This week in the markets: all eyes on interest rates as central banks meet on either side of the Atlantic and in Japan.
Interest rates have lost some of their capacity to move markets, but central bank policy remains a key driver of share prices.
Investors have long accepted that we have reached peak rates in the current tightening cycle and that the next move is down, in the English-speaking world anyway. What remains unclear is the timing of the first cut.
This week sees rate decisions from the Federal Reserve, Bank of England and Bank of Japan. The first two central banks are likely to sit on their hands again as they wait for clear evidence that inflation is under control. In the case of the Bank of England it will be the fifth no change meeting in a row after 14 consecutive rises from the end of 2021.
In Japan meanwhile the question is when interest rates start to head the other way. Japan is an outlier among the world’s central banks in its persistence with negative interest rates. But that is a position that is becoming more difficult to sustain as inflation nudges higher, fuelled recently by the most generous pay negotiation round in years.
What has narrowed significantly recently is the gap in expectations between the financial markets and the central banks. In the US, in particular, investors have started to fall in line with the Fed’s view that it will cut rates just three times this year rather than the six or so they were expecting only a few months ago.
Last week’s unexpected tick up in the rate of inflation cemented that more cautious view. The rise to 3.2% last month highlighted the challenge faced by the Fed in the so-called ‘last mile’ of the fight against rising prices. Economists had expected inflation to remain unchanged at 3.1% and the nudge higher triggered warnings that rates in the US may have to stay higher for longer than hoped.
The US, like the UK, has a 2% inflation target and getting there from the current level could prove difficult in the face of a strong jobs market where unemployment remains low by historic standards even if it too has started to edge higher. The US economy continues to create more jobs than economists expect.
Until now the narrative has focused on the positive soft landing outcome whereby inflation is overcome without undue damage to the economy from higher interest rates. The concern is now growing that inflation may be more persistent in a stronger than expected economic recovery from the pandemic.
Although it’s hard to prove, it does seem probable that central banks are concerned not to repeat the mistakes of earlier inflationary cycles when they called the all clear too soon and allowed prices rises to become entrenched. The 1970s were characterised by an apparent victory over inflation that reverted to a second inflation spike.
What is interesting from an investment perspective is the way in which good news on the economy is starting to become good news for investors too. For some time bad economic news has been seen as a prelude to falling interest rates and so welcomed by investors in a way that sometimes seems perverse to people unfamiliar with the way financial markets work. It’s an important shift in sentiment that chimes with the broadening out of the bull market from its narrow tech stock leadership to a wider market rally.
Another key factor in the timing of the first interest rate cut is the upcoming Presidential election. Although central banks are nominally independent of politicians, it is unusual for a central bank to start cutting interest rates very close to an election which argues slightly for a first cut in the summer rather than the autumn.
A similar calculus applies here in the UK, although unlike in America the timing of the election is uncertain because there is no fixed schedule and it is up to the Prime Minister to decide when to go to the polls except that the election must be held before January next year due to the five year term limit on a parliament.
Here too, inflation has fallen rapidly from its peak of more than 11% in late 2022 to just 4%. But that is twice the Bank of England’s target and wage inflation remains stubbornly higher than the headline rate. Although inflation is expected to fall rapidly through the spring on the back of lower energy bills, sticky wage inflation will make the ‘last mile’ tough over here too.
As it happens, the UK reports on inflation this week just a day before the Bank of England’s rate-setting announcement. Inflation is forecast to fall to a two and a half year low of 3.5% from 4% in January as lower food and goods inflation pushes price rises lower even before household gas and electricity bills get cheaper in April.
Looking more broadly at markets, the rally that got underway last autumn and surprised many by carrying on in earnest in the first few months of 2024 keeps pushing higher. The S&P 500 index, at 5,117, is now 46% higher than the October 2022 low. That is not excessive by the standards of earlier bull markets so the gain is not of itself a cause for concern.
Slightly more so is the rise in valuations from around 15 times earnings at that October 2022 low point to 21 today. With interest rates now thought unlikely to provide too much of a tailwind this year, earnings will need to start coming through in order to bring valuation multiples back to a less stretched level.
The good news is that they are doing so. Estimates are holding up well for 2024 and 2025, with high single digit or double digit gains pencilled in for both years.
Standing back to see the longer-term picture, this bull market is starting to look quite long in the tooth. Share prices bottomed out in 2009 after the financial crisis and with some volatility along the way they have now been rising for 15 years. That is still shy of the 18 years that share prices rose for between 1982 and 2000 but it is getting there. In baseball speak we are probably in the 7th or 8th inning of a 9 inning match.
That, of course, is the US market and while it is far and away the dominant stock market in the world it is not the only one. And elsewhere investors march to a different beat. Here in the UK, for example, the stock market is valued much more cheaply than in the US, at around 11 times earnings rather than over 20. With the economic and political situation looking much more stable than it has for nearly a decade since Brexit, there is a strong argument that the UK could see some catch up.
Another market which was very cheap and now looks a bit less so, but which has momentum on its side, is Japan. Here the story is focused on the benefits of governance reforms and a more market friendly corporate backdrop than had been the case in earlier years. The Japanese market recently cleared its 1989 peak and also seems to have the force with it.
A market that has definitely not benefited from positive momentum is China but here too things are starting to look better. One of the reasons that investors have shied away from Chinese shares in recent years has been the country’s struggle to emerge from Covid restrictions with the kind of robust economic growth that we enjoyed in the West as we came out of the pandemic. But this week we have started to see some green shoots of recovery with a 7% rise in industrial production, well above the 5% pencilled in by economists.
Any sign that China is getting over a period of deflation, low consumer confidence and a property credit crunch could be the trigger for overseas investors to reconsider what is one of the world’s cheapest major markets.