Markets At Key Juncture

Week Ending 22 September, 2023

Markets are at key juncture. There is a feeling out there everything (as prescribed by textbooks) has been tried. You can sense the despair – especially amongst CBs (Central Bankers). They have tried QE, Fiscal Stimulus, Subsidies, Price Controls, Export restrictions – and yet inflation still plagues them. The headline declines in inflation have been driven by falls in energy price inflation. Even the latter could be reversing. Core inflation is simply nowhere near where they hoped it would have declined to. The worry now is if they continue to keep thinking within the box (i.e. keep hiking rates), they will risk a major policy error and ultimately induce a recession! It’s clear to me – and has been for a while – both rates and inflation will remain elevated and this will be the norm for some time. This is THE new environment for Developed Markets (DMs). EMs have been used to it for decades!

The Fed’s latest “Dot Plot” (see below, courtesy of Bloomberg) highlights the shift in expectations of rates from its 19 voting members. GS forecasts the Fed cutting rates in Q4 2024 believing inflation has to fall further than they had previously assumed. Barclays expects a cut at each of the last three meetings in 2024. MS expects the first cut in March 2024. GS and MS do not expect another hike this year but Barclays, BoA and Citi all expect another +0.25% hike in the November meeting. Meanwhile, 2023 GDP is projected to be 2.1%, 2024 = 1.55, 2025 = 1.8% and 2026 = 4.0%.

Thankfully, amongst it all, some signs of creative (at least different) thinking emerged this week which I think will start to become more widely adopted:

Switzerland: which surprised markets by leaving rates unchanged at 1.75%. A +0.25% hike was expected, to 2.00%. It was a surprise because, by their own admission, they are far from beating inflation down to their target range but, instead, the Swiss Central Bank (SNB) decided to prioritise the economy over inflation. The message is clear – a declining economy is a far bigger risk than rising inflation at this point in time.

UK: the BoE left rates at 5.25%, the first time since Nov 2021 following fourteen, consecutive hikes. It was a close call – 4 members wanted another +0.25% rate hike while the other 5 argued the labour market was showing signs of further loosening. Additionally, activity surveys have become more downbeat while interestingly, after nearly two years of consistent rate hikes, now it sees a looming threat of recession (mortgages being a key factor) and is prioritising combatting a recession (i.e. the economy) over inflation. Not dissimilar in principle to the Swiss National Bank.

Sweden: the Riksbank wants to hedge some 25% of its FX reserves (by selling $8bn and €2bn in exchange for buying Krona) over a 4 – 6-month timeline starting next Monday. They are doing this to protect themselves from Krona appreciation – which they believe will happen because they see the Krona as undervalued given the fundamentals of the economy. It’s like adopting a portfolio management approach to FX Reserves.

For markets, it has been a rough week. The upshot, of all the above, is that REAL yields are rising and Bond traders see no let up. The latter results in Bond volatility and is hammering demand for risk assets. Real rates began rising in May this year while the Nasdaq earnings yield declined. On 11th May, the spread between the two was 2.7% It is now 1.7%. For context, the Nasdaq earnings yield would have to reach 4.7% (currently 3.7%) to return to the 11th May position. This would require a drop in the Nasdaq of some -21% (taking its P/E back to 21X, currently = 27X). The S&P and Nasdaq are on track for the worst quarter in a year led by unprofitable technology companies (Peloton, Roku, Lyft). Adding to all this is the run-up in Oil prices with WTI around $90 per barrel. Bets above $100 pb are back on. Critically, with the US 10y Treasury now yielding 4.44%, the big question is will it face resistance or support as it approaches the 4.50% level? Yields at this level are undoubtedly attractive - while they don’t beat cash, they do give you capital appreciation should there be a dramatic flight to safety – and CBs have plenty of rate ammunition to cut. Fixed Deposits won’t give you that.

Two things are striking about the chart below: (1) the 10y Treasury Yield is undoubtedly setting new peaks with each turn and (2) we’re still in for a correction in stocks - on the back of Tech. To cap it all, we haven’t really had a blowout yet in spreads between High Yield and Treasuries. That could be because of the search for yield; it could also be investors believed the path to “normality” (rates and inflation) would play out as CBs prescribed.