27 October 2023
Welcome to what is the 100th edition of Ear to the Ground. Given this anniversary, I thought I would look back at that first edition, drawing from it where we were then to where we are now, covering any predictions which were being made at the time.
So, back on the 5th November 2021, what were we reflecting on? That week the Bank of England had just surprised the market by deciding not to raise interest rates. The base rate was held at 0.1%, the low point reached in the monetary policy response to the pandemic. Moving forward to today and the Bank of England is again on hold, but now at the lofty heights of 5.25%, having gone through a fourteen-hike cycle. There is the possibility that one more rise could be seen, but market sentiment suggests the central bank could have reached their terminal rate for this cycle. Indeed, focus has now switched to how long interest rates could remain at these levels before we see the first cut.
So, why the urgency behind the hikes? I don’t think there are any surprises here, with the reason of course being inflation. At the end of 2021 the central banks of western developed markets had convinced themselves that it would prove to be transitory. Once the supply/demand imbalances had corrected, brought about by inability to moves goods and raw materials, inflation was expected to move back to target. Indeed, the Bank of England were forecasting that inflation would rise to 5% in the spring of 2022 before falling back towards 2% over their two-year horizon.
How wrong they were! The Consumer Price Index (CPI) currently stands at 6.7% for the twelve months to September. This is after a peak of 11.1% was seen in October last year. To be fair, there have been events which no one could have foreseen which contributed the higher for longer inflation figures. There was of course the Ukraine-Russia conflict, which unfortunately is still ongoing, which led to a significant rise in the cost of energy, along with other commodities such as grain. Then there was also the tightness in the labour market, with not enough employees to fill vacancies. Whilst CPI is moving in the right direction, there are concerns that certain components remain ‘sticky’, which could mean the 2% target is hard to achieve. Issues around energy supply of course remain. Was the Bank of England, along with others, too slow to react? Or did the events which occurred mean in was completely out of their control?
So, what about bond yields? As you would expect, the yield on short maturity bonds have risen sharply, in line with interest rate rises. In the first edition the two-year gilt yielded 0.4%. At the time of writing the current yield is 4.8%, with a ten-yield gilt yielding 4.6%. After being inverted, where short yields were higher than longer term yields, we have recently seen yield curves flatten, where yields are more equal. The more conventional shape of a government bond yield curve is one that steepens, i.e., longer term maturity bonds have a higher yield to reflect the greater investment risk. The move to this is likely to be seen at some point in the future.
Finally, what about equity markets. In our first edition we reflected on equity market valuations and how some were more expensive than others. To a degree, a focus on those valuation metrics was the right call to make. To the market close on the 25th October 2023, Japanese and UK large cap stocks have been some of the strongest performers. These were some the cheapest markets based on a price to earnings ratio at the time. Conversely, more expensive markets, such as the S&P 500, have posted a negative return for the period, all returns being in local currency terms. It is not just valuation at play here, of course, and there are other factors to consider, such as the sector composition of the main indices, along with monetary policy in the underlying countries.
Performance of course has not come in a straight line. Japanese equities have really kicked on in 2023 in response to the authorities and regulators efforts to improve corporate governance for the better of shareholders, whilst monetary policy has remained loose. With regard to US equities, 2022 was a weak year, as growth stocks, such as technology names, responded negatively to the rise in interest rates and bond yields. There has been something of a recovery in US stocks in 2023, although leadership has been very narrow. Indeed, it is the ‘magnificent seven’ as they are now coined, being Amazon, Apple, Google (Alphabet), Meta, Microsoft, Nvidia and Tesla, which have led the way. The rest of the market has been left behind. This came despite a continued march higher in bond yields, buoyed by the excitement around artificial intelligence, especially since the breaking news of ChatGPT4.
So, where will interest rates, inflation, bond yields and equity indices head next? Will valuation be a key determinant in the movement of equity indices moving forward? Will the threat of the most predicted recession ever turn out to be real? I guess you will have to keep reading Ear to the Ground to find out. Here is to another one hundred editions.
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