Monday Digest

Posted 22 April 2024

Market quiet on the Middle Eastern front

Israel and Iran’s escalating conflict presents huge risks for the world, but at the moment we can take comfort that the respective aerial bombardments seem to be more about showing force than hurting each other. Israel’s allies don’t want a full-scale conflict and the Iranian regime is weak in its domestic support. Hopefully, this should mean each country’s hawks are satiated by bold but ultimately ineffective long-range shots.

Our job is to think about investment implications. Capital markets weakened last week, but surprisingly this was only partly about the Middle East and global oil fears. Falling stocks and a stronger dollar show falling risk appetite. Investors are booking profits, which is why last week’s worst performers – like Japan – were the best performers year-to-date.

The Mexican peso fell against the dollar, having been on a stellar run (we cover below). But major developed currencies were only slightly weaker and were stable through Israel’s retaliatory strike. Bond yields spiked but, with the exception of the US, real (inflation-adjusted) yields were stable, indicating higher inflation expectations (which we also cover below). We might have thought oil would surge, but Brent crude prices were stop-start – hitting a high of $92 per barrel on Friday morning before slipping back to $87, a pattern it held every day last week.

Growth expectations have been hit by delayed interest rate cuts. Fed chair Powell admitted last week that we will have to wait longer than expected for a cut, but BoE governor Bailey was more dovish, downplaying the UK’s recent inflation surprise and saying the BoE need not wait for the Fed to act.

Investors are having to discount the possibility of tighter short-term policy, which could challenge growth. But analyst expectations for corporate earnings are high – and markets’ implied expectations are even higher. This means stocks valuations are expensive, making them vulnerable – especially as risks grow and volatility rises.

We shouldn’t give up on medium-to-long-term optimism, though. Recession risks are minimal, so if valuations fall it will likely mean buying opportunities. Less exuberant markets could help inflation expectations too, meaning rates can finally fall and the growth cycle start anew.

Real yields, real growth?

Sticky inflation and delayed interest rate cuts are pushing up bond yields. 10-year US Treasury yields have gone from 4.2% to over 4.6% this month, while UK gilt yields have shot from under 4% to nearly 4.3%. One might think this is down to higher-than-expected inflation figures in both regions – which would also explain why the less inflationary Europe has seen smaller bond moves.

However, UK and US bonds differ greatly when it comes to real yields. We work these out from inflation-adjusted bonds. They pay interest on the amount borrowed – but that amount rises each year in line with the official inflation index. Like any bond, changes in the traded price are inverse to changes in yield. So, the difference between the inflation-adjusted face value and the current market price tells you the ‘real’ yield.

US real yields have risen sharply through the latest bond sell off, but UK real yields have stayed fairly stable. Real yields are supposed to reflect markets’ growth expectations, so basically they are saying US growth prospects have improved while Britain’s have stalled. That shouldn’t surprise anyone; the US economy continues to outdo expectations while the UK is at best stagnant.

The more interesting thing is what it says about inflation. Since UK real yields have stayed put, the move up in nominal yields suggests markets expect higher inflation. But US real yields have moved up basically in line with nominals, meaning inflation expectations have not gone up in the US. That is incredible when you consider how strong recent US inflation data has been.

Something has to give. Either inflation has to fall rapidly, growth expectations must weaken of nominal US yields must adjust higher. The first two look unlikely, but the latter could be painful for risk assets. Markets have taken the bond sell-off well so far – but might not be able to take much more.

Mexican peso going strong

The Mexican peso is the only major Emerging Market (EM) currency to gain against the US dollar during this latest rate rise cycle – jumping 20%. President Andrés Manuel López Obrador (nicknamed AMLO) has played a big part. International investors were concerned about the leftist president when he took office six years ago, but as we approach the end of his administration, AMLO will almost certainly be the only Mexican leader in modern history to leave office with a stronger peso than he inherited.

Mexico’s central bank helped him by raising interest rates hard and fast in 2021 – long before developed nations joined in. The Bank of Mexico’s total cumulative rate rise was higher than the Federal Reserve’s too – 7.25 percentage points compared to 5.25 in the US. That made the ‘carry trade’ – borrowing money where it’s cheap (US) and keeping it where rates are higher (Mexico) – more attractive. Capital flowed from the US to Mexico, bolstering the peso.

These flows were only possible because of Mexico’s strong trade links with the US. Mexico officially became the US’ largest trading partner last year, overtaking China. US-China trade has taken a huge hit from the nations’ sour relations, and manufacturers are keen to produce closer to the US – benefitting Mexico.

This structural force pushing up the peso was bolstered by cyclical flows, but those might be ending. Mexico is now cutting rates, and the next president (elections in June) might well want a weaker peso to boost exports – considering the recent drop in activity.

In purchasing power parity terms, the peso is stronger against the dollar than it has been in years. This might mean there is little room to go higher, or it could mean a deep structural change in US-Mexico economic ties. In any case, global trade is clearly shifting – which should shift how investors think about global growth, and EMs in particular.