Monday digest
Posted 5 February 2024
Overview: Central banks challenge goldilocks assumptions
Surprisingly decent monthly returns were soured on the last day of January when the US Federal Reserve dampened the mood by repeating the message that rate cuts will begin later than markets anticipate. That this reiteration led to a sell-off was surprising, because markets seemed to have already grudgingly accepted later rate cuts than hoped at the end of 2023, thanks to surprisingly resilient US Q4 growth. It is therefore reasonable to assume that last week’s stock and bond market falls were about more than central bank press conferences. We turn to the usual suspects: China, banking fears and uninspiring corporate earnings reports.
The liquidation of faltering Chinese property giant Evergrande could spell further short-term trouble for the property-heavy Chinese economy, even if it may spur the Chinese regime to properly address the property crisis. Beijing’s procrastination is an issue we need to watch. More pressing is the return of American banking woes, following New York Community Bancorp’s 40% share price drop. This was compounded by uninspiring corporate earnings outlooks at the start of the week.
Much better than expected results from US mega tech companies and international oil majors changed the tone, as did a report on Friday showing that the US added 353,000 extra jobs in December. Markets initially only traded sideways on the news, bringing us back to the Fed. The strength of the US labour market means there is little incentive to cut rates in the near-term, but renewed banking pressures challenge the narrative that economic strength will overcome high rates. This could mean less vibrant markets and a longer wait for interest rate normalization, which will put pressure on valuations and corporate financing costs. Until the timing of rate cuts is clear, we have to expect more of the same: China is out, US powers ahead, with its Mega Tech market darlings in focus, while the rest of the economy is hoping for more sympathetic central bank rates sooner rather than later.
January asset returns review
After the hangover from December’s Santa Rally, January turned into a half-decent month for investors. Coming into the new year, capital markets were anxious that they had got ahead of themselves, but these fears dissipated as the month went on. Global stocks gained 0.7% in sterling terms, which is much more impressive when considering the rally that came the month before. US stocks gained 1.8%, thanks to expectations of a goldilocks environment – with earnings remaining strong but rates lowering nonetheless. Returns would have been higher if not for the Fed pouring cold water on a March rate cut on the last day of the month. American stocks still rose to all-time highs, making valuations look stretched.
Japan’s stock market was the best regional performer, gaining 4.7% in sterling terms. Short-term factors like continued negative interest rates and a weaker yen (boosting exports) were the immediate factors behind the rally, but improvements in Japan’s corporate structure means there is still plenty room to grow. UK stocks were negative by contrast, losing 1.3%, while eurozone equities gained a mild 0.3%. These mild returns mean that both regions held on to most of the gains seen in November and December, and are up over the last three months. Europe stands to gain from rate cuts, expected in the spring, and any pickup in global demand. Lower valuations than in the US could help on that front.
Emerging markets lagged other major regions, losing 4.5% in sterling terms. The biggest drag on EM assets remains China, whose economic weakness is still being felt. The support measures being pursued now are significant, but the lack of private sector confidence runs deep. For wider EMs, they should at least be able to look forward to looser Fed policy and, eventually, a pickup in global demand. Overall, January turned out better than expected for global investors. Gains from November and December were not just solidified, but in most instances extended.
Central banks confirm ‘lower, slower’
The Fed, the BoE and the ECB all held monetary policy meetings in the last couple of weeks, and all three left interest rates unchanged. Virtually all acknowledge that rate cuts are a question of when not if – but the when is complicated by central bankers’ fear of once again being caught out by inflation. The Fed exemplifies this push and pull. Earlier this month, a senior official said the central bank was within “striking distance” of its 2% inflation mandate, but at its meeting last week, Fed chair Powell poured cold water on the idea of a March rate cut.
As a result, markets expect rates to be 0.5% lower by June. That is extraordinary, considering the enduring strength of the US economy and its resultant inflation pressures. Core US inflation (removing volatile elements like food and energy) has eased but is still around 4%, and the labour market remains extremely strong. The US economy added 353,000 new jobs in January – when only 170,000 had been widely expected. There is no immediate need for support, hence the Fed forgoing a March rate cut. This is also true for the Fed’s balance sheet reduction, which some observers thought would slow in response to banking troubles. The bank’s recent increase in its repo rate for the extraordinary liquidity facility (which was set up in March last year to facilitate and ease regional bank funding pressures) is signalling the opposite.
The BoE, meanwhile, remains planted on the fence. At its meeting last Thursday, the Monetary Policy Committee was split three ways for a hike, on hold, and a cut. Structural supply-side problems mean wages and core inflation are still too high, despite continued weakness in the UK economy. The ECB is similarly cautious. The Eurozone economy is stagnant and contracting in some areas but its central bank left rates unchanged and urged for patience in cutting rates, because of labour market tightness and continued inflation in services. Economic realities should mean European rate cuts come sooner than American ones, but policymakers seem to have different preferences either side of the Atlantic.