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posted 11 months ago

Market sentiment: A soft landing beckons for the U.S, and the relief is palpable on global financial markets. A weak June ISM Manufacturing survey was followed, ten days ago by a weak non-farm payroll report. Last week we had further confirmation of a slowing U.S economy, with lower than expected June inflation numbers. Markets continue to price in one more 25bp rate hike from the Fed, but some Fed policy makers talk of interest rates having peaked and it certainly appears that we can talk about the end of the interest rate cycle in the U.S with greater confidence today, than at any other time over the last twelve months.


Predictably, U.S stocks are rallying. And in fixed income, short-dated Treasury yields (which most sensitive to interest rate expectations) are falling, with the two-year Treasury yield down from 5% on the 6th July to 4.7% today. The dollar is weakening, as the outlook for relative interest rates increasingly favours other currencies. Eg, the two-year U.K gilt yield is at 5.2%, because of a more-stubborn inflation problem. This has lifted the pound to a 14-month high of $1.31.


What is good for America is good for the world. The rally on Wall Street is helping to pull up European stock markets, after a difficult few weeks when hawkish talk from central banks pulled down cyclical stocks. And a weaker dollar means stronger currencies elsewhere, which will help reduce import costs in Europe, Japan etc, and so reduce inflation outside of the U.S. This, in turn, takes some pressure off central banks to raise interest rates.


What is a soft landing? Consensus forecasts for GDP growth in the United States this year are around 1.1%. If this can be achieved, without a recession along the way, and at the same time headline CPI be brought close to the Fed’s 2% target, a soft landing will have been achieved. The world will congratulate Fed chair Jay Powell, for taming inflation without too much damage done to the economy. Investors will start pricing in interest rate cuts, and a new economic cycle. U.S and global stock markets will have support.


But, of course, we are not there yet. The risk of a serious recession persists (the hard landing scenario), given the lagging effect of interest rate hikes on economic activity. Core inflation is remaining stubborn, at still 4.8%, and even if we have reached peak U.S interest rates, they may remain higher, for longer, than expected. Jay Powell is well aware of the risk of easing monetary policy too soon, as the Fed did in 1980 under Paul Volcker’s leadership. As inflation unexpectedly rose again, much higher interest rates were needed in 1981 than would have been had the Fed not cut rates prematurely the year before. The resulting recession was severe.


Europe’s interest rates will continue to rise. The risk of higher for longer interest rates is more acute in Europe, and particularly the U.K, due to the greater strength of organised labour than in the U.S, and very tight labour markets. The fight over who carries the cost of inflation is likely to persist for longer (the answer will be those on fixed incomes, and workers who cannot extract pay rises equal to inflation). While only one more rate hike is priced in by the markets for the U.S, a further two 25bp rate hikes are expected from the ECB. The U.K is expected to see at least 1% more between now and early 2024, taking the Bank of England’s peak rate to 6%.


Of all the major economies, the U.K seems particularly prone to this due to a persistent skills shortage, that predates the Covid pandemic, and a shrunken labour force in recent years. Core U.K inflation actually rose in May, to 7.1% (the highest level since 1992), from 6.8% in April, while wages rose 7.3% in the three months to May. This led Andrew Bailey of the Bank of England, and Chancellor Jeremy Hunt, to both urge pay restraint, even as the Chancellor looks set to sign off pay awards of 6%-7% or public sector workers.


Remain diversified! While the U.S economy may emerge from the current interest rate cycle relatively unscathed, and ahead of European economies, stock market valuation favour the Old World. The U.K FTSE 100 looks particularly cheap. Meanwhile, The strong rally in U.S tech this year has raised fears of over-valuation – and tech now accounts for between a quarter and a third of the S&P500 market cap (depending on definitions). This is a strong argument for diversification, and not betting all on one region or asset class. Financial history demonstrates that this approach delivers best long-term risk adjusted returns.


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