Interest rates have been on an upwards trajectory in recent weeks as future central bank policy has remained shrouded in uncertainty. However, last week saw a fairly sharp rally in global equity markets with the latest economic data and Federal Reserve Bank commentary triggering a decline in rates, resulting in a rally in risk assets.
All evidence would suggest that the Fed will leave interest rates unchanged for the foreseeable future. It is also likely that where they are now represents the peak in this current tightening cycle. The tone of a recent Fed meeting suggested that future decisions about rate changes would be carefully weighed. What this essentially means is that the Fed is now very much aligned with the European Central Bank and the Bank of England in this regard: further changes will be data-dependant.
A closer look at recent US economic data provides some insights into why the Fed has decided to leave rates unchanged. While US employment rates have remained strong, this is expected to change in 2024: the economy is slowing, and an increase in unemployment rates will logically follow. The surge in US consumer spending is currently fuelling strong economic growth – indeed, this resilience has confounded many economists. But one should be cautious. The people who managed to save money during the pandemic are depleting those savings and are finding themselves up against increasingly high borrowing and household spending costs.
There is no playbook for a post-pandemic recovery, and it is difficult to predict how things will unfold. The spectre of recession has been plaguing economists for over a year. But there is still no recession in sight and consumer spending remains robust. But consumer spending is a lagging indicator: things could easily cool over the coming months. What happens at Christmas and New Year – periods when consumer spending is traditionally high – will give us some indication of how things might play out next year.
The markets hate uncertainty and thrive on clarity. The last couple of weeks have confirmed that the bond buyers are back in the market, lured by the total returns that are now on offer. The measure that has attracted the most interest has been the US Treasury market: the yield curve differential between the two-year and ten-year bond yields has moved from about 100 bps of inversion in July to around 29 bps, which is where it currently stands. For investors, this means that they do not need to give up nearly as much yield to extend duration. Across the maturities, risk spectrums and issuer types, investors have the opportunity to buy bonds at yields not seen in over 15 years.
To add to their appeal, yields have a habit of falling (and prices have a habit of rising) once the Fed stops raising interest rates. But much will hinge on the Fed's direction of travel going forward. And that will depend on what happens with inflation, which in turn is contingent on how things evolve in the Middle East and Ukraine, and what happens to crude oil prices.
Like the US bond market, there is also evidence to suggest that US stocks could constitute an interesting entry point for investors (if you disregard the magnificent seven). Just under three quarters of the S&P 500 stocks have been in correction territory (meaning that they are down by 10% or more from their 52-week highs), while valuations are roughly back in line with their long-term averages.
Some seasonal momentum could also prove favourable for the US stock market. Going back as far as 1950, November and December are usually two of the best months for returns. Indeed, the S&P 500 Index has already rallied by just over 4% since the end of last month.
As far as company fundamentals are concerned, US businesses appear to be experiencing a transitional quarter. That said, the S&P 500 is reflecting positive earnings surprises – many companies are above their 10-year averages, and growth going forward is predicted to be healthy. This is particularly true for a number of tech companies, whose fortunes continue to be buoyed by the promises of artificial intelligence finally bearing fruit.
Of course, it is highly unlikely to be smooth sailing from now on. But the markets have gone through a corrective phase over the summer months, so with the economic data suggesting ongoing growth, and given that the Fed is likely to remain subdued and leave interest rates unchanged, many commentators are confident that US stocks will find some further momentum in the final months of this year.
Europe also looks cheap – both in absolute and relative terms. However, it is a stock picker's market. So areas such as consumer-led sectors might be impacted by higher levels of earning and valuation risk compared with recent history. Asian markets continue to trade below their long-term historic averages and are now significantly discounted to the developed markets.
In the UK, inflation is likely to remain a key source of risk. As hostilities continue in Europe and the Middle East, oil prices will remain high. But we remain cautiously optimistic on the medium- and long-term outlook for UK equities.
Overall, we expect to see some solid returns from both stocks and bonds over the next 12 months. A multi-asset approach will help to offset the uncertainty surrounding the various economic scenarios with which the markets and its investors will have to contend.
We live in troubled times. But when things are this complicated, and when there are so many moving parts in play, the ability to remain calm and demonstrate a measure of serenity when investing will help ensure a better long-term outcome.
