This week in the markets: shares enjoy the best week in months as central banks signal interest rate cuts; the UK starts to attract bargain hunters; and corporate bonds are in favour as investors seek to lock in higher rates.
The bull market continues. US stocks enjoyed their biggest weekly gain in three months last week. Shares rose 2.3% on the week after Fed chair Jerome Powell confirmed that the US central bank is hoping to cut interest rates by three quarters of a point this year.
The Nasdaq index, which tends to be even more sensitive to movements in interest rates, was 2.9% up on the week. The S&P 500 has now risen by 27% since last October’s low point and is nearly 50% up on the October 2022 low.
Other markets picked up on the positive tone. The FTSE 100 had its best week since last September, up 0.6% on Friday to 7,930 after a 1.9% gain on Thursday in the wake of bullish noises from the Bank of England. At that level, the UK benchmark is closing in on its all time high, struck in February 2023 of 8,047.
As in the US, the expectation of lower interest rates was the driving force of the rally. Andrew Bailey, the governor of the Bank of England, said markets were right to expect more than one rate cut this year.
He said that rate cuts were ‘in play’ at future meetings this year, calling the fight against inflation ‘an increasingly positive story’. Inflation in the UK has fallen from a peak of 11.1% to just 3.4%, heading back towards the Bank’s 2% target.
In other markets, European shares were 1% up on the week, while Japan’s Nikkei index soared by 5.6%, despite the Bank of Japan increasing borrowing costs for the first time since 2007. Although the BoJ ended a prolonged period of sub-zero interest rates, it made it clear that it is unlikely to increase the cost of borrowing sharply after Tuesday’s rise.
Finally, the Swiss National Bank became the first big central bank to start cutting interest rates last week when it unexpectedly reduced its headline rate to 1.5%.
The expected turn in the interest rate cycle has focused investors minds on locking in higher incomes while they are still available. That has been particularly noticeable in the corporate bond market where a record amount of money has flowed in this year in the US. Inflows of $22.8bn represent the first positive start to the year since 2019 when a similar amount had been invested by the same stage.
Investors are mostly favouring so-called investment grade bonds, issued by the highest quality companies. But high yield, or junk, bonds are also attracting interest. This has pushed the premium demanded by investors for the riskiest debts down to levels last seen before the financial crisis.
Although the US economy is firing on all cylinders at the moment, with high levels of job creation and low unemployment, worries are growing that investors’ enthusiasm for bonds is pushing the market to overheated levels. If there is an uptick in company failures as the delayed impact of higher rates kicks in, some investors may find that they are not being adequately compensated for the risks they are taking.
The rally in the bond market is predicated on falling interest rates which may be delivered more slowly or less forcefully than investors hope. That in turn would threaten the ‘soft landing’ narrative that is currently buoying the outlook for both shares and bonds. Bringing down inflation without causing damage to the economy is a rare feat for central banks.
Another threat to bond prices is the fact that companies are also flocking to the bond market, issuing a record $561bn of dollar-denominated bonds in the year to date. High yield bond issuance has also risen fast, up 64% to its highest level in three years.
The premium above safe government bonds, known as the spread has tightened in recent months. The average investment grade spread is now just 0.92% down from 1.04% in December. High yield spreads, meanwhile, have fallen from 3.39% to 3.14% over the same period.
Just as equity investors seem to be suffering from a kind of FOMO, fear of missing out, so too bond investors seem to be afraid of missing out on the opportunity to lock in today’s yields.
Back to the stock market and a key feature of the current rally has been the participation in it by UK shares, which have tended to underperform other markets recently.
The key driver of this catch up by British stocks appears to be a growing realisation that the UK market stands at a record valuation discount to other market like the US. With US shares trading at around 21 times expected earnings, the 11 times multiple on which UK shares stand is a historically wide discount.
Fund managers are, in aggregate, more underweight UK stocks than any other category covered by the monthly Bank of America global fund manager survey.
The key question is why UK shares are so cheap. They appear to be on the wrong end of a number of different trends. One is the preference for growth shares rather than the value shares that the UK is weighted towards. For a long period of time now, growth has outperformed value. In the US, for example, where there is good data on this, the Russell Value index stands at a discount of nearly 50% to the Russell Growth index. Five or six years ago that discount stood at just 10%.
The second trend is for investors to favour investing in the US. And for investors to be willing to pay more for US companies perceived growth and defensiveness. The third trend is a size effect. US companies tend to be much bigger than in the UK. Even stripping out the top ten mega-caps, the average S&P 500 company is twice the size of the average UK stock. Investors have been favouring big stocks recently.
So, there is scope for some catch up. An interesting question then is whether at the individual stock level, after controlling for these market wide factors, UK shares are much cheaper than equivalent US companies. Here the evidence is mixed.
Back of envelope analysis by the FT shows that the difference in valuation between say a Shell and a Chevron, or between Unilever and Colgate might actually be justified by their worse growth and return on capital prospects. Maybe big US companies are just better than their equivalents over here.
A key anniversary was passed this week. It is the 100th birthday of the mutual fund. Only in 1924 did investors gain the opportunity to safely invest in a portfolio of individual company stocks, getting the benefit of diversification with a level of transparency and liquidity to get in and out of an investment at the underlying asset value of its holdings.
The anniversary comes at a testing time for traditional open-ended mutual funds. Although they still dominate the market for pooled investments, ETFs, often passively invested, are catching up fast. Between 2014 and today, US ETF assets quadrupled from $2trn to $8trn. That is still well short of the nearly $20trn held in mutual funds in the US and three times as much worldwide, but the gap is narrowing.
Actively managed mutual funds have been the biggest losers in recent years, with $1trn in outflows between 2021 and 2023. During the same period ETFs saw $2trn of inflows, powered by lower costs and the launch of attractive new options such as cryptocurrency ETFs last year. As one observer said, ‘it’s a better mousetrap’ and fund managers who have built businesses based on open-ended funds are having to adapt fast to a changing investment landscape.