Monday digest

Posted 31 July 2023

Overview: Rate rises bounce off ‘Teflon’ markets

Equity markets remained buoyant last week after as-expected interest rate rises in Europe and the US, with some labelling them ‘Teflon markets’ because nothing sticks to them. We would rather think of it as a sort of running machine; no matter how steep the incline of the treadmill, markets seem able to keep running upwards. Opinions are divided as to whether another increase will take place at the September meetings.

Talking of monetary policy changes, one central bank seems to be starting a tightening process. Last Friday, the Bank of Japan indicated it would allow greater latitude in its “yield-curve-control” policy. The 10-year bond yield shot up by 0.07%, which for hardy UK Gilt investors is a normal day. Japanese monetary policy will remain supportive. However, there are said to be quite a few hedge funds that have been buying local currency emerging market bonds and borrowing in (unhedged) Japanese yen. This ‘carry’ trade is fine as long as the JPY doesn’t strengthen sharply. Of course, should many of them exit their trades, it could easily strengthen a lot.

Lastly, at the start of last week, Chinese markets rose sharply and maintained their early gains after China’s ‘Politburo’ indicated policy action without offering much detail. Most analysts do not expect the sorts of huge support measures seen at crisis points but, equally, the risks of instability have also diminished. It would be unusual for Chinese markets to head gently higher (rather than shooting upwards or plummeting downwards) but the circumstances suggest it may happen this time. 

Peak rates: are we there yet?
It was a historic week for central banks. The US Federal Reserve (Fed) raised its benchmark interest rate to a range of 5.25-5.5%, the highest level in 22 years. The European Central Bank (ECB) followed suit last Thursday, also raising by 0.25% (it’s ninth consecutive hike) and matching its highest-ever rate of 3.75%. Both central banks left the door open for further action too. Despite the slowing pace of goods prices, monetary policymakers on both sides of the Atlantic are still wary of underlying inflation pressures, and were coy about whether subsequent meetings would see further hikes.  

ECB President Christine Lagarde was downbeat in her press conference, talking of a “deteriorated” economic outlook and being open-minded on another potential hike in September. The Fed’s hike was also expected, but there were rumours that the Federal Open Markets Committee (FOMC) might already be finished in its cycle. The Fed paused at its last meeting and economic data has weakened since then, leading to minority suggestions of no change. Apart from indicating the rate rise, July’s FOMC statement was almost completely unchanged from June’s, albeit the descriptor of growth became “moderate”, replacing “modest”. Fed-watchers love to dissect every word from Chair Jay Powell or his team, but trying to differentiate between moderate and modest is surely over-analysis. The statement still indicates the bias towards additional firming of policy.  

On Thursday it’s the turn of the Bank of England’s Monetary Policy Committee (MPC). Europe faces already tight monetary conditions and a slowing economy, and the same is true for the UK. The complicating factor for us is the severe structural supply-side shortages associated with Brexit and public infrastructure, which shifts the balance from real growth towards (measured) inflation. UK rates are still expected to rise by another 0.25% this week, then again by 0.25% on 21 September, and a final 0.25% around the year-end, before heading lower next year. 

But the central bank meeting that matters most could well be the central bankers’ symposium at Jackson Hole, Wyoming, next month. Like the previous meeting at Sintra, Portugal, these are important because they help central banks to understand how their own actions impact each other, and they have often set the tone for policy decisions some months ahead. 

Q2 earnings season update
Half of US companies have now reported their earnings, and analyst projections have been cut somewhat in the last few weeks. Current expectations are for a 12% fall in Q2 earnings per share for S&P 500 companies compared to a year ago, with European companies seeing a 17% fall (according to JP Morgan). Full-year growth rates are also negative across both regions. But this negativity can hardly been seen in capital markets. Stock markets in the US and Europe are significantly up this year. Optimists say this is a sign of resilient markets; pessimists say it means valuations are too high and ripe for a pullback.  

There is a worry that valuations cannot go much higher, given the strength of the US stock market this year and the weakness in earnings. But the performance of US equities is misleading. The S&P has gained nearly 20% in dollar terms year-to-date, but almost all of this has been driven by booming share prices for just eight companies. These are mostly the technology mega caps, who have been aided by the incredible boom in artificial intelligence (AI)-related investment.  

One can certainly argue that those stocks – and US tech more widely – is overvalued. But the rest look in a much better position. Non-tech companies have lower earnings expectations and relatively muted valuations. The low bars for both mean that positive surprises and momentum are likely. If so, the stock market rally could become more broad-based – a welcome improvement.