“The Federal Reserve kept the target range for the federal funds rate at a 22-year high of 5.25%-5.5% in its September 2023 meeting, following a 25bps hike in July, and in line with market expectations, but signaled there could be another hike this year.” – Trading Economics 20^th September 2023

“The Bank of England held its policy interest rate at 5.25%, keeping borrowing costs at their highest level since 2008. It was the first pause in policy tightening in nearly two years, following the central bank’s unprecedented 515 bps hikes.” – Trading Economics 2^1st September 2023

LAST QUARTER REVIEW

The Federal Reserve (Fed) paused in September keeping the federal funds rate at a 22-year high of 5.5%, with policymakers envisaging the fed funds rate at 5.6% by year end, and at 5.1% during 2024. GDP growth is expected to be stronger than previously anticipated at 2.1% for 2023 (2.0% Q1 and 2.1% Q2) and 1.5% for 2024, while inflation is expected to decline to 2.5% for 2024.

US consumer price inflation accelerated for a second straight month to 3.7% in August from 3.2% in July, which was above market forecasts of 3.6%, with the increasing cost of oil and fossil fuel products a major factor. However, the core inflation rate which excludes volatile items such as food and energy slowed in August for the fifth month to 4.3%, in line with market expectations.

US Treasury (UST) yields continued to rise all along the yield curve, reflecting both market concerns for inflation and a potential dollar crisis on the back of the burgeoning American fiscal debt now at more than $33 trillion or 120% of GDP, while the budget deficit approaches $2 trillion. The end September interest rate for the 2 year Note which began the quarter at 4.94% was 5.03%,while the benchmark 10-year Treasury Note which began at 3.86% closed the quarter at 4.50%.

However, contrary to market fears, the US dollar increased relative to most other major currencies, with the DXY index (a basket of other currencies) rising from 102.9 to 106.18. On Wall Street, the benchmark S&P 500 fell 3.73%, the Dow Jones lost 2.71% and the Nasdaq 100 fell 3.06% as the bulls finally appeared to acknowledge the Fed’s monetary strategy is unlikely to engineer a soft landing and avoid economic recession.

In the UK, the Bank of England (BOE) held its rate at 5.25% at its latest Monetary Policy Meeting (MPC), the first pause in almost 2 years following a total increase of 5.15% during that time. The BOE stated Consumer Price Inflation (CPI) is expected to decline significantly in the near term (6.7% in August from 6.8% in July), reflecting lower anticipated energy inflation, and further declines in food and core goods price inflation.

The British economy has managed to avoid recession (defined as two consecutive negative quarters) thus far, having grown 0.1% in the first quarter and 0.2% in Q2. However, business activity declined the most in over two-and-a-half years during September, driven by sharp decreases in both manufacturing and services output.

In the Eurozone during its September meeting, the European Central Bank (ECB) raised interest rates for the tenth consecutive time by 0.25% to 4.5%, while suggesting further hikes should not be necessary. The annual inflation rate in the Euro Area at 5.2% dropped to its lowest rate since January 2022 after having been 9.1% just a year ago.

As with the UK, the Euro Area is teetering on the edge of recession after the economy grew by just 0.1% in Q1 2023, and -0.1% in Q4 2022. The Euro Area’s largest economy Germany is in recession according to the last three quarters GDP data (-0.4%, -0.1%, % 0.0%) amid cooling investments in construction, machinery and equipment.

At its September fixing, the People’s Bank of China (PBoC) maintained lending rates as policymakers assessed the impact of previous easing measures, including an interest rate cut in August and a recent reduction in the reserve requirement ratio for banks. The one-year loan prime rate (LPR), which is the medium-term lending facility used for corporate and household loans, was kept unchanged at a record low of 3.45%; and the five-year rate, a reference for mortgages, was held at 4.2% for the third straight month.

The Chinese economy expanded just 0.8% in Q2, slowing sharply from the 2.2% during the first quarter, suggesting the recovery in the world’s second-largest economy is losing momentum due to the ongoing property downturn, the possibility of disinflation, record high unemployment rates among young adults, and declining exports. The Chinese stock market also faltered with the Shanghai Composite falling nearly 3% during the quarter.

