market #intelliGENce Sep 23

A detailed analysis of what's been moving markets over the last month.

In a nutshell

• Bank of England raises rates to 15-year high

• US stripped of its top tier credit rating

• Chinese economic data continues to cause concern

• Global markets fall on mixed economic data

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What's moving markets

August headlines were dominated by inflation and interest rate expectations, and the renewed stress in the Chinese property sector. Global equities sold off during August to varying degrees and there was no ballast from fixed income as both Gilts and US Treasury yields rose throughout the month.

The UK’s year on year inflation rate fell to 6.8% in July (from 7.9% in June). While falling energy and food price inflation brought the headline rate down, the cost of services increased by 0.2% to 7.4%, matching highs touched in May. The Bank of England raised interest rates by 0.25% to a new 15-year high of 5.25% in August and warned the fight against inflation may mean tighter borrowing conditions for a prolonged period.

Despite the tight financial conditions, the UK economy delivered 0.2% growth in the second quarter - the biggest increase since the start of 2022. Wage growth also accelerated by 7.8% in the same period, but the ONS reported a rise in the unemployment rate to 4.2%, showing a loosening in the labour market.

In the USA, the annual inflation rate ticked up to 3.2% in July from 3% in June. The reading marked a break after 12 consecutive months of declines, mainly due to base effects. A year earlier, inflation had started to fall from its peak of 9.1%.

US job openings fell in July (by more than expected) to a more than two-year low, offering fresh evidence that labour demand is cooling. The number of available positions decreased to 8.83 million from 9.17 million in June, marking the sixth decline in the last seven months. Despite the fall, there’s still 1.51 job openings for every unemployed person! The question now is – “will the US achieve its ‘Goldilocks’ soft landing?”.

There was some negative sentiment in August with the surprise downgrade of US Government debt by Fitch, the ratings agency. Fitch cited ‘an expected fiscal deterioration over the next three years due to tax cuts, new spending initiatives, economic shocks and political gridlock’.

Alongside the Eurozone’s stubbornly high inflation rate of 5.3% in August, we’re seeing a deterioration in the composite Purchasing Managers’ Index (PMI). It slipped to a 33-month low of 47.0, with the services PMI component falling to 48.3. The deteriorating Eurozone data will give the ECB food for thought as it contemplates additional rate hikes in September.

Chinese economic data continues to be cause for concern. In August we saw China’s consumer and producer prices fall together for the first time since 2020, with retail sales and business confidence remaining weak. The consumer price index registered its first decline in more than two years, falling 0.3% in July from a year earlier while producer prices fell for a 10th consecutive month, contracting 4.4%. The People’s Bank of China (PBOC) attempts to address these issues didn’t spur the kind of recovery many hoped for.

Japan has been one of the best performing equity markets this year outside the US, as corporate governance changes filter through to positive market returns. Japan’s economy also seems to be faring well, expanding at a much faster rate than expected. Their GDP grew at an annualised pace of 6% in the second quarter, far exceeding economists’ forecasts of 2.9%.

Inflation watch continues, and is likely to for some time. Any variation – up or down – from predictions, pushes interest rate expectations onto a new path, and in turn, markets. It feels like we’re almost at a turning point, and it seems a case of when, not if, central banks will pause or halt rate rises altogether.

Asset Class Implications

At this point in the economic cycle there seems to be an ingrained correlation between stronger economic data, yields on government debt and equity markets.

In August we saw yields on government bonds rise as stronger economic data reports came through. However, this drives expectations for further interest rate rises - bad news for equity valuations. So no surprises in seeing broad declines in global stock markets last month.

Gilt yields didn’t move much over the month - around 5bps - but expectations for higher rates continue. The FTSE All-Share decreased by 2.5%, driven by sticky inflation data and higher than expected wage growth figures. Valuations remain compelling in the UK, but investors are asking – “is the UK market cheap for a reason?”

The story is the same in the US. Rising Treasury yields drove the equity market lower given the strength in the economic data, and although the FTSE USA declined by 0.18%, the AI (artificial intelligence) fuelled rally continued in August. The current stock market darling Nvidia (currently trading on an eye watering P/E ratio of 111 x) delivered blockbuster quarterly earnings. But is this sustainable?

