There are two questions being asked by every investor. When are interest rates around the world going to stop rising and what happens to stock markets when they do?

No-one knows for sure when rates will peak, but what we can say is there are two different scenarios which could cause central banks to stop raising. As for what happens to markets next, that depends on which of the two scenarios unfolds.

RECORD PACE OF RATE RISES

If the Federal Reserve, the European Central Bank and the Bank of England stop raising rates because they believe inflation is under control, it will have far different ramifications for stocks and bonds than if they stop because their economies are sinking under the cumulative effects of past rate hikes.

Just to recap, the Fed has raised rates from 0.25% to a 22-year high of 5.5% over an 18-month timeframe, one of the quickest hiking cycles in its history, while the ECB has tightened even faster, moving from a 0.25% marginal lending rate to 4.5% in just over a year.

The Bank of England was the first central bank to respond to signs of inflation when it raised its base rate in November 2021, but it waited a year before it really stepped on the accelerator and pushed rates from 2.25% to 5.25% so it could be argued much of the increase has yet to feed through into the real economy.

EQUITIES STILL BELIEVE IN A ‘SOFT LANDING’

Despite this record tightening of monetary conditions, investors seem convinced the Fed has engineered an ‘immaculate disinflation’ and can achieve a ‘soft landing’ meaning there won’t be a recession in the US.

Although inflation is still above the Fed’s 2% target, it has declined for 12 straight months from over 9% in June 2022 to a current annualised rate of 3.2%.

Importantly, long-term inflation expectations remain relatively well anchored with the University of Michigan consumer survey showing inflation expectations over the next year at 3.4%, down from 5.4% in March 2022.

Market-based measures such as the five-year implied breakeven inflation rate, derived from index-linked prices, has dropped to 2.2% from 3.6% in March 2022 according to The Federal Reserve Bank of St. Louis.

In contrast to equity markets, however, bond markets have been pricing in a recession since the yield curve inverted in July 2022 when 10-year yields fell below two-year yields.

THE POSITIVE SCENARIO

If the Fed is successful in pulling off a soft landing and the economy escapes a deep recession, corporate earnings could accelerate in 2024.

The problem is, consensus earnings are already expected to grow at a double-digit rate in 2024, so unless expectations are revised upward further, stocks may struggle due to valuation pressures.

Moreover, the US cyclically adjusted price to earnings or CAPE ratio conceived by Robert Shiller is also elevated with a reading of 30.7, and has only been higher on two occasions.

That said, valuation indicators aren’t reliable timing tools and it is possible valuations could become even more stretched.

WILL THERE BE A ‘DASH FOR TRASH’?

In theory, stable or falling rates should benefit highly indebted companies and those with weaker balance sheets generally as refinancing costs should not get any higher or even fall.

These higher-risk companies could see a short sharp rally in their shares once it becomes clear rates are not moving higher, but stocks are forward-looking and some areas of the market may have already benefited as investors try to get ahead of the peak in rates.

For example, luxury car maker Aston Martin Lagonda Global (AML), which it’s fair to say is at the riskier end of the spectrum, has seen its shares shoot up over 300% since autumn last year which suggests investors have jumped the gun on rates topping out.

More speculative areas of the market such as AIM mining or oil stocks could also receive a boost as investors seek out higher-risk opportunities.

Long duration assets such as property, REITs (real estate investment trusts), infrastructure and renewable trusts, which have struggled since interest rates started to increase, could turn out to be good hunting grounds once it is clear rates have peaked.

The same goes for royalty-based companies such as Hipgnosis Songs Fund (SONG), noting that peer Round Hill Music Royalty Fund (RHMP) last week received a takeover offer following a prolonged period of share price weakness.

Housebuilders may offer decent risk to reward opportunities once rates peak given the big share price falls across the sector in the last two years.

THE LESS ROSY SCENARIO

So far, the unrelenting strength of the US economy and the resilience of the labour market has allowed the Fed to be aggressive with rate hikes to combat inflation.

However, the reality is the central bank doesn’t know for sure how restrictive its monetary policy actually is, which is why chair Jerome Powell often speaks of ‘data dependency’.

The Fed’s whole approach to the peak in rates is, ‘We will know the destination when we get there.’

Given employment is a lagging not a leading indicator, it is possible the economy is already close to recession and the Fed and other central banks will have to make policy less restrictive.

We don’t think stock markets are properly priced for this outcome and if the ‘soft landing’ scenario turns out to be wrong, equities could be vulnerable.

During economic downturns, commodities, financials, housebuilders and consumer cyclical shares usually take the brunt of the falls, while defensive parts of the market such as utilities, staples, technology and healthcare tend to outperform.

TWO IMPORTANTS ISSUES FOR INVESTORS TO CONSIDER

1. ARE BONDS A WIN-WIN?

Under either scenario, government bonds should perform well because if central banks have brought inflation under control. Both short-dated and longer-dated bond yields should fall (meaning prices move higher, as yield is the inverse of price).

