Quarter in review: Higher interest rates for longer weighs on markets

The global economy has continued to ‘limp on’, in the words of the International Monetary Fund (IMF)[1]. While China’s recovery has been disappointing and eurozone growth  lacklustre, the strength of the US economy has helped compensate. The consensus remains for there to be a ‘soft landing’ for the global economy. Where countries fall into recession, it is likely to be short-lived and shallow.

Nevertheless, there are risks. A resurgence in inflation is perhaps the most pressing. In recent months, energy prices have started to tick higher, to the concern of central banks across the world. The labour market also remains relatively strong, with wages having risen in the US and continuing to do so in the UK.

Elsewhere, geopolitical tensions continue to trouble investors, with the world appearing increasingly fragile. The Western coalition supporting Ukraine appears to be fracturing. The emergence of an energy bloc as the five-strong BRICS trading group of emerging economies expands to eleven is also a cause for concern.

Overall, the picture remains mixed – neither as awful as seemed possible at the start of the year, nor as strong as the past decade. Financial markets have reflected this weakness, with continued volatility and changes in the companies and sectors leading the market.

If there has been a theme over the past quarter, it’s been about the financial markets’ adjustment to ‘higher for longer’ interest rates. With interest rate rises paused, investors had started to anticipate cuts in 2024, despite central bank warnings. Bank of England (BoE) Governor Andrew Bailey said: "We will need to keep interest rates high enough for long enough to ensure that we get the job done.” In September, Jerome Powell, chair of the US Federal Reserve (Fed), used his keynote speech at Jackson Hole to hammer home that commitment.

Eventually, bond markets started to get the message, and bond yields rose, particularly longer dated bonds. Rising yields were supported by an increasing glut of supply, as governments were forced to borrow more to keep up with interest payments. The costs of servicing the US debt pile are currently eating up 14% of tax revenues[2].

Higher interest rates raise the cost of borrowing for governments, companies and consumers. This is likely to weigh on economic growth for the immediate future and impacted financial markets over the quarter. From here, the direction of inflation will be vitally important. While inflationary pressures appear to be easing, with core inflation dropping in the US, eurozone and UK, rising energy costs are giving policymakers pause for thought.

US

The S&P 500 trended lower over the quarter, as the shine came off some of the ‘Magnificent Seven’ technology and consumer stocks. They had bounced a long way in the early part of the year as excitement around artificial intelligence (AI) grew but fell back on some profit taking and when the costs of AI investment became clearer.

At the same time, US markets were suffering from a dose of ‘good news is bad news’. The better news that came through on the economy, the more it seemed likely that the Fed would maintain interest rates at their current high level with the possibility of further rises lurking. The US economy has shown few signs of flagging, with employment growth still motoring and the consumer sector in good health.

UK/Eurozone

The impact of higher interest rates was far more evident in the UK and the eurozone. In the UK, property prices have started to come down. Employment is starting to show signs of weakness, with unemployment rising and hiring slowing[3]. In the eurozone, unemployment continues to hover around record low levels of 6.5%, [4]. In both areas, forward-looking indicators, such as Purchasing Managers Index data, suggest that the economies are slowing.

Weakening inflation data has given central banks some flexibility on interest rates. In the UK inflation (including housing costs) rose by 6.3% in August[5], down from July and lower than expectations. Eurozone inflation had dropped to 4.3% by September, down from 5.2% in August[6].

The UK stock market has seen a late surge, with its dominant oil and gas companies benefiting from a rise in energy prices. The MSCI UK 100 is one of the few markets to have risen over the past three months, albeit with significant volatility in between[7]. The MSCI Europe ex UK index has seen weakness over the same period[8], with many of its flagship luxury goods companies struggling amid  poor expected demand from China.

Asia

Asian markets have struggled under the weight of a fragile Chinese economy.[9] The hoped-for stimulus from Chinese policymakers has not materialised and while there have been some easing measures, they have not been enough to galvanise investors in the region. China is still important for growth: according to the IMF - for every percentage point of higher growth in China, output in the rest of Asia rises by around 0.3%. [10]

The overall trend for Asian markets has been lower, with little discrimination. Commodity-heavy Australia has fallen alongside Singapore, while fast-growing economies such as Indonesia have also struggled. Nevertheless, there have been pockets of strength. India, for example, has continued to deliver strong returns, despite concerns over valuations[11].

