Markets were range bound over the summer period following concerns over whether interest rates were close to reaching their peak. While most asset classes delivered marginally negative returns over the quarter in sterling terms, broad market indices across the US and UK managed to provide some positive returns. However, within the US, it was mainly the largest, technology focused companies like Microsoft, Nvidia, and Tesla that drove the majority of returns while supply concerns across broad commodities provided an uplift to the FTSE 100 index.
In contrast, yields on US Treasuries rose to 4.5% for the first time since 2007 and gilts headed north after the conclusion of the BoE’s latest monetary policy committee meeting. Markets generally weakened as investors worried that the string of rate cuts predicted for 2024 were less likely to materialise.
As interest rates rose across the western world to tackle elevated levels of inflation, global growth slowed. Both manufacturing and services data weakened particularly so across China following concerns surrounding their property sector.
Central banks such as the US Federal Reserve (Fed), and the Bank of England (BoE) kept rates on hold during September. Policymakers presented their on-hold decisions with a definite hawkish tilt, with the Fed suggesting it has raised its estimate of where interest rates would peak while the BoE increased its balance sheet reduction (i.e., promising to sell more UK government bonds that it owns).
The oil price rose to over $93 dollars per barrel at its peak, having risen from the lows of around $65 dollars per barrel in the summer, rising concerns of another inflation spike. This was not demand led thanks to a vibrant economy but thanks to tighter supply as Russia and Saudi Arabia committed to extend production cuts to the end of 2023. In addition to these cuts devastating floods in Libya also had a significant impact on crude supplies.
The impact of energy prices has begun to feed into the inflation numbers and the recent trend down in inflation data is expected to pause in the coming months, as seen in the recent US CPI numbers. History shows that inflation tends to come in waves after the initial spike and it may well be the same this time. Central banks are only too aware of this, hence all the talk from the US, UK and eurozone of rates reaching a plateau.
Central bank policy in control?
While central banks in the US and the UK temporarily paused their programmes of monetary policy tightening, there has been plenty of guidance given for the future path of rates and the prospect of them staying higher for longer. Over the past 40 years, the median length of time between the last rate hike and the first cut is eight months, although the gap varies from just a single month in 1984, to 15 months after the last hike in 2006.
Over the past two years, the Fed has delivered its most aggressive interest rate hiking cycle in over 40 years. Yet despite these efforts to slow down the US economy, growth has so far proven remarkably resilient. This resilience has led to increased optimism around the prospects for a soft landing, whereby inflation moves back to target without a significant hit to activity.
However, the path of the US economy following the last hike in the cycle can vary widely. There are times where the economy cracks quickly, leading to a swift about-turn from policymakers and rapid rate cuts. At other times, economic resilience can result in an extended period where rates are kept on hold, with policymakers watching the impact of their tightening working its way only slowly into the system.
However, it is obvious that investors need to factor in a higher interest rate regime than the one that has prevailed for most of the last 20 years. However, higher for longer is not a normal situation. Since the 1970s there has only been one example of the Fed keeping rates at the peak of the cycle for an extended period. That was in 2006-2007 after the policy rate had been raised from 1% in 2003 to 5.25% in early 2006. Rates stayed at 5.25% for 15 months. Normally policy tightening is quickly reversed because normally there is more of a reaction from the economy. Given the strong labour market maybe we will have to wait a little longer this time.
For equity markets, the first six months following the conclusion of a hiking cycle has typically been positive. The full effect of rate hikes takes time to feed through to weaker earnings growth, while equity valuations are often boosted by the signs of a shift towards a less restrictive stance from policymakers. Thereafter, however, the picture becomes muddier.
The consumer impact.
It is clear that the pass through from higher interest rates has had a longer lagged effect than in previous cycles. This is thanks to mortgages being held by a lower percentage of UK households, while those with mortgages have generally fixed for at least two years, meaning a lower proportion of households have had to feel the pain of higher interest rates immediately.
In the US, housing market data has cooled once again, having stabilised in the first half of the year. While many US consumers are tied to 30-year mortgages and will therefore not yet have felt the impact of higher rates, anyone taking out a new mortgage or moving house is facing a rate of over 7.5%, up from 3% two years ago. This is having a significant impact on transactions, with existing home sales in August falling to a seven-month low. Much like the UK, a lack of inventory is helping keep a floor under house prices.
To date, consumers have been able to draw down on these excess savings over the past 12 months, which has substantially cushioned the impact from the rising cost of living. Of course, these savings will not last for ever, and a key factor in our view is that consumption will weaken over the coming months as data is showing these savings are close to being exhausted.
What next for the global economy & markets?
With the summer holidays behind us, speculation about where markets go from here is ramping up once again. Navigating has not been simple, and we do not expect our job to get any easier given the levels of uncertainty around the economic, political, and central bank landscape.
It looks more and more like we are at, or very close to, the end of interest rate hiking cycles in the US, UK, and Eurozone. Central banks across all three economies have raised rates aggressively and are seeing their policy moves bear fruit in terms of inflation rolling over. But we are yet to see the full impact of this rate hiking cycle as the lagged effect of 12-18 months of rate hikes is yet to feed through to the real economy.
From a macro perspective, the narrative of a soft landing has gained further traction as the combination of strong US growth and softer inflation has firmly erased near-term recessionary fears. However, markets now face the prospect of higher interest rates for longer. However, if we see economies rolling over, central banks may well need to change their policy outlook. This, of course, assumes that the lagged impact of the past 12-18 months of rate hikes feeds into an economic slowdown, as history and economics textbooks would suggest.
If we do manage to escape a recession and settle in a soft landing territory, that may well mean rates need to stay elevated for even longer to ensure inflation is defeated. While it may mean some short-term pain, the clearing event of an economic and earnings recession which brings about interest rate cuts could prove to be a more positive reset than a prolonged period of sluggish growth, and higher inflation.
But there is a political element to this, and avoiding recessions helps your chances of re-election. There will be a US presidential election in November 2024 and a UK general election by January 2025 at the latest. In the US, one reason why the economy has been so robust is the growth in government spending over the past 12 months, with President Biden extremely keen to push out any recession beyond 2024. The US is also on the brink of another government shutdown thanks to a failure to agree a budget beyond the end of this month.
Ultimately, it is hard not to conclude that this cycle will end with a sharp slowdown in growth and even a recession. Such a scenario would benefit assets perceived as safe havens. Both the growth backdrop and the expectations of rate resetting are undermining investment returns and investor confidence is weak. However, it is also important to balance macroeconomic fundamentals with a view of whether that news is already in the price, and it is clear we have been talking about recession for some time now. As the year closes, we will likely gain a better insight into whether markets are heading towards a soft or hard landing.