Slowing inflation and softer rhetoric reignite the case for rate cuts
A series of slower economic data allowed traders to become increasingly convinced that central banks have finished their aggressive campaign of interest rate hikes. US stocks chalked up their largest monthly rise for three years, gaining 5%, although returns were more moderate elsewhere, with the UK up 2.2%. Talk of rate cuts also produced a big rally in bonds, which rose 3% on average. The driving force behind these gains has been a dramatic sea change in the outlook for interest rates following a run of better-than-expected inflation readings across major economies.
Better inflation data across major economies fuels the rally
October's CPI print for the US was unchanged for the month, reducing the odds of another interest rate hike close to zero. While the Fed did not make any formal policy changes at its November meeting, the Powell press conference was widely seen as having a more dovish tone. Inflation also slowed sharply in the Eurozone, with the CPI falling to 2.4% year-on-year.
The narrative received a further boost when the UK joined the party with a third slower-than-expected inflation reading. Consumer prices rose 4.6% from a year earlier in October, down sharply from 6.7% a month earlier and the slowest pace since 2021. Prime Minister Sunak was happy to take credit for the fall, although it was mostly driven by a sharp drop in the energy price cap resulting from the global decline in energy prices. Elsewhere, China slipped back into deflation, with a fall in the CPI of 0.2% over the previous year.
The initial move in equities was led by large cap growth and technology stocks. However, attention soon switched to oversold cyclical sectors that would benefit most from an economic recovery spurred by lower rates. Small caps surged 7%. US 10-year bond yields, having briefly risen above 5% in the middle of October, retreated back below 4.5%. In the UK, 10-year bond yields fell to 4.1%. Gold finally broke through its previous all-time high, touching a record $2,138.
The economy is finally showing signs of cooling
A number of metrics indicated that the US economy is finally slowing down following the Federal Reserve's long campaign to rein in inflation. Gains in employment were lower: non-farm payroll printed at 150k in October, well below the 180k expected by the market and less than half September's print. The unemployment rate increased to 3.9% from a recent low of 3.4%.
The Beige Book activity index slipped into negative territory for the first time since the start of the pandemic, suggesting a pullback in consumer spending. However, this was not borne out by strong initial figures for the Black Friday shopping season, which saw sales rising 7% over last year. A US government shutdown was also averted, as President Biden signed a stopgap bill to circumvent the current political stalemate and extend funding into early 2024.
Flat growth keeps recession at bay, and bargain hunters circle
In the UK, no growth continued to be good news. The economy flatlined once again in the third quarter, defying forecasts of a small contraction and ensuring a recession is avoided for the time being. Consumer confidence headed higher in October. House prices also rose for the second month running, up 0.2% according to data from the Nationwide.
If further proof is required that UK equities are cheap, three more listed companies became the target of takeover bids that underlined the value that exists among UK assets. Luxury confectioner Hotel Chocolat saw its share price almost treble following interest from Mars. Bowling alley operator Ten Entertainment Group received a bid at a 33% premium to the current share price, while City Pub Group was also targeted by Young & Co's Brewery Plc at a significant price premium.
A note from the desk
I am pleased to share our monthly update on market events. The overview seeks to summarise market movements together with our views and the rationale for the positioning of investments going forward. As always, should any aspect of this commentary prompt a question, we would welcome the conversation.
Martyn Charlwood · Managing Director
A lot can change over the course of a month
Whereas back in October, the markets were spooked by the prospect of rates remaining "higher for longer", now they are convinced rates will be cut significantly in 2024. Recent weeks have seen a change in rhetoric from central banks, with the hawkish messaging that has dominated much of the past two years finally softening. As a result, traders have pivoted rapidly to price in more than a full percentage point of cuts in US interest rates over the coming year, starting in March. This is despite Fed Chair Powell's insistence that policymakers have yet to discuss the possibility.
Markets are also expecting the ECB to mirror this move, with the Bank of England cutting slightly less and slightly later in May. These latest predictions may prove a little over-optimistic; the big post-covid forecasting misses of markets and central bankers alike suggest one should treat forecasts with a large pinch of salt. Nonetheless, the direction of travel is clearly down and it is hard to argue against the idea that we are in a better place today than when we entered 2023.
November was a great example of the merits of staying invested and not trying to time the markets.
The month has highlighted the speed at which markets can move and the need to be positioned for the medium term. With confidence growing that central banks will be cutting rates next year, the outlook for both equities and bonds is more appealing than cash. The US has been a standout performer among global equity markets in recent years. Its outperformance has been led by the "Magnificent Seven" technology giants: Apple, Amazon, Alphabet, Nvidia, Meta, Microsoft and Tesla. While these are undoubtedly world class companies, they are currently priced for perfection, commanding a massive premium over other US listed stocks. In market cap terms they now make up more of the world index than Japan, the UK, China, France and now almost Canada too, combined.
In an uncertain environment, investors have sought refuge in household names. However, attention should switch to cheaper assets that can benefit to a much greater degree from a recovery as rates fall. Our standard portfolios are overweight markets outside of the US.
Overweight the UK, Japan, Asia and emerging markets
Our standard portfolios are overweight markets outside of the US, where the outlook is much more compelling. These regions offer cheaper valuations and greater scope to benefit from a recovery as rates fall.
UK equities at a generational discount
No one would really debate that UK equities are cheap right now. The market has been unloved since the initial Brexit vote in 2016 and currently trades below 10X earnings, near the bottom of its 30-year trading range and on a significant discount relative to other major markets. The good news is that its underperformance bottomed out in mid-2020 and so, after a very bad period, things may be looking up.
Small caps at historic lows
The recent strong move up in UK small caps is encouraging. The valuation disparity between small and large caps has rarely been this large: UK small caps are now priced at 8X earnings, and these earnings continue to grow. They have only been cheaper on an absolute basis in 2009 and the period from 1979 to 1981. As economic conditions continue to normalise, this gap should narrow.
Patience, with a reassuring margin of safety
We recognise the need for patience, but the margin of safety is reassuring and provides scope for outsized gains once the outlook improves. The outperformance of value stocks that occurred in 2022 has the conditions to resume as economic normalisation continues.
Important information
This article is a marketing communication intended for general information only. It does not constitute personal advice, a recommendation, or an offer to buy or sell any investment. If you are unsure whether an investment is suitable for your circumstances, please seek personal advice.
Past performance is not a guide to future performance. The value of investments and any income from them can fall as well as rise. Capital values are at risk and not guaranteed. Forecasts and views expressed in this commentary represent our assessment at the time of writing and are subject to change.
To discuss how this commentary applies to your own portfolio, we would welcome a conversation.
Make an enquiry →