The winter (?) of our discontent

Risk assessment is, by and large, what we do. There are long and short-term risks, as there are apparent and non-apparent ones. While we are not ready to throw our hat to the ceiling just yet, a clear look at the market suggests that a cohort of surface risks appears to be receding. We spend a lot of time thinking about the high cost of money and the risk of something breaking, inflation staging a rebound, the equity rally being too concentrated and the bond market pricing in too many cuts.

A quick look at the market justifies a modicum, at least, of buoyance, in at least five fronts.

Why we can be more positive:

• Rates are finally coming down. Last week the Federal Reserve confirmed that it’s on a growth rather than an inflation path, which means that it is not willing to sustain interest rates at 5.5%. While our base case has consistently been that the US central bank will not be off to a strong start in terms of cuts, we see potential for more in 2025. Apollo Asset Management calculated that bringing rates down to 3% would, all other things being equal, lead to a 2.2% bump in GDP (and 1% in inflation). More importantly for British and European consumers, US rates coming down will allow the EU and UK central banks, who struggle with much lower growth, to follow with more steep cuts.

The Fed has been preparing the ground for some time by reducing the pace at which it is withdrawing liquidity from the markets. Quantitative Tightening has been averaging $52bn in the last three months, down from $91bn average since October 2022 (ex Peripheral bank crisis).

The important thing to note is that we are near (but not at) the end of this particular risk corridor: The Fed delivered steep rate hikes and quantitative tightening within target, without allowing anything of significance to break. US Peripheral banks failing was nipped in the bud with a highly targeted strategy.

• Inflation continues to slow. The key risk to rates coming down would be inflation rebounding. Yet data from last week in the US confirm that price cooling is on safe ground. Core personal consumption expenditure (PCE) rose slightly but fell short of market expectations which was ultimately good news.

So the Fed is probably right to focus on slowing growth at this particular juncture (more on that during this week with PMI and US unemployment data). The risk of course remains that prices may rebound. But the data is on the right track, with services inflation slowing across the board.

I have often complained that headline inflation numbers depend on China continuing to deflate the world and that a spike in Chinese producer prices could cause major headaches to central bankers. But a great article by Zongyuan Zoe Liu (China’s Real Economic Crisis) in Foreign Affairs Magazine, convinced me that the risk isn’t as great as I previously thought, for now at least. The Chinese economy, according to the brilliant Ms Liu, is a forceful deflation-generating mechanism. As long as its borders are open and trade wars don’t get too hot, developed markets can enjoy some deflation in goods, possibly even for long enough to see their own services inflation come down.

• The equity rally has widened. For most of the year, the equity rally was extremely concentrated to the so-called Magnificent 7, and mostly Nvidia. Yet for the last two months, the rally has been mostly about the 493 or so US Large Caps who are not the Magnificent 7.

That is not to say that Nvidia is crashing. The stock price fell when the company just matched (instead of blowing past) analyst expectations. Still, Nvidia’s capitalisation is 141% higher than what it was at the beginning of the year and 716% higher than at the end of 2022 when ChatGPT introduced itself to the world.

The crocodile mouth between tech and the rest of the stocks is closing on the upside, which is a huge relief, especially for value investors. Equity markets are in normal operating mode. One sector might be outperforming, but it is now taking a breather allowing others to catch up.

US large caps at their all-time highs, as the result of a wider rally, are cause for optimism.

• The bond market is acting more sensibly. Another big worry has perennially been that fixed-income traders were pricing in too many rate cuts. However last week, yields moved a bit higher. While we do believe that the slightly less than 3.9 cuts priced in is still a bit excessive, it is nowhere near the 5.5x exactly one month ago and certainly the 7x at the beginning of the year. Our House View for two rate cuts in 2024 still stands, but, given a very probable September start, there is room for a third, if unemployment gets much worse.
• The UK’s quiet re-approach with Europe. The UK’s new Prime Minister has, quietly, set about smoothing things out with the country’s 2/3 of trade relations, i.e. the European Union. The timing of his charm campaign to Europe, exactly at the end of the summer holidays and close to his election, is immaculate and sends a very clear message to markets that re-approaching the EU a priority. Our House View has long been that, while Brexit can’t really be undone, some of its more controversial aspects can be mitigated. Investors have long been looking for cues of a more realistic approach with the country’s largest trade partner in order to re-elevate the country’s equities (and even debt). At the very least, the move justifies UK equity valuations at par with their own history. Possibly, a positive re-rating could be argued for UK stocks if the course remains positive.

Thus some short and medium risks are coming off the table. Does this mean clear skies from now on? History might say not immediately, as September and October are usually the worst months for equities.

