“The Federal Reserve left the fed funds target range steady at 5.25%-5.50% for a 7th consecutive meeting in June 2024, in line with forecasts. Policymakers do not expect it will be appropriate to reduce rates until they gained greater confidence that inflation is moving sustainably toward 2%. Meanwhile, the dot plot showed policymakers see only one rate cut this year and four reductions in 2025. Back in March, the Fed was seeing three cuts in 2024 and three in 2025. The Fed made no revisions to GDP growth projections and still sees the economy expanding 2.1% in 2024, 2% in 2025 and 2026.”

LAST QUARTER REVIEW

Thanks to the continuing strength of the US economy which shows no signs of impending recession despite the US Treasury yield curve inversion now being the longest in history. The Fed revised its inflation forecast higher for 2024 (2.6% vs 2.4% in the March projection) and next year (2.3% vs 2.2%) but kept its 2026 at 2% for 2026, while the unemployment projection rate for 2024 remains unchanged at 4%.

Longer term interest rates soared at times during the last quarter with the yield on the benchmark 10-year Treasury Note which began the quarter at 4.20%, at one point exceeding 4.7% while ending the quarter at 4.39%. The Treasury yield curve remains inverted all along the curve suggesting the risk of recession while seemingly receding based on other economic indicators remains a possibility as the interest rate on the 2-year Note began the quarter at 4.59% and ended at 4.71%

The US dollar remained strong throughout the quarter reflecting the expectation the Fed is likely to keep interest rates at current levels for now and the DXY index (a basket of other currencies) rose from 104.57 to 105.84. Currency markets appear to be pricing in a 66% chance of an interest rate cut in September followed by a strong possibility of another in November and potentially a third in December if inflation data remains accommodative.

The realisation that the US now looks increasingly likely to avert a recession in 2024 resulted in Wall Street continuing to climb to new highs as the iconic Dow Jones Industrials Average (DJIA) index recorded 40,000 for the first time and the more representative S&P 500 climbed another 3.92% and the tech heavy Nasdaq 100 rose an extraordinary 7.82%.

In the UK, the Bank of England (BOE) kept interest rates at 5.25% during its June meeting, as expected, while some policymakers noted that the decision not to cut was “finely balanced”. Recent economic indicators show inflation has returned to the target of 2%, but while GDP growth has exceeded expectations, underlying economic surveys suggest a slower pace going forward.

Interest rates at the long end of the UK bond market rose with the benchmark 10-year gilt yield rising from 1.99 to 4.18 while Sterling was steady throughout the quarter at around $1.26. UK equities continued to do well with the FTSE 100 climbing almost 3% and the FTSE 250 just over 2%, but the best returns were in smaller domestic stocks as the FTSE Small Cap index climbed more than 5%.

In the Eurozone, the European Central Bank (ECB) lowered the three key interest rates by 25 basis points in June, in line with expectations, marking a shift from nine months of stable rates following the fall in inflation of more than 2.5 percentage points since September 2023. The Eurozone economy expanded 0.3% on quarter in the first three months of 2024, recovering from a 0.1% contraction in each of the previous two quarters, which marks the strongest GDP growth since the third quarter of 2022, with net trade making the largest upward contribution

The People’s Bank of China left key lending rates unchanged at the June fixing, aligning with market expectations. The 1-year loan prime rate, the benchmark for most corporate and household loans, was maintained at 3.45%. Meanwhile, the 5-year rate, a reference for property mortgages, was retained at 3.95% following a record cut of 25bps in February. Both rates are at record lows, amid fragile economic recovery that reinforces calls for more support measures from Beijing.

The Bank of Japan unanimously maintained its key short-term interest rate at around 0% to 0.1% at its June meeting, as widely expected, after delivering the first hike in rates since 2007 and ending its eight years of negative rates in March. At the same time, the board indicated that it may consider how to start reducing bond purchases at its July meeting as the BoJ currently purchases about JPY 6 trillion in bonds per month.

