Summer is over and bearishness is back. All the “things” we hoped might get better over the summer haven’t. Inflation is high and central banks are still raising rates. Meanwhile, we all face the effects of the cost of living crisis. As we get into winter, governments are going to do “things”. How markets react is uncertain, but unless “things” deliver lower energy prices the growth outlook cannot be good. Defensiveness might have to prevail until cheapness becomes a “thing” again.
The optimism of the early summer has evaporated. Given the seemingly never-ending flow of bad news it would be prudent to take a defensive approach to portfolio management into the end of this year. Inflation continues to rage, the idea of the US Federal Reserve (Fed) “pivoting” away from tighter monetary policy is now fanciful, the war in Ukraine continues and the energy crisis is impoverishing households and businesses alike. After calling the peak in bond yields in June, I am now open to the view that yields could exceed those levels. Indeed, it has already happened in the UK with the 10-year UK gilt yield at 2.9% compared to the June high of 2.74%. Both the Fed and the European Central Bank (ECB) are likely to raise rates by an additional 75 basis points (bps) at their respective September 21st and September 8th meetings.
Up and down
For equity markets higher bond yields are not welcome. The rise in real yields in Q2 contributed to negative returns from stock markets. Growth equities significantly underperformed the value-style. It is happening again. The real US 10-year yield – as measured by the yield on Treasury Inflation Protected Securities (TIPS) – moved from 7 bps at the end of July to 71 bps at the time of writing. The S&P 500 growth index has underperformed the value index over the same period. Higher yields, when the macro environment suggests lower earnings, is a potently negative combination for equity markets. A re-test of the June lows for US and other equity markets is on the cards.
Energy, inflation, rates and growth
The outlook is not clear. In the States, the labour market remains strong with the recent JOLTS survey indicating over 11.2mn open job positions in the US (more than twice the level of registered unemployed). The last two GDP reports showed negative growth, but the Fed is still intent on pushing rates higher until the labour market cracks, in order to stop wage growth adding to inflation. At the same time, in most economies, real incomes have been hit by higher inflation. European countries face potential rationing of energy over the winter. Governments are rapidly trying things to offset the energy crisis but in the end this comes down to political choices of who pays – consumers, taxpayers or the energy companies. The underlying issue is still that Russia’s aggression in Ukraine has disrupted the global supply and demand balance in gas markets. Until that is resolved, the prospects of the world seeing sustainable economic growth are very poor.
In the absence of an end to the war what could possibly happen to limit downside risks? Clearly rebalancing energy supply is important and the increase in gas storage in Germany in recent months is a positive development (data from Bloomberg suggest storage is at 84% capacity which is above levels seen this time last year). Governments everywhere are scrambling to reduce reliance on Russian supplies so increased nuclear output where possible, more LNG imports and efforts to increase extraction of energy sources, including oil and gas on the UK continental shelf are being contemplated or even seen. Demand may have to be constrained through encouraging efficiency, reducing energy usage for non-essential activities and, potentially, some rationing. There will be demand destruction as well as households and benefits purposefully reduce energy consumption. Maybe the decline in European wholesale gas prices this week is a sign that some of these things are already impacting supply and demand. Prices for 1-month delivery at the Dutch trading hub are down 25% over the last week (but still 50% higher than they were 2 months ago!)
When will the turn come?
It would not be a surprise for a global recession to follow a global energy shock triggered by a war on European soil. This makes it hard to reconcile interest rates going much higher. It’s been said many times, but central banks can’t directly impact energy prices. They can, indirectly, by reducing demand but it is likely that their actions exacerbate the demand destruction already underway. A pivot will happen at some point, but the Fed needs to see lower inflation and a softening of labour market trends and the ECB has to be comfortable that it has reached an appropriate level of rates to control inflation after having kept them too low for too long. My guess is that a “pivot” in market expectations could happen quite quickly – the inversion of the US Treasury yield curve is a strong pointer in that direction. I am always looking for a buying opportunity in bonds.
Interest payments up
Fed rate expectations are closing in on 4%. If we do see another 150bps of hikes this will be the most aggressive tightening cycle in decades, in terms of the size of the move. And it is the delta rather than the level that is important. Every additional 1% on rates has the same effect whether the starting point is 0% or 5%. The fact that rates were so low for so long and then increased aggressively is the point when it comes to how much extra borrowers will have to pay. The increase in rate expectations since early August has pushed up yields across the curve. That has created interesting opportunities. Looking at the Bank of America/ICE index for 3-yr to 5-yr US Treasuries, the yield is now 3.4% and the average price of bonds in the index is 93.3. While I worry about markets in the short-term, I don’t think July was the last positive returns month for fixed income this year. One can be defensive and still get a positive return.
After the circus
The UK will get a new prime minister next week – or might have one by the time you read this. It’s clear that the number one priority will be to tackle the cost of living crisis following the hiatus in policy making since Boris Johnson was ousted earlier this summer. There are no easy solutions, and it is likely that the social fabric in the UK will continue to be stressed for some time. The rise in gilt yields is seemingly driven by fears of further increases in inflation numbers in the wake of the next two adjustments to the domestic energy price cap. On one level this seems crazy as there is bound to be massive economic stress from such an assault on household finances and small businesses. Or gilt yields might be up because of the possible fiscal cost of combatting the effects of the energy crisis. Either way, no one seems ready to buy the gilt market yet.
The performance of sterling highlights how markets view the UK. Against the dollar, sterling has never regained the level it traded at on the day of the Brexit referendum in June 2016. If markets react badly to the new administration, a sterling exchange rate of less than $1 cannot be ruled out. Not exactly the sunny uplands! After sterling left the ERM in 1992, it fell 17% on a trade-weighted basis. After that, the economy did recover, and political change eventually delivered a centre-left government in 1997. Since 2015 the trade weighted index is down 18% – I would not bet against a political transfer of power in 2024.
There has been a lot of money changing hands between European football clubs this summer. Surprisingly (or maybe not), Manchester United have been big spenders. I reckon, on an average match day, Portuguese will be the native language of around half of the starting eleven. That can’t be a bad thing in terms of potential entertainment value. The reds are a long way behind Arsenal and City but there is a little more optimism, or that is what I like to think. Ajax have always been my favourite Dutch team and now we have their most recent manager and three of their ex-players. So “Op de Reds”.