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Article | 21 August 2023 | Investments
The US Federal Reserve (Fed) resumed its rate hiking path in July, with interest rates hitting a 22 year high. However, as US inflation continued to moderate, the Fed insisted it would be ‘data dependent’ regarding further rate hikes this year. The European Central Bank (ECB) and the Bank of England also raised rates, despite falling levels of inflation. The Bank of Japan took a surprise step on the path to tighter conditions, tweaking its yield curve control policy to allow a greater degree of flexibility. Conversely the People’s Bank of China cut a short term policy rate, in order to stimulate economic demand.
Global equities rallied over July, on hopes of a soft landing for the US economy, then became more mixed as the summer progressed. Government bond yields edged higher on robust economic data. The yield on the benchmark 10 year US Treasury moved above 4% and touched a 15 year high in mid August, while the German 10 year Bund yield traded above 2.5%. Yield curves remained inverted, however the extent of the inversion lessened, indicating that a more moderate US recession is anticipated. Brent crude oil jumped above $85 per barrel, on hopes of further Chinese fiscal support and as OPEC+ production cuts restricted supply. The US dollar traded at a two month peak, after the release of hawkish minutes from the Fed’s July meeting. Central bank intervention was anticipated in both the yen and renminbi markets.
Hawkish central bank rhetoric indicates further interest rate hikes. Markets are beginning to feel a little overstretched, following a near 30% rise in US equity markets and a 27% rise in eurozone markets since October 2022. Near term upside for equities could be capped by low summer volumes and traditionally negative markets during September. Nonetheless, the macroeconomic backdrop is increasingly benign, given an improving inflation outlook, strong labour markets and reasonably resilient economic data, so any market correction is not expected to be material or long-lived. In the meantime, hawkish commentary from the US Federal Reserve (Fed) could raise fears of higher or ‘higher for longer’ interest rates. With these risks in mind, our sense is that the Fed and other central banks might intentionally maintain such rhetoric, attempting to combat market complacency or overoptimism, which could itself precipitate a loosening of financial conditions.
We maintain a neutral stance within equities, although continue to prefer the US versus the eurozone. The differentials between the US and the eurozone, in terms of growth (more sluggish in eurozone), monetary policy (probably more ECB rate hikes than Fed hikes to come) and equity style (the US market is more weighted to quality than cyclical/value sectors), should continue to favour US equities. That said it would not be surprising to see a change in US market leadership with more broad drivers of market performance from here. For this reason, we would look to position our US preference outside the mega cap growth names and into broader strategies, such as all-cap funds or equal weighted indices.
Within fixed income, we maintain our neutral position on US government bonds. Yields have moved higher in recent weeks, meaning falling prices, and are now approaching levels not seen since 2007. Nonetheless, we believe hawkish rhetoric from the Fed and other central banks means bond prices will not recover much from here. We maintain a slightly negative stance on eurozone government bonds. The ECB remains on the back foot in the fight against inflation and rate hikes could prove higher than markets expect.
We are looking to take profits on our position in investment grade credit, a trade we have had in place since late 2022, as the yield spread over government bond yields has tightened notably in recent months. We maintain our positive stance on emerging market debt, where credit spreads remain attractive, which could benefit from a period of US dollar weakness. We maintain a neutral stance on global high yield bonds, with a preference for the eurozone markets.