Global oil prices showed extreme volatility with the West Texan Intermediate (WTI) at one point soaring to more than $87 a barrel before falling to less than $73 and ending the quarter barely changed at around $81. The oil price volatility is being driven by several issues, with some more complex and opaque than others, which include supply demand, anti-fossil fuel sentiment and increasing geopolitical concerns surrounding middle east tensions.

GDP Data shown are to the 31st March 2024; Interest Rate, Equity & Bond Index Data are to the 30th June 2024; 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.CURRENT CONSIDERATIONSThe last quarter was a pleasant surprise both from an economic and market perspective. What appeared to be an inevitable recession in the UK did not fully materialise and for now looks to be behind us while more importantly the world’s biggest economy, the US continues to show impressive, albeit slowing GDP (gross domestic product) growth.

Elsewhere global economic growth has faltered with Japan and Germany in recession and China barely posting positive growth. The high hopes investors had that once China had recovered from Covid, it would return to powering the global economy with its industrial growth and exporting strength have been dashed by its continuing property market (which accounts for 30% of the Chinese economy) malaise with seemingly no end in sight.

Some analysts are likening the problems China is experiencing with its property market to what Japan experienced in the nineties, which took the land of the rising sun decades to recover from. The continuing mistrust and tensions between the US and China geopolitically add to the unlikelihood of China playing a similar role in the global growth engine in the future that it did pre-Covid.

Wall Street has taken the continuing economic strength of the US in its stride with its benchmark equity indices consistently hitting new highs. At the same time the dollar has also been maintaining its relative strength in currency markets aided by the Fed’s decision to delay cutting interest rates.

While inflation has been slowing, interest rates at the longer end of the US Treasury (UST) bond market suggest inflationary pressures remain. The previously infallible recession indicator of an inverted UST yield curve appears broken.

However the fact the UST yield curve remains inverted suggests investors should be cautious when contemplating whether a recession is definitely not going to materialise, especially as the combined economic data remains mixed. On the positive side, data recently revealed by the Economic Cycle Research Institute (ECRI) suggests that the US is unlikely to experience a recession and that the Fed is right to delay cutting interest rates just yet because we could be at the start of a new secular inflation cycle.If this proves correct, then we can expect higher interest rates to continue for now, albeit with at least some reduction in base rates either later this year and or during 2025. While the  ECRI macro data has proved reliably accurate in the past, we must note as they observe, that it is too soon to say definitively that a new secular inflationary cycle is here to stay.

Additionally, more recent data (both macro and micro) out of the US suggest that much of the economic growth and Wall Street strength post Covid has been on the back of the $2 trillion fiscal injection to jump start the economy after the collapse due to the enforced lockdowns. The benefits of this largesse now seems spent with the individual savings ratio at all-time lows and retail feedback suggesting the only way corporate growth can now be achieved is with massive price cutting and discounting.

In addition the oil price which is usually a reliable barometer of economic strength remains relatively subdued despite the driving season in the US being almost upon us. Thus far, the increasing geopolitical tension and exchanges between the West and the East in the Middle East and Ukraine appears to have had little long term impact on fossil fuel prices.

If these trends persist, then the recession foretold by the yield curve inversion may still materialise, accompanied by a return to the secular deflationary era that had pre-Covid prevailed since the dotcom bubble bust at the beginning of the millennium. To an extent, and more so than necessarily in previous US presidential elections, the outcome on November 5th could play a big part in market sentiment as a clean sweep for the Democrats of the Oval Office, Senate and House would likely mean an increase in the corporate tax rate reduction introduced by President Trump in 2017 and put an added dampener on a slowing economy.

The alternative of a clean sweep for Trump and the Republicans would likely boost Wall Street stocks still further since an extension of existing tax cuts along with possible new ones would prove stimulative for the economy although likely import tariffs would negate sentiment to some extent. Perhaps reassuringly, the likelihood of a clean sweep for either side looks unlikely.

We must also consider the effect of servicing an ever-increasing government debt burden has on the US economy. Around $34 trillion and growing, this represents 122% of the country’s GDP in 2023, compared to historical data that shows Government Debt to GDP in America averaged 65.70% from 1940 until 2023, reaching an all-time high of 126.30% of GDP in 2020 and a record low of 31.80% of GDP in 1981.