But this is mostly a seasonal issue that doesn’t always play out.

Risks are still there

What we are more worried about is not surface risks, which seem to abate, but the less obvious and definitely non-linear risks. Namely politics and debt, which add to inherent (not immediate or obvious) macroeconomic and market volatility.

When globalisation comes under fire, the clear alternative is the reinforcement of the previous status quo, namely the nation-state. And when high debt increases fiscal constraints and hampers the ability of governments to address chronic social issues, uncertainty ensues. This feeling can cause people, as Dr Benjamin Spock attested in his book Decent And Indecent, to “hug the flag”.

Last weekend saw the victory of AfD, a German far-right party, in the country’s regional elections, putting pressure on the weak coalition government. Not being ones to acknowledge the eery echoes of the past as anything more than journalistic sensationalism, we simply see Germany as late joining a nationalistic trend observable in France, Hungary, Italy, the Netherlands and the UK before it.

While we don’t fear another war, we believe the rise of nationalism in Europe poses an additional and non-negligible threat to the shaky foundation of the currency union, presently sustained mostly by the efforts of the central bank. And whereas the Middle East has not so far caused a new wave of inflation, the longer the wound remains open, the higher the risk that oil-rich Sunni-majority countries, like Saudi Arabia or Qatar, might decide to enter the fray. Meanwhile, the US elections on at a razor’s edge. The election of a Democrat or a Republican president might produce very different outcomes. More importantly, we see both the US and China, much like all empires of the past, struggling with the possibility of their own imperial (in modern form) future. The US and China are sleepwalking into a ‘Thucydides Trap’, where one country considers that a great future might only lie on the tatters of their competitor.

A world indebted and more fragmented is not only more expensive (higher inflation than before), but more inherently (when not manifestly) volatile. This means that while we see less overt risks, as investors we can’t ignore the bigger picture when we make asset allocation decisions. This is an environment ostensibly friendly for investors to try their risk limits for a short time. But they should always keep in mind that underlying inherent event-driven risks are on the rise. 

George Lagarias – Chief Economist

Market Update

Equity indices remained within a percentage point of their starting values this week in GBP terms in a light week of trading. US markets had their quietest day of the year in terms of trading volume on Monday, save for 3 July when markets closed early before Independence Day. Markets appeared to react positively to upwardly revised US growth data, (3.0% in Q2 versus the initial estimate of 2.8%) and core personal consumption expenditures data, the Federal Reserve’s preferred measure of inflation, which was slightly lower than consensus (2.6% YoY vs 2.7% expected). The shares of the chipmaker Nvidia, which has led much of the AI rally in US tech stocks, dropped sharply after hours, after it reported earnings on Wednesday which for the whole beat expectations. However, the wider market impact was muted as other sectors of the market such as financials showed positive returns.

US markets returned -0.1% in GBP terms. EU stocks fared better as inflation data decelerated from 2.6% to 2.2% YoY in July, close to the European Central Bank’s stated target. Japanese stocks rose by +1.1%, fully recovering from the sharp drop seen earlier in the month driven by fears over the unwinding of the Yen carry trade.

Yields increased modestly over the week, as traders priced in a lower probability of a 50 basis point rate cut at the Federal Reserve’s September meeting. 10-year US, UK and German government bond yields increased by 12, 10 and 7 basis points to 3.91%, 4.01% and 2.29% respectively.

Macro news

Price pressures continue to ease in the largest eurozone countries. German inflation slowed to 2% (the European Central Bank's target) in August, supporting the case for another interest rate cut next month. Inflation also eased in France and Spain, with CPI rising by 2.2% in both countries. The favourable CPI reports come less than two weeks before policymakers meet in Frankfurt to decide whether to cut interest rates again after a first cut in June. Investors are betting that recent price trends, along with sluggish economic growth, will prompt the ECB to cut its deposit rate to 3.5% from 3.75%.

UK house prices fell by 0.2% in August compared with the previous month, according to data from mortgage lender Nationwide. The stagnation in prices is a sign that affordability remains stretched, even after the Bank of England eased borrowing costs in August. On a year-on-year basis, property prices have risen by 2.4%, but remain 3.1% below the highs seen in September 2022.

Core PCE, the Federal Reserve’s preferred inflation gauge, rose by 0.2% in July, in line with expectations. On a year-on-year basis, core PCE rose by 2.6%, a tick below consensus estimates of 2.7%. The figures set the scene for the Federal Reserve to start cutting rates at its September meeting next month.

The week ahead

It will be a busy week for US macroeconomic data, as US PMI, job openings and non-farm payroll data will be released. Markets will be closely watching these figures, along with any potential data misses to try and gauge how the Fed will organize its timing of interest rate cuts.