A growing feeling that a “higher-for-longer” interest rate environment is taking hold weighed on stocks and bonds into the end of the third quarter. However, UK investors were largely shielded from these declines due to a sizable depreciation in the sterling to US dollar rate while domestic benchmarks in both stocks and bonds outperformed their peers. The MSCI All Country World Index ended the quarter slightly higher in sterling terms while gilt indices edged lower, closing -0.8%.
The shift in overall market sentiment gained momentum following September Federal Reserve (Fed) policy meeting. US rate setters revised higher projections for future interest rates due to surprising economic strength and although they have been guiding higher than market expectations for some time, the messaging caused a repricing among investors who had previously been expecting a lower path for rates. Shortly afterwards, the US 10-year Treasury yield closed above 4.5% for the first time since 2007.
Elsewhere, the Bank of England (BoE) and European Central Bank (ECB) gave the surest sign yet that they are closing in, if not already at, the end of their cycles of increasing rates. The UK and Eurozone economies have fared worse than the US of late recent messaging suggests rate setters are starting to feel they may have done enough, even though inflation continues to run well above target.
The BoE narrowly voted in favour of a first pause at a policy decision since December 2021, ending a run of 14 consecutive interest rate increases. Although the 5-4 vote split to maintain the base rate at 5.25% was by the smallest margin, notably it was supported by prominent members of the panel; governor Andrew Bailey, deputy governors Ben Broadhurst and Sir Dave Ramsden and chief economist Huw Pill. An unexpected drop in the Consumer Price Index (CPI) the day before the announcement no doubt played a part with a print of 6.7% a third consecutive decline in this metric. Furthermore, it was well below the consensus forecast and represents a significant drop from last year’s peak of 11.1%.
UK equities outperformed on the quarter returning 2.5%, boosted by the BoE update and the fall in sterling to 1.22 against the US dollar, 4% lower. Although UK government bonds declined over the three-month period, they fared better than European and US peers due to the positive news on the inflation front and the subsequent shift in the BoE’s stance on monetary policy.
Wall street sold off into quarter end as US yields reached new multi-year highs, ending around 3.5% lower in local currency terms. Still, returns year-to-date remain higher in the US (13.1%) than global indices (10.5%), the UK (+5.2%) and Europe ex UK (9.2%).
An interesting dynamic has developed in the relative performance of growth and value stocks, with the former outperforming in the US and the latter doing better in Europe. Although the Artificial Intelligence (AI) hype has clearly boosted a number of US tech stocks, the growth’s outperformance can also be attributed, at least in part, to the strength of the economy. Higher rates are typically viewed negatively for growth stocks, due to a higher discount rate being applied to future earnings.
However, this dynamic depends upon why rates are rising. If a stronger than expected economy is causing the rise, companies expected to grow more in the future will fare even better, potentially offsetting the negative of a higher discount rate. This has seemingly transpired in the US thus far in 2023. The outperformance of value stocks in Europe also supports this, as more pessimistic forecasts for a weaker economy will hurt growth stocks more than their value counterparts.
In summary
Heading into the final quarter of 2023, most stock benchmarks are sitting on respectable year-to-date gains, even after recent weakness. The latest leg higher in yields has provided a headwind for further advances and there is a sense that investors are waiting for an easing in this respect before they feel emboldened for another push higher.
UK and Eurozone economic activity is feeling the adverse effects of tightening monetary policy, but the US is an outlier and performing relatively well. That said, US real interest rates are now well into positive territory and will provide a slowing effect going forward. Furthermore, the 3 Ss – shutdown, schools and strikes – are potential causes for concern with another government shutdown looming, the resumption of student debt repayments for 27m Americans after a three-year break and industrial action centred around the auto industry.
China’s economy is showing some signs of stabilisation following central bank stimulus measures, although the outlook remains clouded by the ongoing property downturn, high debt levels and geopolitical tensions with the US. The oil price rose sharply in the third quarter, with international benchmark Brent crude gaining 26% to US$96 a barrel- its highest level since November 2022. Heading into winter attention will grow on natural gas prices and we are closely watching energy markets for signs of another rally which would apply upside pressure to inflation.
Overall, stocks are not expensive with valuations broadly in line with long-term averages after last year’s de-rating. However, bonds look increasingly good value compared to previous years and therefore are relatively appealing. Our Fixed Interest positioning is a little bit overweight duration, given our view on where we are in the monetary policy cycle and slightly underweight credit versus sovereign, a reflection of our view on the current position in the economic cycle.
