Market View - 3rd Quarter 2023
“US Curve Inversion Expands to 1% After Powell Signals Fed Pause May Be Followed By More Tightening Thereby Deepening Bond Investors’ Concern Over A Potential US Recession” – Bloomberg News 21st June 2023
“Recessionary Fears In The UK Increased After The Unexpected Decision By The Bank Of England To Raise Interest Rates by 0.5% Instead of 0.25%. The BOE Initiated The Rate Hikes Nearly A Year And A Half Ago Making It The First Major Central Bank To Take Such Action And Resulting In The Fastest Policy Tightening In Over 30 Years” – Trading Economics 23rd June 2023
LAST QUARTER REVIEW
In June, the Federal Reserve (Fed) left the target for the funds rate unchanged at 5% -5.25%, but signalled rates may go to 5.6% by year-end if the economy and inflation do not slow down more In remarks made at the Semi-annual Monetary Policy Report to the American Congress last month, Fed Chair Jerome Powell advised inflation pressures continue to run high, and the process of getting inflation back down to 2% has a long way to go and will take time for the full effects of monetary restraint to be realised
US consumer price inflation which was 9.1% in May 2022 fell to just 4% in May 2023 from 4.9% the previous month, the lowest since March 2021 thanks largely to falling energy prices. The core inflation rate, which excludes volatile items such as food and energy slowed to 5.3% the lowest since November 2021, which justified the Fed’s decision to pause monetary tightening for now.
US Treasury (UST) bond yields at the long end were less volatile during the second quarter than they had been in the first quarter when a full-blown banking crisis looked possible. The daily closing yield range for the benchmark 10-year Treasury Note was between 3.3% and 3.84%, with the quarter end interest rate being 3.81%.
Likewise, the value of the US dollar was relatively stable throughout the quarter ending at 102.9 on the DXY index (a basket of other currencies) having been at around the same level commencing April. On Wall Street, the benchmark S&P 500 gained 8.39%, the Dow Jones rose 3.51% and the Nasdaq 100 more than 15% as bulls held sway while choosing to shrug off (at least for now) the likelihood of an economic recession.
In the UK, the Bank of England (BOE) raised interest rates (for the thirteenth consecutive time) by 0.5% to 5.0%, catching investors off-guard as the anticipation had been for just 0.25%. Arguably the writing was on the wall for the actual hike once the inflation print of 8.7% for May (unchanged from April) was in a couple of days earlier suggesting much stronger monetary medicine may be required to bring the rate anywhere near the desired 2% target!
So far this year the UK the British economy expanded 0.1% in the first quarter of 2023, the same as in Q4 2022, and matching market forecasts. The unexpected larger than expected interest rate hike sent the yield on the 10-year UK gilt down to 4.2%, having peaked at 4.49% during the quarter as the risk of recession increased.
In the Eurozone, the European Central Bank (ECB) raised interest rates by another 0.25% during its June meeting, bringing the rate on main refinancing operations to 4%, the eighth consecutive rate hike, and the highest since 2008. The ECB has already implemented an unprecedented 4% increase in rates over the past year, marking the fastest tightening pace in the history of the bank.
The ECB has also revised its inflation forecasts upwards and slightly reduced its growth projections, particularly for this year and the following year. Interest rates continue to rise in Europe because inflation remains stubbornly high at 6.1% in May 2023, albeit the lowest since February 2022.
As a result of the Eurozone economy shrinking 0.1% in the first quarter of 2023, and the final quarter of 2022 GDP number was revised to show a 0.1% fall, instead of a flat reading, the European economy is now technically in recession. The European stock market which is up more than 28% over the past 12 months, rose a more modest 2% during the second quarter.
At its June fixing, the People’s Bank of China (PBoC) slashed two key lending rates for the first time since August 2022 at the June fixing with the one-year loan prime rate (LPR), which is the medium-term lending facility used for corporate and household loans, lowered by 0.1% to 3.55%; while the five-year rate, a reference for mortgages, was trimmed by the same margin to 4.2%, in line with market expectations.
The Chinese economy grew by 2.2% on a seasonally adjusted basis during the first quarter, on the back of 0.6% growth in the fourth quarter and matching market forecasts. The Shanghai Stock market fell just over 2% during the quarter as recent data showed the recovery remains uneven.
At its June meeting, the Bank of Japan (BOJ) kept its key short-term interest rate unchanged at -0.1% and that for 10-year bond yields around 0%, while annual inflation rate in Japan unexpectedly declined to 3.2% in May 2023 from April’s 3-month high of 3.5%. The Japanese stock market continued to reward investors as the Nikkei 225 climbed more than 18% during the quarter.
