The fuel for the rally has been sliding inflation, which has buoyed hopes of a cut in interest rates next year. However, is the market’s recent strength a triumph of hope over reality?
It is perhaps unsurprising that many of the strongest gains have been in those areas that have proved most vulnerable to interest rate rises. That includes commercial property, for example, infrastructure, financial and healthcare stocks, but it also includes smaller companies in the US, Europe and UK. It is noteworthy that China and the broader Asia Pacific region has not kept pace. For investors, it has been a welcome relief after a volatile year.
Bond market rally
The rally in the stock market has its origins in the bond market. The 10 year US treasury hit a peak of almost 5% in October, but moved down sharply from November onwards to its current level of 3.9%. Bond yields moved lower again when Federal Reserve forecasts showed it expected three quarter-point rate cuts in the year ahead, significantly ahead of previous expectations. The rally in the equity market has run almost consecutively to falling bond yields.
The problem is what happens next. Lower bond yields feed into mortgage and corporate borrowing and create a de facto rate cut. From an economic perspective, there has already been 1% of cuts.
Many of the factors that pushed bond yields to 5% in the summer are still in play. The US government is still having to issue significant amounts of bonds to support its borrowing requirements. Yields may have dropped, but they are still more than double their level at the start of 2022, which in turn creates the need for more borrowing.
The Federal Reserve may have changed its stance, but other central banks continue to caution against expecting a rate cut next year. Christine Lagarde, ECB president, has said there is still “work to be done” in achieving the 2% inflation target, while Bank of England Governor Andrew Bailey said there was “still some way to go” before the UK could contemplate rate cuts. Sustained falls in bond yields look optimistic.
It is plausible that disinflationary forces come in play over the next six to 12 months as money supply shrinks and economic growth weakens, but it is difficult to see how this happens alongside the expansion in earnings necessary to drive equity markets in the longer term. There are already cracks showing in economic growth data. Markets have reacted to the prospect of lower interest rates without contemplating what it implies for economic prospects.
It opens up the market for disappointment, and may keep it in thrall to changes from the Federal Reserve. A lot of the components of the inflation basket are losing downward momentum and there is a risk that the US central bank is not in a position to cut rates as expected. As it stands, neither the inflation data nor the growth data appears to warrant a cut in rates.
There is a danger that the Fed’s current approach creates volatility. With falling bond yields reducing borrowing costs without the Federal Reserve actually having to cut rates, it can test the economy’s response to lower rates. If inflation expectations pick up, it can start to talk tough again. It may create a rollercoaster in terms of market expectations, with a rally and then a sell-off.
There could be a New Year hangover if rate cuts don’t materialise as expected.
Nevertheless, equity markets may continue to see rate cuts as good news until the economic impact becomes clearer. The key swing factor may ultimately be the US consumer. It has been the engine of growth for the US economy and beyond, buoyed by a healthy labour market and a store of pandemic savings. Yet these factors may start to ebb in the year ahead and we need to watch whether retail spending starts to dry up.
If the equity market rally looks vulnerable, there may also be pressures in the corporate bond market. Economic weakness could bring about higher defaults and there are already some signs of distress. At their current levels, credit spreads leave little margin for error and could move wider. For higher risk corporate bonds, this could counteract any fall in government bond yields. This argues for a higher weighting in higher grade corporate credit.
While no-one likes a party pooper at this time of year, this rally is going to be difficult to sustain. It is hard to envisage a scenario where inflation drops significantly, rates are cut, but economic growth is sufficiently buoyant to sustain earnings. There could be a New Year hangover if rate cuts don’t materialise as expected.
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