Ear to the Ground

8 December 2023

After the excitement of November we have seen a more sedate start to December.  Economic data across both the UK and Europe has been thin on the ground.  We saw the release of the Financial Stability Report from the Bank of England.  118 pages in total, but there were some interesting facts drawn upon by the central bank.  Overall, they are of the opinion that the risk environment remains challenging.  This is due to subdued economic activity, further risks to the outlook for global growth and inflation.  They also state increased geopolitical tensions.

In terms of the interest rates which we have seen, particularly in the UK and US, they believe that we are yet to see the full effects.  One such area is UK mortgages.  Whilst the estimate that around 55% of mortgage accounts have already repriced since late 2021, when interest rates started to rise, this still means a further 5 million households are yet to refinance at higher rates between now and 2026.  This could mean that a typical houseowner with a mortgage who needs to refinance between now and the end of 2026, could see their monthly payments increase by £240.  The mortgage debt servicing to household income ratio is therefore expected to rise, but should still remain below previous peaks, undoubtedly helped by the increase in wages that have been negotiated over the last 12 months or so be it private or public sector.

Interestingly, they also reflected on equity valuation, in particular that of the US.  Here they pointed out that cyclically adjusted price to earnings yield minus the yield available from government bonds has continued to come down, and is approaching the level last seen in the early 2000’s.  This implies a lower risk premium for holding equities over government bonds.  I guess the key questions here are, at what level do investors become concerned about this level and two, just how risky are equities relative to bonds in the first place, particularly given the volatility which we have seen around inflation.

We have seen data this week from the US in the form of the latest jobs data.  Non-farm payrolls came out stronger than expected, with 199k jobs added during November, compared to the consensus forecast of 180k.  This meant a lower than expected unemployment rate, at 3.7% versus consensus 3.9%.  With the JOLTS quits figure showing a slowdown in the quit rate also, it is perhaps unsurprising to see stronger than expected preliminary consumer sentiment, with the University of Michigan number surging to 69.4, well above the consensus estimate of 62.  This is a survey which covers three broad areas, including personal finances, business conditions and buying conditions.  American households being in a stronger position financially is likely to also be a contributing factor.

So, what are current expectations for US interest rates?  The rhetoric from central bank policy setting members last week, coupled with more muted inflation data, means that the market is now pricing in a greater number of interest rate cuts for next year.  Data suggests that the first cut could come as early as next year, and by this time next year we could have seen 5 moves downwards.  This, to us, implies that the market has decided that inflation will be sustainably back towards target and that economic growth will be slowing to such an extent so as to justify these moves.  Market commentators appears to be split here, especially given the easing in financial conditions seen through November.  We suggest that the US Federal Reserve will have to be really certain of the inflation path before we see the level of cuts being suggested.