At its September 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%, stating it would patiently continue with monetary easing and respond to development in economic activity, the dynamics of prices, and financial conditions, amid extremely high uncertainties at home and abroad. During the last quarter, Japanese inflation remained largely unchanged at 3.2%, while the stock market was broadly flat, but the yen lost further ground against the US dollar moving from 145 to 150.

Global oil prices rose strongly during the quarter with the WTI crude futures above $90 per barrel, after rising to as high as $95, the highest in over a year as a sharp decline in US crude stockpiles exacerbated concerns about tight global supplies. European natural gas futures doubled during the quarter, from a low of less than €20 per megawatt-hour to more than €40 due to supply concerns as winter approaches, despite healthy current inventories in Euro Area.

GDP Data shown are to the 31^st July 2023; Interest Rate, Equity & Bond Index Data are to the 30^th September 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.

CURRENT CONSIDERATIONS

With the exception of the ECB, none of the major developed market central banks increased interest rates at their September meetings, suggesting the concerted monetary tightening actions begun in late 2021 by the BOE are at or near completion. This is hardly surprising with both the UK and Euro Area economies on the brink of recession, and economic expansion in both China and Japan slowing.

Only the US, the world’s largest economy appears to be still powering ahead, with the latest estimate from the Atlanta Fed’s real time GDP model suggesting 4.9% expansion in the third quarter, following growth of 2.1% and 2.0% respectively for the first two quarters of this year. A key question for markets to ponder remains whether the Fed will be able to engineer a soft landing, or will the recession signposted last summer by the inversion of the US Treasury yield curve materialise within the timeframe dictated by this previously infallible indicator?

Every US recession since 1957 has been preceded by the US Treasury bond market yield curve inverting, and research by the St Louis Fed shows the lag between the inversion and a recession has ranged from 8 to 19 months, with an average of about 13 months. The yield curve inversion has steepened over the past year with the interest rate on the Treasury-10 and Treasury-2 notes currently at 4.50%, and 5.02% respectively and on the 1-month Treasury Bill at 5.55%.

While the most widely followed recessionary signals of economic growth (GDP) and employment data remain vibrant in the US, these are lagging indicators that only provide confirmation of a recession in the rear-view mirror. However a number of early warning key indicators as clearly identified by long term independent research firm ECRI and others already suggest the US is headed for a hard landing sometime during the next nine months.

These indicators include consumer spending (officially known as “personal consumption expenditures”), which accounts for over two thirds of US GDP, and has recently been close to a record high of more than 70%. Counter-intuitively, consumer spending has historically surged in the run up to a recession and remained elevated until GDP expansion recommences.

Meanwhile US Gross Private Domestic Investment (GDPI) has been declining markedly, which historic data reveals is another tell-tale signal of approaching recession. Of course, a potential US and global recession will have implications for equity, bond and currency markets as it unfolds.

Many market commentators have been expecting the US dollar to fall as a result of the US’s unprecedented national debt now exceeding $33 trillion (including credit card debt at an historical high of $1 trillion) in an economy valued at $27 trillion. Additionally, strained political relations with China, Russia and many other oil producing nations has led to concerns that the days of the petro-dollar as the reserve global currency may be nearing an end.

Admittedly there have been plenty of statements from China, Russia and other nations (including the BRICS plus group) that they will bypass the dollar and trade with each other in alternative currencies like the yuan, rouble or gold. However, the reality is that the sheer size of the offshore eurodollar market at $30 trillion plus (some suggest nearer $80 trillion) and the liquidity convenience it affords corporations and business of every nation makes this geopolitical threat unlikely to materialise in the foreseeable future.

When speculating about the dollar’s future, many market commentators fail to appreciate that despite countless years of quantitative easing (QE), multiple stimulus campaigns, bailouts and helicopter money, the greenback is almost 20% higher today than it was at the beginning of 2008 at the commencement of QE in response to the collapse of Lehman Brothers. Accordingly, if the dollar’s value follows the same pattern as it has in previous global recessions and financial crises such as Covid, it should actually strengthen from its current value of around 106 on the DXY (up more than 5% since its third quarter low) and possibly exceed the 114 it reached in October 2022.