Given their greater sensitivity to moves in interest rates, longer-dated bonds (those with a 10-year maturity and above) should generate greater gains than shorter-dated bonds.

One caveat to the positive outlook for bonds is a scenario where central banks stop hiking prematurely, and inflation remains above target or takes longer to fall back to target.

In other words, persistently elevated interest rates could prove a problem, especially for bonds with longer maturities where the damaging effects of inflation will have a bigger impact.

2. DOES CHINA STILL MATTER?

China certainly still matters to global investors and policy makers, but surprisingly not in the way it used to before the pandemic.

As Bloomberg’s senior economics writer Shawn Donnan explains, Western attitudes towards China have shifted of late as its $18 trillion economy struggles to recover its former growth trajectory.

‘Policymakers are convinced that what is unfolding in China isn’t just symptomatic of bigger long-term problems like its ageing and declining population but also what ought to be a shift in strategic thinking,’ says Donnan.

‘No longer are they planning for China’s inevitable rise. The conversation now is venturing into whether the Chinese slowdown marks a sign its power is peaking prematurely, and that the hard work now should be to prepare for a declining rather than a rising China and all its consequences.

‘This could be the (time) an economic narrative that for decades has guided the flow of capital and government assumptions and policies around the world flips on its head,’ adds Donnan.

In that scenario the implications for energy and commodity companies are huge, as they are for foreign firms selling lifestyle or aspirational products into China.

It has even been suggested that president Xi Jinping is deliberately letting the economy fail, offering only limited measures to support the failing real estate sector and the yuan, which is heading towards its lowest level in over 15 years while foreign investors flee the markets.

The theory is, whereas US president Joe Biden has spent trillions of dollars to run the US economy hot, Xi is doing the exact opposite in order to destroy once and for all the country’s reliance on speculative development and shadow banking, namely unregulated lending.

China is undergoing ‘an expectations recession’, according to Bert Hofman, former China country director at the World Bank. ‘Once everybody believes that growth will be slower going forward, this will be self-fulfilling.’

As it is, Bloomberg Economics estimates it would take until the mid-2040s for China’s GDP (gross domestic product) to overtake that of the US, and even then, it would only be by a small margin, before falling behind again.

After growth of just 3% last year, analysts at JPMorgan Chase expect the economy to grow by 4.8% this year and 4.2% next year, which would mark the first time since the Mao era of the 1970s that growth has been below 5% for three years running.

What this means is Western economies – and by extension stock markets – can no longer rely on China to turn on the stimulus tap every time there is a risk of a global slowdown: they are now masters of their own destiny.

WHAT IS THE DATA TELLING US ABOUT ECONOMIC GROWTH GLOBALLY?

For all the talk of US resilience, it is clear from soft data like industrial confidence surveys and hard data such as manufacturing output that growth is slowing elsewhere around the globe.

While the US manufacturing PMI survey seems to have stabilised just below the expansion/contraction line (a reading of 50), the European and UK surveys are plumbing news lows, and whereas in the post-pandemic recovery phase the readings tended to beat expectations now they are regularly undershooting forecasts.

In terms of hard data, German factory orders plummeted by 11.7% between June and July, far worse than the estimate of a 4.3% fall.

Although the June reading was boosted by a large order in the aerospace industry, July showed continued declines in orders for technology products, mechanical engineering and electrical equipment, typically the kind of goods associated with industrial demand.

Domestic orders fell by nearly 10%, while overseas orders fell by close to 13% with orders from the Eurozone down 24%.

Meanwhile, UK factories suffered their worst month since the pandemic in August with orders collapsing ‘at rates rarely seen outside of crisis periods’ due to lack of confidence driven by rising interest rates, according to S&P Global.

The only saving grace seems to be the fact consumer spending is holding up better than might be expected given the cost-of-living crisis.

According to the British Retail Consortium, total retail sales rose by 4.1% in August, above the three-month average of 3.6%, with non-food sales having their best month since February.

The total figure was surely helped by higher prices and better weather after July’s washout, but the increase in in-store purchases was a welcome sign, nonetheless.

WHERE DOES THAT LEAVE US?

The consensus view is that as long as people have jobs and unemployment stays low, as it is at present, then the global economy will muddle through, led by the US thanks to a mix of private consumption and government spending.

For now, central bankers seem prepared to sit on their hands and watch the economic data trickle through before they raise rates again, but the generally accepted view is the job isn’t done yet.

The Fed’s mind-set is, having been late to recognise the danger, it would rather put the economy into recession than risk easing rates too soon because it cannot allow the inflation genie to escape the bottle, even if it takes time to come down to its 2% target rate.

So far it appears investors have given central banks the benefit of the doubt and been happy to take on risk, but as we know sentiment can turn rapidly and if markets sense the economy is going down the tubes the mood music will change very quickly.

‹ Previous2023-09-14Next ›