Extensive academic research suggests that once an economy’s debt to GDP ratio reaches this level, hyperinflation is never far behind. However we must not forget that the GDP ratio of most western nations is not far behind the US and different rules apply when your currency is the reserve currency of the world. Accordingly the breaking point for the US debt /GDP ratio is likely much higher, but hopefully no future President and Congress will try to test these limits.

Meanwhile the elephant on Wall Street remains the influence and increasing market control of indexed funds. Arguably these have been a blessing for investors in good times and bad times during the past few decades as regardless of the economic backdrop, these funds keep on buying more of the most highly valued stocks and less of the value stocks.

Price discovery and value mean nothing to an algorithmic index fund which is programmed to buy regardless of fundamentals and in the percentages represented in the index. Naturally this means the magnificent seven which dominate the main large cap indices on Wall Street keep on getting bigger, while more fundamentally attractively priced value funds remain undervalued.Many market historians and analysts have begun to compare these stocks to the vastly overvalued Nifty Fifty that dominated Wall Street during the roaring twenties before coming down to earth with a bang in the crash of 1929. This is not to suggest the same will happen this time but it makes sense for risk averse investors to be mindful of the risks caused by the preponderance of index funds in all equity markets today, and increasingly in bond markets also.

FORWARD OUTLOOK

The challenge for investors remains trying to discern exactly where we are in the economic and inflation cycles. The data remains unclear as to whether the US has averted a recession or are we simply awaiting for the $2 trillion post Covid stimulus cheques to finally wash out before the consumer cupboard is shown to be bare as the majority tighten spending belts just to survive.

The increasing geopolitical tensions in the Middle East and Ukraine between Western and Russian interests add to the uncertainty in markets. While the outlook for the price of oil based upon supply and demand fundamentals would suggest the current range of between $70 and $90 is likely to continue, any escalation of current tensions in the Middle East could see a surge in the price which would have an adverse impact on stocks.

The possibility that the US economy is cooling and that a recession does eventually materialise either later this year or early 2025 makes having exposure to US Treasuries and other quality government debt and high yielding investment grade bonds within portfolios a sensible option. A new US Treasury bull market looks like it may have commenced in late 2023 and be set to continue during 2024.

However, we shall continue to exercise caution, just in case the excessive liabilities that US and global banks have in commercial real estate and multi-family apartment block residential property develop into a major banking crisis. We shall also be looking selectively at emerging market equities to add diversification and increase risk proofing.

In the UK, investors this year have finally seen some reward for their patience as the FTSE 100 (+2.66% last quarter) smashed through the 8000 mark, while the FTSE Mid Cap ( +2.02%) and FTSE small cap (+5.31%) have also rewarded investors. We expect these stocks to continue to reward investors with the FTSE 100 benefitting from the strength of the US dollar and the Mid-Caps and Small Caps continuing on the back of the improving UK economic outlook.

The UK election adds a little uncertainty to the UK macro picture short term, whilst an incoming Labour government could unease markets for a while. Longer term however, the UK economic outlook is not dissimilar to that of the US (albeit without the dynamism) with the likelihood of a return to recession receding.

As previously observed, the undervaluation of UK stocks remains unprecedented with the price to earnings ratio (PER) of the FTSE 100 at 10.4 times at the beginning of the year, compared to 26.1 times for the S&P 500, suggesting ample value opportunities. As the outlook for US dollar is continuing strength relative to sterling, this is another positive factor for UK large cap stocks as the FTSE 100 derives 80% of its earnings from overseas.

Maintaining a well-diversified and balanced portfolio remains key while we navigate a potential forthcoming recession. For now, we continue to advise a defensive 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 present themselves. 

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 1^st July 2024.

Data Sources: Bank Of England: Bloomberg; Brookings Institute; Economic Cycle Research Institute; European Central Bank; Financial Times; German Federal Statistical Office; Hoisington Investment Management; Macro Voices; National Bureau of Statistics China; Office for National Statistics; 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.