Rate rises bouncing off ‘Teflon’ markets

Posted 28 July 2023

Equity markets continue to be buoyant after the rate rises in Europe and the US. Some market participants have been calling this the ‘Teflon market’ because nothing sticks to it. 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.

We look at this week’s rate rises – and where they leave rate expectations – in a separate article below, and we also touch on next Thursday’s Bank of England Monetary Policy Committee (MPC) meeting. Expectations remain for rate rises in the UK of 0.5% to 0.75% by the end of the year, with a 0.25% hike next week.

This week, the central banks of the US and Eurozone – the Federal Open Market Committee (FOMC) and Governing Council of the European Central Bank (ECB) – both delivered as-expected rate hikes of 0.25%. Opinions are divided as to whether another increase will take place at the September meetings.

In Europe, credit conditions remain very difficult for smaller firms. The ECB’s second quarter survey of banks tells us they are worsening in this third quarter. A similar situation is at play in the UK. The US bank survey is out next week and may tell us that regional banks are also reluctant lenders.

However, credit conditions for the larger, more global firms seem to be generally improving. It has been a remarkable thing, watching their credit spreads come down. While the interest rate cost on newly-issued debt is still way higher than debt taken on before the pandemic, there is no sign of a squeeze in the usual definition. Companies might have to pay a higher interest rate, but equally there are many investors willing to be providers of capital.

Indeed, we looked at the amount of debt in the Bloomberg Barclays US Corporate Aggregate Index (using the nominal or “par” value of those bonds). Below is a graph showing the year-on-year growth rate:

We have considered the state of the corporate bond market before in previous weeklies, and made the assertion that the increase in the interest cost of financing would be prohibitive, and that this would precipitate a reduction in the size of the market – essentially firms would choose to de-lever. Well, they could be reducing the relative size of debt in comparison to their reasonable revenues and profits. And overall, corporate debt has definitely declined relative to the size of the overall economy. However, in absolute terms, US corporate bond debt is increasing at a good clip. On a three-month annualised basis, it is growing at nearly 17%, and has been through the past three months.

We find this outcome really quite surprising. It may prove to be fairly short-lived, but it does suggest there is a solidity to corporate and confidence that isn’t coming through in data such as the Purchasing Manager Indices (PMIs). Equally, the US gross domestic product (GDP) data showed good real growth (+2.4% annualised) and declining inflation (+2.2% annualised), with employment costs edging down to about +4.1% annualised. Consumption growth was mild but consumer confidence continues to improve and is definitely stronger than surveyed corporate confidence. Could it get better?

One thing to note is that, finally and despite the decline in credit spreads, corporate financing rates are higher than the 4.6% annualised nominal growth rate. Beforehand, revenues were rising because of inflation, even for those companies that were not so competitive. Now we’re into a period where inflation isn’t high enough to bail those companies out. This applies to the US, but real growth is weaker in Europe and the UK, and although inflation appears stickier, overall nominal growth is coming down fast to meet the financing costs.

In a separate article, we give some thoughts on US and Europe company earnings at the halfway point through the season. Analysts seem to be indicating reasonable demand growth in US, more tepid in wider Europe, with margins in both areas under a bit of pressure. However, Eurozone margins have been in better shape. Generally, margins were reasonably stable (after taking out the highly cyclical energy and materials companies). It will be interesting to see how they hold up though the rest of the year.

The tech company earnings continue to support their high valuations and suggest they are benefitting from the sharp uptick in corporate capital expenditures, which comes from government-led policies in both the US and Europe. It is way too early to ascribe the profits to an artificial intelligence (AI)-led boom. As Bloomberg put it: “Google parent Alphabet Inc., Meta Platforms Inc. and Microsoft Corp. certainly talked about AI, but their post-report share moves showed investors are still primarily focused on the businesses that make them the most money — and that clearly won’t be AI for a while.”

Talking of monetary policy changes, one central bank seems to be starting a tightening process. Today (Friday 28 July), the Bank of Japan indicated it would allow greater latitude in its “yield-curve-control” policy. The 10-year bond yield shot up. Actually it rose by 0.07% which, for hardy UK gilts 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 the week, Chinese markets rose sharply and maintained their early gains. After months of rumoured policy action, the leadership or “politburo” said something would happen, and despite few details at least there was no doubt that action is intended. 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 might happen this time.