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As May passes the usual “sell in May” headlines are notable by their absence. The market trends are clearly up and based on historic patterns, a new Bull Market has started. However, the fundamental supports are not, as yet, fully in place. Interest rates have yet to be cut in the lead market (the USA), why have they not?
Inflation is only just falling to target and at a “glacial pace”. Inflation remains the key market driver for now. It is also a major factor in the US Presidential Election.
Joe Biden is constantly reminded that for many ordinary Americans the cost of living is an issue, famously the price of a Burger King/Big Mac has doubled over the 5 years, this is indicative of the economic pain that is easy to exploit by the opposition.
Furthermore, US Mortgage rates are also, painfully, still over 7%. The US Federal Reserve Bank has a shrinking window to cut rates before the Election. “Magically” recent inflation numbers, that had been running too hot are now just right and a rate cut may be possible? Bond markets have flip-flopped this year from three US interest rate cuts, to none and are now moving back to cuts again.
In the UK, the Governor of the Bank of England looked to be about to piggy-back on the European Central Bank and cut the Base Rate. This was always going to be a risky move, as whilst UK inflation was back at target (2.3%) underlying components such as Services inflation continue to run well above target.
For once he got lucky, Rishi Sunak’s surprise decision to call a July General Election gave him the excuse he needed not to make the difficult decision.
Crucially, Gilts didn’t move on the news. The UK remains very cheap, especially Mid and Small Caps, the result of the Election (as long as it isn’t a hung Parliament) will bring the UK back into the global investment consciousness.
UK Inflation and Interest Rates
Source:Tradingeconomics.com
This chart from 2014 shows the relationship between two of the three key markets drivers for the UK.
Clearly, the invasion of the Ukraine caused a huge spike in inflation as gas and electricity prices shot up and food prices followed shortly after. After a period where the Bank of England was widely criticised for being too late, interest rates had to rise and M2, the money supply, severely curtailed.
Economic theory says that, after a time lag, putting up interest rates and reducing the Money Supply will bring inflation down and it has.
As this chart shows though interest rates are being held at high levels but are just at the point in time where they should start to come down. Unemployment in the UK is starting to tick up and wage growth has slowed significantly.
Given a helpful international environment it shouldn’t be long before UK rates come down.
US Presidential Election
One of the key market influencing events in 2024 is the US Presidential Election. May, with Trump’s trial, saw the election ramping up in earnest.
July 15th is the Republican National Congress where their candidates for President and Vice President will be appointed.
The Democrat event is on the 19th August. The national opinion polls have Trump and Biden virtually neck and neck, with the gap as shown on the left table narrowing. There is a third candidate, Robert Kennedy Jr, who is currently taking a not insignificant 10% of the polls. Usually, the Independent candidates rarely make it to the actual vote day, however, he does have financial backers with deep pockets.
His impact could be crucial. Whilst the national polls are close, Trump is ahead (so far) in the six key swing states.
For the markets the ideal would be a clear victor (so not a repeat of the GW Bush recounts) with Congress going to the losers Party. So far market impact has been minimal though could the Fed yet do Biden a favour?
UK and European Small Capitalisation Equities
It cannot be a true Bull market without the Mid and Small sized companies driving it.
Much has been written of the impact of the 7 large Technology companies that have driven the initial stages of this rally.
Helped by the “goldrush” into Artificial Intelligence, profits and thus share prices have risen nicely. But this has left “the rest” behind and at record low valuations, which is historically highly unusual in an earnings recession. In the US and Europe non-Tech companies have seen profits fall by 15% just as they would in a recession.
Normally, this pushes valuations to high levels, this time though, they are cheap. The STOXX index includes both UK and European Mid/Small Capitalisation equities and as this first chart shows the valuation relative to large companies is at a post Great Financial Crisis low.
There are reasons for this, small cap companies can be difficult to buy and investors believe that they are overly sensitive to interest rates. This is somewhat true but with the outlook for interest rates and the economy improving so does the investment opportunity. As the second chart shows the performance of small caps tends to follow the underlying economy.
Here if we use the forward looking Purchasing Manager Survey (PMI) we can see a pick-up in outlook, this, historically, is followed by small cap outperformance.
This is not unique to the UK and Europe, in the US the small cap indices from the Russell 2000 to even the technology heavy Nasdaq Next Generation 100 are displaying similar performance and valuation patterns. This is very unusual and based in history shouldn’t last for long.
Markets
- The Goldilocks i.e. Inflation keeps falling and yet recession is avoided
- Economics is right i.e. the US will join the UK and Europe in recession during 2024
- The Fed has done too much i.e. a major financial crisis arrives as banks see a wave of defaults
- Inflation returns i.e. inflation isn’t beaten and comes back with a vengeance
If we return to our 4 broad scenarios number 1. remains the dominant theme and was under threat from 4. in April, in May, however, inflation worries eased and 2. came back into play.
A whole raft of data suggested that the US economy is finally starting to slow, GDP growth forecasts have been slashed.
Hence, a US interest rate cut is now back on the investment agenda.
This constant switching around of interest rate expectations means that traders default to buying the big technology companies, the rest of the markets keep attempting to rally on positive interest rate news but then get knocked back.
They are waiting for the “fog to clear”. As we write the global interest rate cutting cycle has just started.
Traditionally, Canada is the first and they have just cut, they rarely act without first consulting the Fed. The ECB has also moved as well, if it were not for the General Election markets have no doubt the Bank of England would have cut as well. The Fed wants to cut, Biden is pressurising them to do so, they just need the data to be weak enough to justify a move. There are now consistent signs that the economic data is finally deteriorating, it does though remain very finely balanced and the Inflation numbers do need to stay low.
We can’t escape the fact that global markets are unusually cheap at this point of the cycle, inflation is falling and getting close to target. Now, crucially, interest rates are finally starting fall. All very positive for the global market outlook.
June 2024
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This information is not intended to be personal financial advice and is for general information only. Past performance is not a reliable indicator of future results.
