This week in the markets: shares remain stable in the face of escalating geo-political concerns; the dollar rises as rate cuts are taken off the table; and investors prepare for first quarter earnings season.
There is always something to worry about, which is why investors need to develop a sense of detachment. This is especially the case when geo-political concerns flare up as they have over the weekend.
The potential escalation of tensions in the Middle East in the wake of Iran’s retaliation to Israel’s recent attack on its consulate in Syria is a good example of an extremely worrying development that may or may not have a big impact on financial markets.
It’s tempting to seek out safe havens at times like these and sometimes that will be the right approach. But not always. It is worth reminding ourselves that the magical power of compounding does not work if you are sitting in cash on the side lines of the market.
But the equity market is clearly pausing for breath after the near 30% rise since its last wobble last summer. The S&P 500 is down around 2.5% from its April 1st high - a bit more than that for the equal weighted version of the index which had been catching up recently.
The everything rally that had taken 85% of shares above their 50-day moving average has lost momentum. Just 44% of stocks are now up on this measure of momentum.
The parts of the market that tend to do well at times of stress are acting as you would expect. Gold, in particular, is living up to its reputation as a safe haven asset, hitting $2,400 an ounce last week as Middle East tensions combined with worries of persistent inflation to make the case for the precious metal again.
Gold can languish for years and then suddenly take off when the circumstances are right. It happened in the 1970s as uncertainty and inflation combined in a worryingly familiar way from today’s perspective.
That’s prompted some bullish forecasts for gold including one from the chief strategist at BNP Paribas looking for the metal’s price to rise to $4,000 an ounce in the near future.
There are many drivers of a higher gold price. One is heavy central bank buying, including from China, as the co-operative relations between countries during the Great Moderation years starting in the 1990s begin to break down.
Something similar happened in the 1970s as the Bretton Woods currency system began to break apart against a backdrop of rising inflation and the Cold War.
Another reason to be bullish on gold is the worrying picture on US government debt which is rapidly becoming unsustainable some believe. US debt stands at 99% of GDP and is on track to reach 170% within 30 years according to the congressional Budget Office.
One of the only things that politicians can do if debts run out of control is reduce the cost of their interest payments so despite its nominal independence the Federal Reserve could easily be pressured into cutting interest rates even in the face of inflation. Were that to happen, gold would be a rare safe haven.
The other asset to have responded positively to rising tensions is oil. The price of crude edged down to $90 a barrel after the weekend’s events suggested that the risk of a wider conflict had reduced. Iran said it thought the matter ‘concluded’ after it launched a well-flagged military strike on Israel. With the US telling Israel that it would not participate in any further military initiatives against Iran the temperature cooled somewhat.
But oil has still risen from less than $75 a barrel in December to over $90 today. The oil market had been relatively complacent about the prospect of the Gaza conflict rippling out into a wider regional fight. But recent events have started to focus attention on what is already a relatively tight oil market as demand rises in the US and China while OPEC producers continue to constrain supply.
A third asset that invariably rises in line with global tensions is the US dollar. The US currency had its strongest weekly performance since 2022 last week, boosted also by unexpectedly robust inflation data. The dollar was up 1.7% against a basket of other leading currencies as traders reversed bets on an early pivot towards lower interest rates by the Fed.
The euro and sterling are at their weakest levels against the dollar since November at $1.06 and $1.24 respectively as investors bet that the differential in rates across the Atlantic will widen. Divergence is the buzzword in markets now as the ECB last week said it was still on course to deliver a first interest rate cut in June.
The US, by contrast, may only now have one or two rate cuts this year. That compares with the Fed’s long-held view that it would cut three times and the market’s view as recently as the start of the year that there would be six rate cuts in 2024.
The fall in the pound has been a positive for the UK stock market because many of the UK’s leading companies earn a high proportion of their revenues in dollars. There is also a bias towards oil and gas and other commodities that are favoured by investors’ current preference for so-called hard assets. The UK benchmark remains close to its all-time high at just under 8,000.
One asset that has not benefited from the higher-for-longer interest rate environment is bonds. Expectations for a delay to the forecast cut in interest rates has pushed bond yields higher, hitting the price of bonds which moves in the opposite direction.
Although the rise in bond yields is bad news for existing holders of fixed income assets, it does make the asset class increasingly attractive to income seeking investors. Private investors have been piling into government bonds in recent months to lock in high yields as rates stay higher for longer.
Of particular interest are short-dated government bonds which were issued when interest rates were low during the pandemic. Because of a quirk in the UK’s tax system, tax is only payable on the interest paid on a gilt but not on any capital gains. Low-yielding gilts trade at less than their par value in a higher rate environment and most of the total return comes in the form of a tax-free gain, making them attractive to investors holding assets outside tax sheltered vehicles like ISAs or pensions.
One thing to watch for fixed income investors, however, is the increasing tendency for bonds to move in the same direction as shares. We saw that in October last year when fears that interest rates would stay higher for longer hit both shares and bonds. This was also the pattern during the 2022 bear market when shares and bonds both fell over the calendar year for the first time in many years.
If bonds and shares are no longer uncorrelated as they were for many years from the 1990s onwards, then the attraction for investors of holding a portfolio balanced between the two assets will be diminished. Investors looking for diversification will need to look further afield, maybe incorporating more gold, commodities and property in their portfolios to achieve a smoother ride.
One of the reasons that stock markets are holding up well in the face of rising geo-political tensions is the fact that corporate earnings are growing again, justifying the higher valuations for shares as markets have risen.
This week the first quarter results season gets underway with the big US banks as usual the first out of the blocks. In the next few days, we will see results from Goldman Sachs, Bank of America and Morgan Stanley as well as other financial companies like American Express and Charles Schwab.
The outlook for earnings is key to whether or not the market can hang onto its substantial gains since the market low in October 2022, and for now things look promising. Earnings growth is expected to improve incrementally through 2024 until by the end of the year profits are growing in the low double digits on average year on year.
That will help reduce the currently stretched valuation of the US stock market, which trades on more than 20 times forecast earnings, up from a mid-teens multiple at the market low. Multiples in the rest of the world, including the UK and Europe, are considerably lower than in the US, but so too are growth expectations.