Japan

Japan has been the favoured market for much of this year after receiving the endorsement of multi-billionaire investor Warren Buffet early in 2023. However, the Nikkei has been weaker over the past quarter[12] in line with other global markets. The stock market had seen a boost from corporate governance reforms and the tentative re-emergence of pricing power for companies.

Japan’s economy is still growing notably faster than it has for some years, delivering 4.8% annual real GDP growth in the second quarter[13]. However, both capital expenditure and private consumption continued to be relatively weak, and the export-driven economy faces headwinds from weaker Chinese and US growth.

Bond markets have been buffeted by changes in interest rate and inflation expectations. US 10-year bond yields have been moving higher since August as investors have recognised that inflationary pressures have not gone away. At the start of August, yields were 4%, but have subsequently ticked up to 4.8%[14].

Inflation expectations are certainly part of this. US inflation, according to the consumer Price Index (CPI), increased at a rate of 3.7% in August, up from 3.2% in July[15]. While economists had been expecting a rise, this was at the upper end of forecasts. Rising energy costs were a key contributor to inflationary pressures over the month.

However, there are also technical factors driving bond yields higher. Governments are boosting supply, issuing more bonds to support rising spending and falling tax revenues. At the same time central banks have stopped reinvesting the proceeds of any maturing bonds into new issues, removing a significant demand from the market.

Elsewhere, the moves were not as significant. The UK 10-year bond yield moved from 4.4% at the start of August to 4.5% by the end of September. The BoE’s surprise pause on interest rates and weakening data emerging from the UK economy were key factors. In the eurozone, the benchmark German 10-year bund moved from 2.6% to 2.8% over the same period.

For corporate bonds, spreads over government bonds remained stable in the absence of any significant tick-up in defaults. While there have been small pockets of distress, this has been limited to the lowest quality businesses.

The message from the global economy remains mixed. While there is perhaps greater clarity on inflation and interest rates than at the start of the year, investors are still nervously hanging on every word from central banks. That said, there are some reasons to be optimistic: inflation appears to be falling, the corporate sector is in reasonable health with some company profits continuing to grow, while equity and bond valuations look far more realistic today. Financial markets have been through a painful adjustment, but the lion’s share of that shift could be behind them.

[1] https://www.reuters.com/markets/imf-says-global-economy-limping-along-cuts-growth-forecast-china-euro-area-2023-10-10/

[2] https://www.cnbc.com/2023/05/12/kelly-evans-the-debt-ceiling-is-just-act-one.html

[3] https://www.ft.com/content/765711d1-b00d-407a-b76b-32590b67eae7

[4] https://ec.europa.eu/eurostat/documents/2995521/17602217/3-02102023-AP-EN.pdf/ffbb9c08-7100-2774-f099-d3ab657d14eb

[5] https://www.ons.gov.uk/economy/inflationandpriceindices

[6] https://ec.europa.eu/eurostat/statistics-explained/index.php?title=Inflation_in_the_euro_area

[7] https://www.marketwatch.com/investing/index/ukx?mod=mw_quote_switch&countrycode=uk

[8] LSEG Datastream/Evelyn Partners

[9] https://www.marketwatch.com/investing/index/899800?mod=mw_quote_switch&countrycode=xx

[10] https://www.imf.org/en/Blogs/Articles/2023/02/20/asias-easing-economic-headwinds-make-way-for-stronger-recovery

[11] https://www.marketwatch.com/investing/index/935600?mod=mw_quote_switch&countrycode=xx

[12] https://www.marketwatch.com/investing/index/nik?countrycode=jp&mod=home-page

[13] https://www.reuters.com/markets/asia/japan-downgrades-q2-gdp-growth-soft-capital-spending-2023-09-08/

[14] https://www.marketwatch.com/investing/bond/tmubmusd10y?countrycode=bx

[15] https://www.cnbc.com/2023/09/13/cpi-inflation-report-august-20

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