tightening of credit spreads, but riskier bonds also did well: US high yield (“junk bonds”) made over 5%, with markets heartened by a modest fall in the number of companies defaulting. More strikingly, local currency emerging market bonds made over 9% in US Dollar terms, as a broad range of currencies rose against the Dollar.

The start of the Fed’s rate cutting cycle reduced the attractiveness of the Dollar in yield terms; and broadening investor confidence that recession would be avoided reduced its appeal as a potential safe haven in times of trouble. No surprise, then, that the US Dollar weakened against all major developed-market currencies in Q3 - in some cases considerably. Diverging interest rate policy, with the Bank of Japan hiking rates, saw the Japanese Yen spike to a 12% gain against the Dollar in Q3 (it remains negative for the year, however), mostly playing out in a frenetic 3 week move in July and August. This prompted a sharp reversal in risk assets, particularly in leveraged speculative investments that had been funded by borrowing in Yen - a potential market shock, that in the end stabilised almost as quickly as it emerged. Other major currencies have strengthened against the Dollar as the Fed catches up on rate cuts: the Euro gained 4% in Q3, the Pound 6%, as investors continue to react reasonably positive to the new UK government and the prospect perhaps of both an increase in public sector investment and possibly a thawing of trading conditions with the EU. Many emerging market currencies rebounded more strongly against the Dollar, notably south east Asian currencies: the Indonesian Rupiah gained 8% in Q3, the Thai Baht 13% and Malaysia’s Ringgit 14%. These moves helped underpin very strong gains by emerging market bonds issued in local currency.

Commodity markets overall were quite subdued in Q3, with oil prices trading down to two-year lows in mid September (before the escalation of hostilities between Israel and Iran prompted slightly higher prices at quarter end). Gold told a different story, surging 13% in Q3 to new all-time highs above $2600/oz - less spectacular in Euro or Sterling terms, perhaps, but still an impressive performance. Gold produces no cash flows, so is inherently hard to value: but is clearly responding positively to an environment of looser policy, lower interest rates and a weaker Dollar. Rising geo-political tensions, particularly the concerning security situation in the Middle East, also play a role.

Normally, central banks start cutting interest rates from a point of weakness, in order to revive a deteriorating economy, ease credit conditions amid rising defaults, or pump liquidity into dysfunctional financial markets. Not so this time. We have already seen significant rate cuts, and more are priced in, with the Fed now joining the party too. And yet we have buoyant financial conditions, stocks near all-time highs, easy credit availability and tight spreads, inflation trending slightly lower and economic growth seemingly steady. While recessions are often not obvious until well after they have started, and only clear in retrospect, there is an overwhelming weight of evidence that US consumers are still increasing their spending, which is not at all consistent with the idea of a slowdown. Little wonder, perhaps, that some commentators are whispering of benign, “Goldilocks” conditions for markets - not too hot, not too cold. Stocks may be expensive - US, large cap growth stocks in particular look expensive enough to suggest that long-term returns from this starting point could be below average - but profitability is high, and many segments of the equity market both in the US and globally, seemingly offer much better value. September’s market rotation, with the outperformance of Value over Growth, could give us a glimpse of what this looks like.

Perhaps a likelier source of risk in the months ahead is the scope for investors to worry that a super-easy liquidity environment, which could be good for stocks and commodities, could accelerate into an overheating global economy, effectively reviving inflation concerns - and potentially adding delay and disappointment on interest rate cuts that markets have already priced in. A sustained spike in oil prices, or an implementation of significant import tariffs (if Trump edges ahead of Harris in November) could add a flavour of stagflation to such a scenario: inflationary pressures combined with pressures on growth. Markets have rightly taken heart from what looks increasingly like an elusive economic soft-landing, but there is no cause for complacency. 

N.b. All content is based on data at the time of writing on 7th October 2024.