End of central bank hiking?
• Israel declared itself at war following a deadly Hamas assault in southern Israel.
• Key global central banks all paused their interest rate hiking schedules.
• US headline inflation remained unchanged at 3.7% in the 12 months to September. UK inflation held steady at 6.7%.
• Strong 3rd quarter economic growth for the US, but slowdown expected. US Federal Reserve warned that geopolitical tensions pose a threat to the global financial system.
• US 10-year Treasury bonds rose above 5% for the first time since 2007.
• China's economy showed fresh signs of slowing.
• Majority of US companies beat expectations during 3rd quarter earnings season.
• Global wheat prices hovered at the lowest level in three years, easing global food inflationary pressures.
• The Bank of Japan said it will continue to loosen its grip on the bond market. The Japanese yen fell to 152 to the dollar, a level it hasn't seen since 1990.
• UK prime minister Rishi Sunak confirmed that the northern leg of HS2 will be scrapped.
With the war between Israel and Hamas increasing geopolitical tensions, equity markets struggled in October. Recent data showed that the US economy grew by an annualised 4.9% during the third quarter, which is the fastest growth in nearly two years. This is fuelling concerns that the US Federal Reserve may need to keep interest rates higher for longer. The good news is that inflation pressures are continuing to subside around the world, with Euro inflation falling particularly sharply in October due to lower energy prices and a drop in food inflation. This encouraged the European Central Bank to halt its hiking cycle in October after ten consecutive rate rises. The Bank of England and the US Federal Reserve also kept rates unchanged at their last meetings.
Regionally, US equities held up better than most markets. A large number of US companies reported third-quarter results during the month and a majority posted earnings that beat expectations. Overall, the companies in the S&P 500 are on track to register a small positive year-over-year profit increase, which would mark the first earnings growth in four quarters. However, investors focussed on the weak forward guidance from several high-profile companies.
The price of crude oil endured a roller coaster month but ultimately ended the month down sharply, despite a spike following the Israel-Hamas war breaking out, on concerns that supply could be impacted. Investors focussed on the strong supply coming out of the US, which reached a record high during the month, and on the potential for falling demand, particularly from China as its economy showed fresh signs of slowing. The gold price was strong on the back of safe haven buying, with the price exceeding $2,000 per troy ounce for the first time since May.
Global government bond yields broadly rose, with the US 10-year Treasury Bond yield rising above 5% for the first time since 2007. US Treasuries have been particularly hard hit due to a glut of new debt being issued to help plug a large government budget deficit. This created a headwind for the performance of funds holding bonds.
In the face of rising interest rates, corporations have reduced their debt, house prices have fallen, and banks have struggled with fiscal frugality. Can the economy cope? The probable answer is yes, on the assumption that rates have risen for the right reason. Economists typically think that interest rates are determined in the long term by the balance between the world’s desire to save and to invest. The most popular explanation for the rock-bottom rates of the 2010s was that ageing populations were stashing away more money for retirement, while insipid long-term growth prospects had sapped companies of the desire to expand—a phenomenon sometimes called “secular stagnation”.
For rates to have shifted permanently, that outlook must have changed. One possible reason it might have is the anticipation of faster economic growth, driven perhaps by recent advances in artificial intelligence (AI). In the long term, growth and interest rates are intimately linked. When people’s incomes rise over time, they have less need to save. Companies, expecting higher sales, become keener to invest. Central banks have to keep rates higher to stop economies from overheating. The interesting question though is higher rates compared to the last 15 years can still be some way below where they stand today (5.25% in the UK as of the end of October 2023).
It might seem farfetched to say that optimism about AI is pushing up bond yields. Yet it would explain why the prospect of higher-for-longer has not caused stock markets to fall too much. In theory, higher bond yields should reduce the value of companies’ future earnings, an effect that bites hardest for technology firms, since they tend to promise jam tomorrow. In fact, as optimism about AI has spread, the value of big tech firms such as Microsoft and Nvidia has soared. We feel this might have moved too far and we have been reducing our exposure to this area.
To the extent that productivity growth explains higher rates, the new era could be a happy one. Set against the rise in debt-service costs, households will have higher real incomes, firms will have higher revenues, financial institutions will enjoy low default rates and governments will collect more tax. Healthy competition for capital might even bring benefits of its own. Some economists long suspected that the low-rate era of the 2010s made the economy less dynamic. “It was easy for relatively inefficient companies to stay afloat, so there wasn’t much creative destruction,” says Kristin Forbes of MIT. In a higher-rate world underpinned by faster growth, there would be plenty of dynamism.
We must not forget that a key target of indebted governments is a healthy level of inflation to erode away the real value of government debts, as it has in the past after moments of economic crisis. In that case, though nominal interest rates might be higher-for-longer, the real interest rate would not have risen as much. Companies and governments would survive high rates because their incomes would be strong in cash terms.
A realistic possibility is that high rates push the world economy into a mild recession, which in turn causes central banks to cut rates – then fixed income bonds become very interesting and we have started to increase exposure in this area. In line with this thesis, on October 23rd Bill Ackman of Pershing Square Capital announced that his fund was no longer betting that rates would keep rising. “There is too much risk in the world to remain short bonds at current long-term rates,” he wrote. “The economy is slowing faster than recent data suggests.” If he is right, higher may not be for that much longer.
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