Global oil prices fell again during the quarter with West Texas Intermediate (WTI) and Brent Crude futures around $70 and $75 per barrel respectively as fears of recession accelerated following interest rates rising in the developed markets of the West. Natural gas futures in Europe ended below €40 per megawatt hour after touching a nearly two-month high of €49.95 on June 15th, as volatility related to the possibility of lower supply and hotter weather eased.
|Q1 GDP||Annual GDP||Base Interest Rate||Equities Last Quarter||Equities Last 12 Months||Bonds Last 12 Months|
GDP Data shown are to the 31st March 2023; Interest Rate, Equity & Bond Index Data are to the 30th June 2023; Equity Indices used: US – S&P 500, UK – FTSE 100, Eurozone – Euro Stoxx 50, China – Shanghai Shenzhen CSI 300, Japan – Nikkei 225, Germany – Xetra Dax; Sovereign Bond Indices used: S&P US T-Bond, S&P UK Gilt Bond, S&P Eurozone Sovereign Bond (Eur), S&P China Bond, S&P Japan Government Bond, S&P Germany Sovereign Bond.
The BOE’s Monetary Policy Committee (MPC) caught markets and most investors by surprise at its June meeting when it raised the UK base rate (for the thirteenth consecutive time) by 0.5% instead of the anticipated 0.25%. The UK equity, bond and currency markets fell on the day in anticipation of the action prompting a recession which some had hoped the British economy could somehow avoid.
Arguably the MPC action should not have been a surprise following the release of data earlier in the same week that showed UK inflation in May was unchanged from April’s 8.7% more than double the rate in both the US and Euro Area. This was all the more concerning in light of falling energy costs, while the core inflation rate which excludes volatile items such as food, energy, alcohol and tobacco increased to 7.1% the highest since March 1992!
UK equity investors reacted negatively to the news as the benchmark FTSE 100 fell more than 2% during the week of the rate hikes, the largest weekly reversal since March. The anticipation of a UK recession resulted in the benchmark 10-year gilt falling marginally to almost 4.2% from 4.5% following the rate hike, while sterling’s dollar exchange value retreated to $1.27 from a 14-month high of $1.2848 a few days prior to the MPC’s action.
With the Eurozone already technically in a recession (defined as two consecutive quarters of negative GDP) and UK GDP barely positive (0.1% in Q1 and 0.1% in Q4 2022), markets will be relieved to see the anticipated US recession for now at least looks like it may be avoided. US GDP grew at 1.3% last quarter which followed an impressive 2.6% expansion during the last quarter of 2022.
The latest expectations according to the Atlanta branch of the Fed who run a real time GDP model that has historically proved fairly accurate most of the time suggests US economic growth is gradually slowing as it quotes, “The GDP Now model estimate for real GDP growth (seasonally adjusted annual rate) in the second quarter of 2023 is 2.2% on June 30, up from 1.8% on June 27.”
Admittedly, one month prior, the GDP Now model was estimating 2.9% for the second quarter and therefore the US economy appears to be slowing a little! Nevertheless, these resilient data suggest that just maybe the US Treasury’s (UST) 100% recession prediction track record since 1957 could be under threat!
Just to recap on the historical narrative, the US Treasury bond market has proved incredibly reliable when it comes to forecasting recessions as evidenced by several research papers and blogs over the past few years from the St Louis branch of the Fed showing that every recession since 1957 has been preceded by a yield curve inversion. The St Louis Fed research observes that the lag between the inversion and a recession varies with the lag for the 10-year and 1-year yields being between 8 and 19 months, with an average of about 13 months.
On the 12th July 2022, the Treasury Yield Curve was inverted all the way back to the 1-year bill with its closing yield of 3.07% compared to the benchmark 10-year note interest rate of 2.96%, suggesting that 2023 will see the US (and most of the developed world) economy suffer a recession. On the 16th November the yield on the benchmark 10 Treasury Note was 3.67% while the yield on the 1-month T-bill was 3.81% and interest rates along the curve all the way from the 10-year to the 1-month have remained inverted since then.
If the yield curve indicator is to be proved right again, and within the previously observed historic time frames, a US recession will have to have commenced anytime between February 2023 and January 2024 (19 months from July 2022 when the inversion commenced). Accordingly there is still plenty of time for the indicator to be proved correct, and if the Fed continues to hike as indeed it has suggested it will, the odds on a recession will shorten still further.
For some investors the optimism and confidence of Fed Chair Jerome Powell in following the May FOMC meeting at which the Fed raised the US base rate by 0.25% will be most reassuring as he commented, “as, you know, we’ve raised rates by 5% in 14 months, and the unemployment rate is 3.5%, even lower than where it was when we started, while job openings are still very high. So I think the case of avoiding a recession is, in my view, more likely than that of having a recession, although it’s possible that we will have what I hope would be a mild recession.”
Additionally the concerns the markets had during the first quarter concerning a potential global banking crisis after four sizeable US banks along with Credit Suisse in Europe collapsed and had to be rescued due to the pressures on their balance sheets from rapidly increasing interest rates appear to have receded judging by the bullish price actions on Wall Street. For now, the Fed can relax as the quick fix actions taken by the federal authorities appear to have halted the potential banking crisis at least in the short term.
