Will equities benefit as interest rates fall?

So far this year, the S&P 500 index is up by 13% in sterling terms and the FTSE 100 has delivered a 9% rise. These have outstripped continental Europe, which has gained 7% in sterling terms. Investors will also have enjoyed some dividend income.

We have in the past set out the diversity of emerging market economies and the wide range of different equities listed on their exchanges. In terms of gains in the main equity index, India at 12% and Taiwan at 18% are the two leaders this year, with Brazil losing 15% and China down 4% in sterling being the big laggards.

Emerging markets remain a varied group of countries with different economic prospects and aligned with different trading blocs and groupings. Political risk can be an issue. Emerging economies in the main can benefit from more global economic expansion and a weaker dollar as some have begun to do.

A good year for sterling so far

In 2024 to date sterling has been strong, reducing gains on overseas holdings unless the investor had taken out currency protection. The yen has been especially weak, though it had a major rally when the Japanese authorities introduced a positive low interest rate after a long period of no interest rate support for the currency.

The dollar has recently weakened on market beliefs that US rates will now be taken down more quickly, reducing the attractions of the currency. The euro has gently appreciated against the dollar, despite an interest rate cut – but is also down against sterling. The euro enjoys some strength from the good balance of payments position of the bloc.

The UK has benefitted from a much better economic performance this year so far. Its growth leads the G7 list in the first half of the year and inflation has come back down to the Bank of England’s 2% target. Despite this, it is thought rates will stay higher for longer as inflation is sticky, given the strong bias of the economy to services and continuing wage pressures.

All currencies have suffered when compared with gold in recent months, as the precious metal has hit new price highs. Some see gold as a good hedge against inflation, over longer time periods. That is not always true for any given year or two, even when inflation takes off. Recently, gold has been given a boost after India cut tax on imported gold. This implies a likely increase in demand as Indians like acquiring gold and gold objects for their homes and personal adornment. There is also steady central bank buying. Gold tends to do better when interest rates are lower, cutting the return on safer assets such as cash and short-dated government bonds.

Where are we in the cycle?

Covid-19 lockdowns distorted the cycle of many economies by inducing a sudden and large slump in activity. The Western central banks then created a new cycle, with excessive credit allowing a recovery that helped trigger a fast inflation. These price rises were exacerbated by the impact of the Ukraine war on energy and food prices.

This spike in inflation was followed by tough monetary tightening, resulting in a slowdown. In the case of parts of the European Union, this entailed entering a recession. It was an unusual and brutal cycle noted for the speed of the changes.

We are now embarking on an expansionary phase. China was locked down for longer. It did not inject so much money to support its economy and avoided the big inflation seen in most Western nations. The Peoples Bank of China is now relaxing money and credit, as well as bringing interest rates down to promote more growth.

Japan continued its money creation and bond buying throughout the pandemic period, without accelerating the money supply as much as the West – it thus avoided a big inflation spike.

More recently, Japan has moved in small steps to remove zero and negative rates of interest. The country has recently recorded a bit more growth based on consumption, as wage increases come through. The Bank of Japan will want to tighten monetary policy a bit more against the global trend but must be careful not to overdo it given the government’s huge dependence on borrowing.

The US Federal Reserve is poised to cut interest rates and to shift its main worry from inflation to employment prospects. The Europeans have started cutting rates and have more to do to stimulate their economy, where the manufacturing sector led by Germany is still weak. Both Germany and France have manufacturing purchasing managers’ index (PMI) readings down at 42 in August, showing continuing weakness, whilst Italy and Spain are faring a bit better.

The UK may get some more Bank of England relaxation but faces a fiscal tightening as the new government looks to raise taxes as it reports budgetary pressures. The UK is likely to slow from the good growth achieved in the first half of 2024. So far, it has been well ahead of the Bank of England and Office for Budget Responsibility (OBR) forecasts this year.

Bad economic outturns and political change

The surge in inflation on both sides of the Atlantic triggered by the monetary policies during the pandemic and the events in energy markets were unpopular with voters and have left incumbent governments struggling to stay in power. The price rises led to cuts in real incomes and undue pressure on household budgets. There have already been big defeats for President Macron’s party in France, for the UK Conservatives and for the governments of the Netherlands and Portugal.

In Germany the ruling SPD trails way behind its centre-right opposition rivals ahead of its federal election in a year’s time. Its unpopularity emerged in stark terms in the two regional elections last Sunday. In the US where growth has been stronger thanks to an expansionary fiscal policy offsetting some of the effects of tighter money, the two main parties are very close in the polls. The economy remains a negative for the incumbent Democrats.

Likely market implications?

Bond markets have been discounting falls in interest rates whilst not expecting longer-dated bonds to experience the same big drop in yields they did during Covid-19. Equities should benefit from easier money and efforts around the world to boost growth and output.

Inflation is largely under control in the main economies. There are varying degrees of difficulty in labour markets as the tough policies lead to fewer hirings and more unemployment in some places, which will temper consumer demand. Where this happens, the central banks are likely to drop rates further.

There are signs this year of gains in equities broadening out from their reliance on the dominant US technology sector. The economic conditions imply more scope for some non-technology sectors to expand turnover and margins.

Read more: Market commentary for August 2024