MGP monthly report: “wait and see” after September's market declines
Summer has come to an end and the “heavenly” markets of those months have given way to a more turbulent landscape that is typical of this time of year. The adjustment in interest rate expectations led to a poor month of September for both bond and equity yields.
The famous mantra “higher for longer” has begun to gain traction in the last month following Jerome Powell's statements at the last monetary policy meeting of the US Federal Reserve (Fed) and the decision of the European Central Bank (ECB) to raise official interest rates, for the tenth consecutive time, by 25 basis points to 4%, which is the highest level in the history of the Eurozone.
In September alone, 10-year interest rates in the United States were up by 45 basis points, 37 in Germany, 45 in Spain and 66 in Italy. This sharp rebound in the bond yields being demanded is likely to lead to an unusual situation for fixed income investors: for the third consecutive year, we may see negative returns on the major government fixed income indices.
In equities, the main stock markets closed September with significant declines led by the technology sector and high-growth companies, as well as by small and mid-caps. However, for the year as a whole, equities have held up better than expected and are only 5% below the highs reached in June.
This leads us to conclude that equities are presently the asset that has least discounted an adjustment of expectations and therefore offer the least attractive price/performance ratio. Taking few risks and being uncreative are, without a doubt, two good recommendations for the rest of the year.
Growth: resisting or recovering?
Although visibility as to the timing of the current economic cycle is very low, the fact is that short-term growth forecasts continue to improve. The macroeconomic surprise index, which rises when macro data are better than expected and falls when they are not, has been rebounding in recent weeks, especially in Europe. This is despite the fact that growth expectations remain very low both in absolute terms and relative to the United States.
This is likely the improvement that is causing central bankers the greatest anxiety, since it would put a brake on the (so far downward) trend in inflation. Although last month we described inflation as “the great forgotten one,” this month it is back in the spotlight.
The market keeps swinging like a pendulum, and if something was unimportant a month or two ago, a 10% rise in oil prices is enough to push it back into the headlines. From our point of view, inflation has always been “the bad guy” and expectations are still far from current levels (5.3% in Europe and 3.2% in the United States), so another inflation scare cannot be ruled out.
It is not the “higher” but the “longer”
Against this backdrop of resilient growth and inflation that does not seem to be entirely forgotten, interest rates have had to be tightened. Market discounted benchmark rates for December next year have risen sharply over the past month while those expected for December 2023 have remained stable.
Therefore, the expectation that interest rate cuts will not come sooner than expected has caused the most damage to bond price performance recently, and not an expectation of higher rates. Inflation expectations discounted by the futures market (five-year rates five years from now) have also been trended upwards, but they stand at levels that match their historical average.
These movements are driving real interest rates (nominal rates minus inflation) to positive levels for the first time in Europe for a long time and to levels of 2.5% in the United States, with both levels now viewed as high enough to cause damage to growth. Even so, our view is that the conditions are not ripe for us to expect a rate cut soon unless some financial accident takes place.
Liquidity: the hidden enemy
For some time we have been developing the idea that, apart from occasional movements caused by published macro figures, the direction of the combined monetary base of the main central banks (liquidity) is what drives the future of the markets. And according to only mid-September figures, liquidity levels fell sharply during the summer months.
The main underpinning of many asset valuations for several years has been quickly disappearing and it is difficult to find a replacement that can play the same role. We can focus our attention on what central banks will do with interest rates, but what is really important is to know how they will manage the reduction of their balance sheet. And in this regard, it would not appear that anything is going to change.
Both the Fed and the ECB are ready to reduce their bond portfolios by reducing liquidity in the financial system so that money flowing into the real economy (known as M2) will also do so and thus cool price levels. In fact, for a couple of months now, we have been seeing negative year-on-year M2 growth rates in Europe and the United States, although it is true that we were starting out from very high levels.
Undoubtedly, this lower monetary mass will put a brake on consumption and we are already seeing an upturn in the use of credit cards by households to make purchases. If we look at alternative sources of liquidity to that of central banks, we can say that they are gone and will not be back anytime soon, since China (the main holder of US Treasuries) reached peak bond holdings in 2014 and continues to reduce its bond portfolio, and large commercial banks seem for now unwilling to take on duration risk to avoid the imbalances that led to the failure of US regional banks.
Conclusions of the Global Asset Allocation Committee
Three scenarios were sketched out for market movements in the coming months:
- Baseline: Inflation stays above the central banks' 2% target for a longer period of time. In this scenario, growth would continue to be resilient (especially in the United States) even if consumer spending continues to rely on the use of credit. In Europe, being a more global economy, growth will suffer more due to the intrinsic problems of the Eurozone and dependence on China. From a market perspective, valuations would not have much room for improvement unless corporate earnings beat expectations and fixed income would continue to offer a better risk-adjusted return.
- Ideal: central banks manage to bring inflation below or very close to target with no palpable damage to growth. In this scenario, returns would be positive across most assets and styles.
- Realistic: if history is any guide, the fastest and most intense interest rate hike in 40 years would trigger a severe recession. Central banks have a long history of mistakes arising from a failure to anticipate the risks of their monetary policy.
What is common to all three scenarios is the rapid contraction of liquidity, which makes the “ideal” scenario very unlikely and would lend greater weight to the “realistic" scenario, even if there is no room to cut rates. “Wait and see” seems to be the most sensible approach at this time.