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For the global bond and equity markets it is still all about the “Fed”. The US Federal Reserve Bank is raising interest rates at a record pace whilst undertaking Quantitative tightening (instead of printing cash they are shredding it).
The Bank of England and the European Central Bank are merely passengers on this journey to bring US and thus global inflation down. As we said many times before the Fed is being so aggressive because they have only a limited political window to achieve this. They want a return to “normal” interest rates and inflation i.e. 2% to 3% but run the risk of doing too much too soon.
Economies are like super tankers they are not very manoeuvrable, it generally takes 6 months for an interest rate increase to be seen in an economy, the Fed is effectively “flying blind” or at least through a very cloudy sky. However, there are signs that we are getting closer to the end of the cycle of interest rate increases. The “Fed” keeps talking up its’ likely peak rate, just recently it has raised this to 5.5% from 4.75%, but as markets know, it always does this and US Treasury Bonds are not buying it.
They continue to indicate 4.75% as a peak with official rates currently at 4.0%. Why? There are a few signs appearing that US inflation has peaked. In the UK the political soap opera has come to a conclusion, at least for now. Rishi Sunak has replaced Liz Truss and the Gilt market is happy.
The UK Public Finances
There are two debts in any government, the first is long term borrowing, akin to a mortgage, which is the Gilt market. As a percentage of GDP, UK long term borrowings are low by international standards (second lowest in G7, and below US and France).
Also the UK has on average 14years before they have to be paid (refinanced) one of the longest dated. Conventional Gilts have a fixed rate of interest and most were issued during the last 10 years when rates were low. However, a quarter are Index-Linked which means the interest payments go up with inflation. The second debt is the Budget Deficit, or excess spending over tax receipts (more like an overdraft).
Clearly, the bigger this is, more Gilts and short term Treasury Bills need to be sold to banks, insurance and pension funds in order to pay for spending.
The OBR is naturally pessimistic and the media often only reports the worst of the several presented scenarios. Clearly, something in the numbers has “spooked” both the Bank of England and the Treasury, we suspect that the Pension Fund LDI issue might be far greater than it might currently appear?
The alleged £40bn fiscal “Black Hole” if filled, would not wipe out the Budget Deficit, it is about getting the UK back on a path that shows a steady reduction in the deficit. The Truss solution to grow the GDP number faster than the debt has been discarded. It would now seem, regardless of the political consequences, Sunak is keen only to please the Gilt market and leave pleasing voters until later.
One of the issues is that the household energy subsidy is currently open ended and the total cost is dependent on market gas prices. Here there is good news, with European gas storage full and the weather mild, the key Dutch TTF price has fallen from a peak of e338 MWh to a current e104 MWh.
Peak US Inflation… are we there yet?
For markets it’s all about the Fed and for the Fed it’s all about inflation. Until the headline inflation (CPI) number starts coming down US interest rates will remain on an upward trend.
Given that everyone else’s interest rates are set relative to the US then the Bank of England and the European Central Bank are just passengers on the Fed’s journey. They have gone “hard and fast” taking US official rates from 0.5% to 4.0% in under a year, this is unheard of in economics.
What the consequences of this will be no-one knows, have they gone too far and will it tip the US into a deep recession? There is no evidence so far that they have, but as we say above it takes 6 months for a rate increase to be seen in the real economy. However, if we look “underneath the bonnet” at the fundamental drivers of US inflation (CPI) can we see some positive signs?
A third of the CPI is made up of “Shelter” i.e. rent and 8% is Transportation (cars). Gasoline prices, rents and used car prices have been the biggest drivers of the high US inflation numbers.
The fall in crude oil is helping with gas(petrol) prices and as both of these charts show markets are seeing price pressures abating in both rents and used cars. Together with gasoline these represent over half of the US CPI index. If we then look at the broad economic picture then there are further reasons to be optimistic as well.
Markets
Markets aren’t predictable, but they do follow regular patterns. We are in month 11 of what is normally a 12 to 18 month period of difficulty.
Furthermore, traditionally, there is an economic boom just ahead of a Presidential election. The Presidential candidates will be chosen in February/March 2024, so the boom needs to start by Thanksgiving/Christmas 2023. The Fed therefore has a window to get inflation under control and this will close early next year.
With US interest rates at 4% they are getting very close to where market interest rates are, this is suggestive that whilst they may not have peaked just yet, we are not far away.
All of this is pointing towards being at, or close to, the zone where the risk and reward equation tilts heavily towards future rewards. Bond yields and equity dividend yields are back at historically attractive levels. But there does remain the fear that has the Fed done too much, too fast and the US economy and thus the global economy will collapse next year? It is all about Fear and Greed.
However, if the uptrend in inflation is slowing and about to reverse and if interest rate increases are also about to stop, then investment market conditions improve dramatically almost regardless of what happens to the economy.
A recession, perversely, from a mercenary market perspective could actually be a good thing for bond and equity investors as interest rates and inflation would then start falling.
In November, we have the US mid-term elections, which could result in extra political pressure on the Fed; also Rishi Sunak’s difficult Budget.
On the positives there is no sign of a deadly Covid-19 returning (ex-China) and we are entering the period of strong market seasonality. Much will depend on the Fed and whether the economic stats allow them to ease the pressure on markets and economies.
November 2022
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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.
