Monday digest
Posted 23 October 2023
Overview: Bond yield volatility has markets guessing
While the human suffering in the Middle East conflict worsened, capital markets have still not meaningfully acknowledged the rising geopolitical risk, beyond the slight increase in oil prices that was already under way a week ago. Nevertheless, the volatility in long bond yields continued as the global benchmark US 10-year government yield yo-yoed between 4.5% and 5.00%. The risk premium for accepting fixed yields for longer periods remains the talk of the investment community at large. Fact though is that investors now want more reward for any new investment beyond cash.
What’s been interesting in past weeks is that the biggest relative change in required risk premium (that incentive of extra expected return) has been in the assets generally described as the least risky – government bonds. The 10-year US Treasury yield traded at 4.992% last Thursday. Some of this rise is attributable to rising inflation fears although (oddly, given the oil price rises) not in the near-term – the fears seem to be more visible in five years’ time. It seems that investors hear the words ‘risk-free asset’, but perceive long-term US Treasuries bonds as one of the riskiest of defensive assets.
To sum up, one reasonable conclusion to draw from the raging debate is that this inflation-fighting tightening cycle may have indeed reached its nadir. Therefore, the emerging crunch point is whether the higher rates and yields are slowing activity just enough to declare victory over inflation (so we get away with an economic soft landing over the coming months), or whether the additional dynamics introduced by the ‘collateral damage’ of the high yield environment leads to an acceleration in the slowdown – or even possibly trigger a credit default cycle – all of which causes central bank tightening to turn into a policy error outcome that leads to a hard landing recession. We continue to watch credit spreads and stories related to default stress, which have increased but not to worrisome levels. Market liquidity remains good and intraday volatility well within the usual boundaries. This can all change quickly, but currently give little reason for concern, but equally the conditions are not tempting us to declare and position investor portfolios for one outcome or the other.
Chip cycles and tech bubbles
The microchip industry is in an odd place. On the one hand, investors have been eager to eat up anything related to the generative AI boom. This has given a huge boost to companies like high-end chipmaker Nvidia, whose share price has risen an eye-watering 192% year-to-date. On the other hand, more ‘traditional’ semiconductor manufacturers – those specialising in large-scale production of run-of-the-mill microchips – are struggling under the weight of a substantial cyclical downturn. Some analysts even think global semiconductor revenue will decline for the first time since 2019, and many chipmakers have announced plans to cut back production or capital expenditure.
Nvidia specifically has been hit by the US government’s decision to stop it selling high-end microchips to China – where 25% of its data centre chip revenues reportedly come from. Controls were introduced a year ago, but the Biden administration last week announced a tightening of restrictions to curb China’s technological advancement. Nvidia shares – previously the darling of tech investors – have fallen by 9% in the last five days. It is a reminder that, even if AI technology itself is genuinely transformative, it means little to businesses if they cannot (either through ability or government intervention) capitalise on it. One could easily argue that current chipmaker stocks are undervalued relative to AI-propelled peers, certainly if the US Federal Reserve achieves its fabled ‘soft landing’ and eases interest rates without ever triggering a damaging recession. What it suggests to us is that structural stories around AI and innovation may have their place, and will be especially visible in hindsight, but cyclical factors driven by supply and demand are at least equally important.
How far can Americans run down their savings?
One of the biggest investment topics over the last few years has been so-called ‘excess’ savings. Over the pandemic, consumers across major developed economies tucked away huge rainy-day funds, some of which were spent as the world opened up. This is usually cited as a major factor behind the extraordinarily resilient post-pandemic economic figures. Central banks have therefore paid close attention to consumer savings, and as we come to the inflection point for global interest rates, predicting what will happen to excess savings is crucial to any outlook for inflation or monetary policy.
What this means in practice is much harder to tell. Economists are unanimous that lockdowns and fiscal handouts caused consumers to save more than they normally would, but putting a precise figure on this requires figuring out what the ‘normal’ rate would have been. Then there is the question of how much of those excess savings are still available. The US, experiencing the high and consistent GDP growth, also saw a sharp reduction in consumer savings rates as we came out of the pandemic. Others, like the UK and Eurozone, still have savings rates above their pre-pandemic averages.
Back in June, Federal Reserve Board economists predicted US excess savings would run out by the third quarter of 2023. At which point, one would expect consumption to fall back in line with underlying real income, which itself is slowing. That suggests a significant slowing of US consumer demand, bringing down both growth and inflation. This scenario is broadly in line with the latest economic data, which has shown a cooling of US growth without an outright downturn, and it also makes sense of the Fed’s recent pause on interest rates. But on the other hand, betting against the US consumer has been a losing game over the last few years; they have been incredibly resistant to things that we might have thought would knock their sentiment or spending habits. Moreover, US Americans, more than most developed world consumers, are big investors in their own stock market. Its stellar performance has had a direct impact on their abilities to spend. A reversal of this trend could be triggered by a US financial shock, though that does not look likely at the moment. It could also come from a sharp reduction in US fiscal spending, for example under a deficit-busting Republican presidency. All of these scenarios are shrouded in uncertainty. US outperformance has no immediate threats, but with savings in the balance, it looks more fragile than it has in years.