Monday Digest

Posted 13 May 2024

A blooming May for the UK

Markets had a bright week, thanks to weaker US job market data and hints that the Federal Reserve might cut rates. US consumer sentiment seems to be wavering thanks to higher inflation, but the Fed thinks inflation pressures are abating. Hong Kong stocks were up too, thanks to potential Chinese tax waivers.

The UK market is performing well now, with the FTSE 100 storming above 8,400. Data shows Britain rebounded in the first quarter of this year, with surprising strength in manufacturing and services. That didn’t stop inflation expectations falling either, allowing Bank of England Governor Andrew Bailey to indicate interest rates will be cut.

That might not happen by the June meeting, though. UK businesses gave become more confident, and sectors like property are primed to bounce back if rates do indeed fall. Even so, the BoE doesn’t think real growth is inflationary, and the dovish tilt is boosting bonds and equities.

That has helped turn thins around for FTSE, which underperformed Europe and the US in the first quarter but is now level year-to-date. A lot of this is down to external factors (HSBC’s Hong Kong exposure or Anglo American’s buyout) but smaller, domestic focused companies have started rallying too. They will be helped by the BoE’s dovishness.

Interestingly, currency markets seemed more affected by politics this week than by central bankers. The Labour party’s fiscal policies have become increasingly conservative – with both a big and little ‘C’ – and markets now expect a gentler path for UK government debt than for the US under a potential Republican presidency. That is a role-reversal when it comes to markets’ political preferences. It is possible that currencies may be ruled less by yield differentials and more by political differentials in the next few months.

UK stocks are enjoying a bit of time in the sun, after what feels like a long period in the cold. Maybe it has something to do with the improving weather.

What to take from a strong earnings season

Corporate earnings reports for Q1 have been very strong. US company profits were up 5.2% year-on-year, beating the 3.4% forecasted and delivering America’s strongest profit growth in two years. European firms joined in the good times too: UBS reported $1.8 billion net profit for the first three months of 2024, while UniCredit announced plans to distribute €10bn to investors after beating earnings forecasts.

These reports are crucial given the market backdrop. The timeline for interest rate cuts has been repeatedly pushed back this year – particularly in the US – to the point where investors are questioning whether they will actually happen. Markets don’t know how to interpret strong data; it could delay rate cuts, but it could also bring the profits that ultimately give stocks their value. This confusion has meant up and down equity prices, as economic expectations bounce between ‘soft landing’ and ‘no landing’.

Q1 earnings suggest ‘no landing’ – growth or inflation strengthening without ever properly tailing off. Not only were previous earnings strong, but future earnings projections strengthened through the reporting season. This is the opposite of what normally happens, since companies tend to temper profit expectations the closer they get to give them a lower target to beat. Expected S&P 500 earnings for the current quarter have risen to 9.8% from the 9% expected in March.

Even better growth is expected later in the year, with 17.3% projected for Q4. Mentions of “recession” in corporate reports have dropped to the lowest point since early 2022 too – a sign that the current growth cycle will be reignited before its even burnt out. How much of this optimism is itself down to rate cut expectations – which are sure to be tempered if strength continues – remains to be seen. We also don’t know how much of this strength is unique to the US: European earnings have been strong, but the economy still looks weak. At the very least, we know that if inflation continues, profits will continue alongside.

Share trading catches up with technology

Trading settlement times are about to be cut in North America. Securities trading currently works on a ‘T+2’ rule, mandating a maximum of two days between a trade being agreed and the cash and shares officially changing hands. That will be shortened to T+1 by the end of this month in the US, Canada and Mexico.

Others will soon join the tighter schedules. The EU will publish a consultation on T+1 by the end of the year, and the UK has already committed to adopting it by 2027. India already has T+1 and is talking about moving to T+0 – same-day settlements – with an option for instant settlements.

Many outside of finance think it strange this hasn’t been done already. Not only are long settlement times annoying, they introduce risk for trading parties: asset or currency values might change between trade and settlement.

But fund managers have been fretting about T+1 for months. Updating and shortening processes costs firms. Funds will need greater liquidity access, which is currently expensive thanks to high interest rates. British or European investors in the US have to contend with time zone differences and foreign exchange problems too.

These issues prove why regulation is necessary, though. Everybody wants quicker settlements, but nobody wants to be the first to invest in back room operations that would cost a lot but bring little competitive advantage. As the UK’s consultation highlights, “No one will invest to upgrade their technology to enable T+1 unless the whole market does so at the same time.”

Further cuts to settlement times are likely in the future, but the costs do not scale evenly with every day knocked off – and actually accelerate the closer we get to zero. This is why a seemingly obvious update has taken so long to come about; it is a cost-benefit trade-off. But if T+1 goes smoothly, further reductions are likely.

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