This week in the markets: shares hold up despite hot competition from rising bond yields; earnings season beats expectations; commodities eye another supercycle; and the world gets used to a stronger dollar.
Stock markets have stabilised over the past week, putting a floor under the mini correction since the late March high. That’s come in the face of increasing bond yields, usually a headwind for shares, which are rising back towards last October’s highs.
When bond yields rise, there is less incentive for investors to take on the stock market’s greater risk and volatility. If you can earn an almost no-risk 5% on a 10-year US government bond, then why bother with shares that can and do go up and down in value? So, the recent bounce back is an unexpected positive, and reflects the strength of the US economy and rising corporate earnings.
Last week delivered some unhelpful data in the US. GDP growth was disappointingly low while inflation was unexpectedly high. That’s a bad combination, familiar to anyone who lived through the stagflation of the 1970s. Specifically, the economy grew at 1.6% in the first quarter of 2024, well down from both the 3.4% achieved in the last quarter of 2023, and also the 2.5% consensus forecast.
Meanwhile inflation, as measured by the Fed’s preferred gauge, the Personal Consumption Expenditures figure, edged up to 2.7%, again above the most recent reading and forecasts.
Unsurprisingly, bond yields are nudging higher on the expectation that the Federal Reserve will struggle to get interest rates down this year as they and the market had hoped. Already, the futures markets have reined in their expectations from six quarter point rate cuts to only one or two. Investors are now even less optimistic on rate cuts than the Fed itself which has been more consistent in pointing towards three rate cuts this year.
The yield on the 10-year Treasury is now 4.7% which is where it stood last autumn when the market last fretted about higher for longer monetary policy. The optimism of late 2023 and early 2024, when investors picked up on hints from the Fed that it was ready to pivot lower, is now fading in the memory.
The fact that shares have managed to shake off this rising competition from fixed income is due in large part to the ongoing buoyancy of corporate earnings. As we push through the first quarter earnings season, results are once again emerging safely ahead of expectations. About 80% of the 280 or so S&P 500 constituents to have announced already, have beaten forecasts by on average 8%. The outlook for the full year is now for low double digit earnings growth, which suggests that the currently stretched stock market valuation will start to come down again soon. That’s allowed share prices to stabilise after the 6% slide from the late March high.
This week we are due to get two more of the key Magnificent Seven results announcements that have done so much of the heavy lifting in terms of supporting the market recently. Apple and Amazon report this week, and investors will hope they build on the pretty good showing of Microsoft, Meta and Alphabet last week.
The belief that US interest rates will remain higher for longer is also showing up in the currency market where the prospect of higher yields makes dollar assets look increasingly attractive. Nowhere has this been more evident than in Japan, where persistently low interest rates (barely above zero) make the yen look an ever less interesting destination for global investors. A US dollar bought nearly 158 yen last week, the most in more than 30 years, after the Bank of Japan decided to leave its interest rate at between zero and 0.1%.
A yen at this level is potentially problematic for Japan because it makes imports increasingly expensive and so threatens to ignite inflation. After years of deflation, that might not seem to be a huge problem, but it certainly complicates decision making by the BoJ.
Japan is also a very big holder of US Treasuries, so another potential consequence of the recent currency moves is the sale of US bonds by the Japanese government in a bid to manage its currency. That could push bond yields even higher in the US, with a knock-on impact in the stock market too. All of these markets are interlinked.
With all of this going on, attention will focus on Wednesday on the latest interest rate decision by the Federal Reserve. No change is expected but what Fed chair Jerome Powell has to say will be watched closely. As the US election approaches, the nominally independent Fed’s words become ever more politically charged. Donald Trump has already indicated that he sees the rise in the dollar as a big problem. Any market judgement for the rest of this year needs to take into consideration what might happen after November.
With so much attention on shares, bonds and currencies, one asset class that has received less attention is commodities. But here too there’s plenty to keep an eye on. That’s because there is a clear link between the price of raw materials and inflation. It’s not an easy one to read or to trade, but the link is there.
Over time commodities are a reasonable hedge against rising prices. They tend to keep up with inflation over time, but they do so in a volatile way, going nowhere for years on end and then suddenly taking off. So arguably they are not worth holding in a portfolio as a strategic asset allocation, but they can be worth a look at certain points in the cycle.
Indeed, every 30 years or so, commodities take off and deliver the markets best returns for a few years on the trot. Since the second world war there have been three of these supercycles and some believe that we may be on the cusp of a fourth. The first of these was driven by the second world war and the subsequent recovery which drove demand for metals and energy. Then in the 1970s, high inflation and a massive build out of US infrastructure and the Vietnam war drove another spike. More recently, commodities performed strongly from about 1999 to 2011 as China was brought into the global economy.
One hint that something may be afoot in the commodities space is the recent outperformance of commodity-related equities over the commodities themselves. Investors may be positioning for another upswing in prices. The bid by BHP Billiton for Anglo American is another sign that insiders see value.
The World Bank recently warned that the drop in commodities prices over the past couple of years had reversed and threatened to keep inflation and interest rates higher. A combination of factors is at work here. Geo-political tensions are keeping energy costs high while a rebound in activity in China as well as secular drivers like the move to net zero are pushing up demand for metals.