The fast-declining inflation data for the American economy, now just 4.0% compared to 9.1% twelve months ago has given the Fed breathing space which it duly took advantage of by holding interest rates steady at its latest FOMC meeting last week! However the Fed’s reported reserve levels suggest that after a brief consolidation, bank deposits are again turning lower.
The reality is the US banking system is still sitting on a lot of bonds and loans that are yielding less than their current cost of capital. If the Fed carries through with its recent pronouncements of at least two more interest rate hikes in 2023, we could see another round of bank failures that would necessitate a sharp reversal of the monetary policy seen over the last twelve months to avert an economic meltdown.
Maybe the last word on the future potential for the US economy should go to economic research carried out by Fed economists Maximilian Grimm, Òscar Jordà, Moritz Schularick, and Alan M. Taylor at the San Francisco branch in a paper titled, “Loose Monetary Policy and Financial Instability”. They caution that, “Policymakers should take the dangers imposed by keeping policy rates low for long seriously, and thus weigh the potential short-run gains of loose monetary policy against potentially adverse medium-term consequences.”
The Fed research paper concludes that, “such policies increase the risk of financial crises and thus the risk of high social, political, and economic costs.” Accordingly the likelihood remains that soon the Fed will once more encounter the well-known ‘pushing on a string’ predicament that is the result of impotent monetary policies unable to address declining economic activity, declining inflation and declining money velocity.
For now, on Wall Street it is almost as if there was never a mini banking crisis or threat of recession as the benchmark S&P 500 has risen almost 16% year to date while the tech heavy Nasdaq 100 is up a remarkable 40%! This begs the question as to whether investors who have kept their powder dry and remained cautious have missed the first leg of a new bull market?
The likelihood remains that investors who have exercised caution and been underweight US and global equities will eventually be proved right as equity market bottoms on Wall Street have usually occurred after the Fed has ceased raising interest rates and switched to reducing them instead! Accordingly, the pivotal time to go long on Wall Street is usually when the Fed has cut rates sufficiently enough to steepen the yield curve.
As we noted at the beginning of this update, the previously infallible recession indicator of the US Treasury yield curve inversion has deepened further suggesting the US economy is a long way from being out of the woods! The silver lining is that it likely also signals the four decades plus old Treasury bond bull market remains very much alive and this year’s decline in long-term Treasury bond yields can probably be expected to continue.
Last year, with both equity values falling and bond yields rising, many market analysts and commentators suggested the traditional portfolio 60/40 equity bond asset allocation was past its sell by date. This seemed a rather premature prediction as 2022 was only the fourth time in more than a century of data that equity and bond allocations had both fallen in value over the calendar year!
While we continue to exercise caution for the reasons espoused above, we perceive the continued undervaluation of most UK listed stocks, especially those that are value oriented, as areas to which we might selectively increase portfolios’ allocations at this time. Widely held views that this is now the time to switch back to growth does not rationally make sense given current valuations and especially in a scenario where American and global recession is a distinct possibility.
We would reiterate that the arguments for longer term price appreciation in much of the commodity sector including energy and foods remains compelling, although short term, a European and UK recession will likely impact the demand side. It is worth reiterating that during 2022 spending on exploration & production (E&P) in oil and gas was the highest in history, as reality dictates we are decades away from having green energy replace the fossil fuels to power economic prosperity.
Accordingly, maintaining a well-diversified and balanced portfolio remains key while we navigate the potential for a forthcoming recession. We accordingly continue to advise a defensive position with regard to portfolio allocation with an emphasis towards value and income.
Allocation to Fixed Interest will be largely maintained via actively managed Bond and Multi Asset funds with a view to providing additional diversification and the potential to take advantage of future growth opportunities as they may arise.
We shall keep a close eye on developments and, in particular, any changes in investor sentiment with respect to both inflation and the global banking sector in order to determine when may be an opportune moment to look again to growth. As always, investment risk is at the forefront of our advice. Whilst it is often necessary to undertake adjustments in portfolio allocation to meet individual needs and preferences, we are confident that our advised portfolios will continue to remain well placed in meeting our clients’ overall objectives.
Copyright © Ash-Ridge Asset Management 1st July 2023.
Data Sources: Bloomberg; Brookings Institute; Economic Cycle Research Institute: Financial Sense; Financial Times; German Federal Statistical Office; Hoisington Investment Management; Macro Voices; National Bureau of Statistics China; Office for National Statistics; Real Vision; S&P Indices; The Cabinet Office Japan; The Economist; The Federal Reserve; The National Bureau of Economic Research; Trading Economics; UK Debt Management Office; US Debt Clock.org; Wall Street Journal; Zero Hedge.
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