Equities rally as bets on interest rates shift
October may have been a month to forget, but November was certainly one to remember.
In fact, 2022 was a whole year to forget for investors. This year, on the other hand, has very much been characterised by returns on risk assets – US technology in particular. The strong November rally in equities that we have just enjoyed has been supported by several encouraging economic updates: inflation has continued to fall across the developed world and the US Federal Reserve Bank has suggested that it might not need to tighten policy any further, attracting a large number of potential buyers.
That does not mean that it has completely ruled out further rate hikes in the future. Indeed, two Fed officials made the case for continuing to hold interest rates steady, while another two were even more hawkish. The sceptics were quick to express their doubts that the battle against inflation had been won, with some even believing that a further hike was required.
Nevertheless, November saw the S&P 500 Index rally by 9% – the biggest monthly gain since July 2022, and the seventh-best monthly return in 30 years. Even more encouragingly, the index is now up nearly 12% since its 27 October low, and just 5% down from its record high.
This extraordinary turnaround has erased the weakness that beset the markets from August through to October (concerns over further rate hikes prompted a 10% correction). While last month's rally has propelled the S&P 500 to a new high for the year, it's worth remembering that double-digit pullbacks can create excellent buying opportunities for quality assets at low prices.
Fears remain over overstretched valuations
It goes without saying that some bear market doomsters will be fearful that valuations may now be looking a little stretched – particularly when they focus on the sharp climb in stock prices for some tech names. There are also concerns over a decline in consumer spending in the US. This, combined with falling inflation and a cooling jobs market could add further bearish fuel to the fire and lead to speculation over a US economic slowdown.
Recent US economic data has suggested quite the opposite – it grew by more than initially forecast over the third quarter of the year. And consumer spending remained healthy from July through to September, albeit slightly lower than forecast.
The S&P 500 Index may have enjoyed a phenomenal recovery, but it's worth noting that two years ago on 30 November 2021, it closed at 4,567.00. Last week, it closed at a remarkably similar 4,567.80, demonstrating how volatile the market has been post-pandemic. Wall Street's success this year has been mainly driven by the magnificent seven. Their consolidated performance for 2023 is just over 100%, while the overall performance of the S&P 500 is up just shy of 20%. What's more, US growth stocks have significantly outperformed their US value counterparts.
Rising interest rates mean several market winners
Market leadership has changed with those cyclical sectors, as well as those areas most sensitive to a cut in interest rates rallying from their recent lows. Small-cap stocks have also gained some momentum, registering healthy double-digit gains since late October. Sectors such as financial services, consumer discretionary, technology and real estate have all shone, their fortunes catalysed by the hope that interest rates have now peaked.
The equity markets were not alone in performing well last month: investment-grade bonds (as measured by the Bloomberg Aggregate Bond Index) registered their best monthly returns in 30 years. But the fact still remains that all of this good news has come on the back of an extremely painful September. Should interest rates start to ease back and if inflation continues to fall over the coming months, then bond returns should also improve.
The UK economy should grow this year and next year, according to the latest figures from the OECD. House prices have risen for the third month in a row, catalysed by hopes that both interest rates and mortgage rates have peaked. Nevertheless, the FTSE 100 Index is only marginally up for the year, while the mid- and small-cap indices are in negative territory. A strong pound has also been a headwind for larger cap stocks: sterling strength reduces their profitability when it is translated back into the UK's currency.
Phasing out dependency on fossil fuels means stepping up commodity mining
Elsewhere, COP28 is now underway in the United Arab Emirates. High on the agenda is the need to transfer more money to emerging nations so that they can invest in clean energy. Commentators will be paying close attention to the language used about phasing out dependency on fossil fuels and any pledges made. A key consideration will always be the speed of the transition: so many of the smart commodities required for clean energy products will need to be mined. And there are still questions over whether or not mining potential is sufficient to meet those needs.
We think that the rest of this year will be positive for equities and bonds, but we foresee challenges next year. Changing expectations regarding Fed policy and potential economic growth scares will take their toll, keeping the market volatile. Geopolitical uncertainties will persist, sparking periodic pullbacks; but these should be seen as buying opportunities.
Historically, each time the market has returned to its previous peak, stocks have typically gone on to deliver double-digit returns over the following year. The cycle we have just entered will be different to that of the last decade. Higher interest rates and inflation will be the new norm and are likely to be closer to those long-term averages which the markets will be able to absorb without too much difficulty.
Farewell Charlie Munger
Finally, it would be remiss of me not to mention the passing of Charlie Munger, vice-chairman of Berkshire Hathaway. Warren Buffett's closest partner and right-hand man died last week, a month before his 100th birthday. Munger was quick-witted and straight-talking and was a pioneer in combining investment strategy and psychology. In addition to being Berkshire’s vice chair, Munger was a real estate attorney, chairman and publisher of the Daily Journal Corp, a member of the Costco board, a philanthropist, and an architect.
In early 2023, his fortune was an estimated US$2.3 billion – significantly less than Warren Buffett's estimated US$100 billion. He lived fairly frugally, and even spent the best part of 70 years in the same house. He recently told CNBC that his number one tip for living a long, happy life was to “avoid crazy at all costs”.
He admitted having two relatively minor but impossible-to-give-up vices: eating peanut brittle and drinking Diet Coke. “I’m sure Diet Coke shortens my life a little, but I don’t give a damn”, he once said. That was Charlie Munger for you. RIP Mr Munger.
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