Meanwhile, the latest data from a combination of the International Monetary Fund, Bank for International Settlements and the Institute of International Finance show total global debt of $305 trillion compared to just over $200 trillion ten years ago. The reality is that if recession commences in the US economy either this quarter or early 2024, it will likely be triggered by a phase two credit cycle downturn that will follow on from the banking crisis that occurred in Q1, that the US Treasury and Fed managed to nip in the bud (as detailed in our second quarter MV).

As interest rates across the US debt curve keep rising in anticipation of further hikes from the Fed, the catalyst for the credit crisis is already in place as the costs of servicing debt continue rising. However, in light of the crippling global debt levels, the increases in interest rates of the past couple of years are likely an aberration and not a return to a “normalization” of the higher rates of the late 20th century.

The interest rate hikes of 2022 and 2023 were necessitated by central bank policy errors in reacting too slowly to the excessive short-term stimulus that had to be injected following the Covid lockdowns, and not by genuine long term supply demand inflationary pressures. The delayed response of the Fed and other central banks has resulted in much higher interest rates than would otherwise have been likely needed and has put enormous pressure on the cost of refinancing.

Vulnerable sectors include high-yield bonds, as higher risk-free rates have led to a pronounced shortening in the maturity profile of the index, and the accompanying risk should interest rates stay high. For investors, the onset of a US recession as signalled by the Treasury yield curve would herald attractive potential returns in the bond market and especially US Treasuries, as inflationary pressures quickly dissipated, and were followed by a resumption of the secular deflationary trend that had until recently prevailed since the dotcom collapse of 2000.

In this scenario, the Fed and other central banks would have to quickly begin slashing interest rates in an effort to limit the recessionary fallout. Conversely, confirmation of economic recession will likely see the value of Wall Street stocks decline markedly, including the seven mega tech stocks (Amazon, Alphabet, Apple, Meta, Microsoft, Nvidia, and Tesla), which have accounted for most of the 12% appreciation of the S&P 500 and the 36% of the Nasdaq 100 indices during 2023.

Once the full impact of a recession was assessed and digested by Wall Street however, an attractive buying opportunity in both US and global stocks would soon materialise. At that stage, investors who have kept some of their powder dry and remained cautious will be well placed to take advantage a new equity bull market.

FORWARD OUTLOOK

It is worth reiterating that equity market bottoms on Wall Street have usually occurred after the Fed has ceased raising interest rates and begun 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 an American recession (which will exacerbate the current global anaemic growth) looks to be coming into view either this quarter or early 2024, we shall be looking to take advantage of opportunities in the US Treasury bond market in anticipation of interest rates falling all along the yield curve. We shall also be carefully evaluating Wall Street following the inevitable correction that will occur, to determine the optimal inflection point when the bulls are back in control.

Meanwhile, the undervaluation of UK stocks is clearly evident when comparing the current price to earnings ratio (PER) of the FTSE 100 at just 11.4X compared to the index’s three-year average PER of 20.9X! This is further emphasised when looking at US stocks (PER of 26.8X and three-year average of 31.5X), even allowing for an historical premium for American valuations.

The biggest undervaluation remains in the mid cap (FTSE 250) and small cap stocks, where investors are provided an extra layer of value through typically higher dividend yields. Some especially attractive longer-term sectors include the UK oil and gas industry (current PER of just 5.1X).

A global recession will probably exacerbate this undervaluation still further; nevertheless the arguments for longer term price appreciation in much of the commodity sector including energy and foods remains compelling, Remember, that in 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 fossil fuels to power economic prosperity.

Both the gilt market and high yielding dividend stocks should also benefit longer term from the aging UK population as both the government and large corporations look for ways to bolster their pension offerings for employees. Accordingly, we envisage attractive opportunities in the near future to increase exposure first to fixed income funds focused primarily upon US Treasuries and UK gilts, and subsequently to US and global equities once we have reached the bottom of the recessionary business cycle.

Maintaining a well-diversified and balanced portfolio remains key while we navigate a potential forthcoming recession, and for now we continue to advise a defensive portfolio allocation with an emphasis towards value and income. The 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  October 2023.

Data Sources: Bank Of England: Bloomberg; Brookings Institute; Economic Cycle Research Institute; 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; Zero Hedge.