The banking sector led European stock markets declines in August as Italy’s government announced a tax on banks’ ‘excess profits’. There was one standout exception. UBS’s announced the largest ever quarterly profit by any bank following its emergency takeover of Credit Suisse. Though looking deeper, the reported $29 billion gain was a result of an accounting difference between the $3.8 billion UBS paid for Credit Suisse and the value of the acquired banks’ balance sheet.

Given China’s dominance in the FTSE Emerging and FTSE Asia Pacific ex Japan, both indices declined throughout August again. Negative sentiment in China continues to filter through to stock market returns. This is despite the best efforts of its government to turn around demand by cutting interest rates and stamp duty on share trading.

Going into the second half of the year with caution seems prudent right now. Government bond yields seem to be nearing a peak, equity risk premium is diminishing and markets are likely to remain volatile for the foreseeable future.

Inflation watch continues. It's the key data point every month, and the one with direct impact on people's lives. Until inflation is under control and a lot closer to target, this theme is set to stay. Any variation versus expectations, up or down, pushes interest rates and markets onto a new path.

May's UK headline CPI (released in June) was 8.7%, the same as the previous month and higher than the anticipated 8.4%. This helped the Bank of England (BoE) to decide on a 0.50% rise over 0.25%. Higher interest rates mean higher mortgage rates, higher loan costs, and in the end, less money for people to spend on goods and services. Not a great situation, but it should help bring down what is known as Core CPI, the part of the inflation number that is demand-led so can be controlled. However, the problem is that Core CPI is still going up, having risen from 6.8% to 7.1% - a sign that the BoE don't really have the situation under control.

Mortgage holders are feeling the brunt of the interest rate pain. The somewhat unexpected 0.50% rate hike has pushed both 2 year and 5 year average deals over 6%. This is starting to have an impact on house prices, reducing the number of new buyers in the market and the affordability for existing homeowners as they’re forced to refinance onto much higher rates.

Across the pond, the Federal Reserve are in a much more comfortable position. So much so, they felt it was time to take a pause in their rate hiking cycle. Granted, they went at a quicker pace than the BoE, but with both Headline and Core CPI falling in the US, they have time to consider their next move. An enviable position.

China is on a different monetary policy path. Unlike most developed nations who are concerned about rate rises, a number of lending rates there were cut through June. Their focus is on getting economic growth back on track following harsh lockdown restrictions. Q2 growth numbers will be out shortly and examined closely.

US equity market returns remain narrow, with big tech stocks leading the charge. This was emphasised further in June by Apple reaching a market capitalisation of $3trn. They are the first company in the world to reach this milestone, so a pretty historic moment. To put it into perspective, Apple is now bigger than the entirety of the FTSE100 - that’s BP, Shell, HSBC, and 97 more massive companies combined!

Asset class implications

UK short term bond yields rose following the larger than expected BoE rate rise. The yield on a 2 year Gilt shot up by about a percent over the month, finishing around 5.25%. Interestingly, longer dated bonds didn’t move very much at all (the Gilts All Stock index return is roughly flat for June). This meant a further inversion in the yield curve (shorter bonds yielding higher than longer) which puts more weight behind the looming recession argument.

The bond market might think we are heading for recession, but it seems no one has told the equity market. All the main indices were up for the month, led by the US with the FTSE USA returning nearly 4%. Our view is that the US market is overvalued, albeit a market can be overvalued and still do very well. The US is proving that, with a double digit return year to date.

Emerging Markets also posted a positive return in June. Poor Chinese equity performance has weighed heavily on the FTSE Emerging and FTSE Asia Pacific ex Japan markets of late. June will be a welcome relief, though at the halfway stage, both are still in negative territory for 2023.

We continue to see value in fixed interest and pockets of risk in equity markets. These themes are likely to continue as we approach peak interest rates and push closer towards a recession. However, as 2023 has proven so far, that doesn’t mean risky assets can’t do well.

Source: FE Analytics, GBP total return (%) to last month end