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21 Nov 2023

A Kind Of Magic

Although we expect central banks to remain publicly cautious around the prospect of rate cuts for fear of prematurely declaring victory over inflation, the outlook is beginning to look rosier.



Continuing the musical theme from last week, a recent project at home has been to refurbish my mum and dad’s vintage 1970 record player and amplifier. OK, I paid someone to do it because it was a very specialist job requiring all sorts of new valves, resistors and capacitors, not to mention a lot of cleaning and lubricating of gummed-up (not) moving parts of the turntable and tone arm. But worth every penny in terms of the enjoyment of listening to my old vinyl records which had been stored in the attic for a couple of decades. It’s a proper treasure trove up there, even if Mrs Wyn-Evans is more inclined to view the majority of contents as junk!

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This week’s title references Queen’s single (and album, which is in my collection) of the same name released in 1986. One of the lyrics refers to “one golden glance of what should be”, and it seems to me that this is what markets have offered us in the last two or three weeks: a magical world in which interest rates and bond yields come down and equities rise. At least that is what everyone would like to see.

I wrote last week about how comments from the US Federal Reserve had initially sparked the November rally, with various technical factors contributing to the squeeze higher in both equity and bond markets. The latest fuel came in the form of a lower-than-expected US inflation figure for October last Tuesday. Although the beat was only marginal, the key point was that it confirmed the trend of falling inflation. Even so, consumer sentiment remains low because falling inflation is not the same as falling prices, which remain, in aggregate, around 18% higher than they were three years ago.

For once, the UK went one better with its inflation data release, and in a good way. The headline annual Consumer Price Index rise came in at 4.6% against expectations of 4.7%, down from 6.7% in August. Here again, though, consumers are still dealing with overall prices that are 19% higher than they were in September 2020.

This increase in prices is possibly the biggest factor undermining support for incumbent governments in the US and the UK, both of whom face elections in the not-too-distant future. The US Presidential election is less than a year away now (5 November 2024), while the UK General Election must be held before January 2025. In fact, elections are going to be a big global theme in 2024. More than half of the world’s population (also accounting for around half of global GDP) are scheduled to go to the polls next year. Some other important country elections include Taiwan (January), Russia (March), India (April) and, for my former colleagues, South Africa (TBA).

Elections are going to be a big global theme in 2024. More than half of the world’s population (also accounting for around half of global GDP) are scheduled to go to the polls next year.

The better-than-expected inflation data galvanised interest rate markets, which have concluded that we have seen the peak of interest rates in the US, the UK and Europe. We have been saying for a few weeks now that economists were only arguing over the possibility of a final 0.25% upward tweak to conclude the cycle and so we were not particularly fearful of further policy tightening. Even so, the speed with which potential rate cuts are now being priced in has taken us a little by surprise, especially in the absence of significantly weaker economic data. Having said that, our increased appetite for government bonds as yields pushed higher has been rewarded with some pleasing capital gains as yields fall again.

In terms of potential interest rate cuts, futures markets are now pointing at June 2024 as the key date, with the probability of a reduction by then rising above 50% in the US, the UK and Europe. No doubt this depends upon inflation indices continuing to behave. There is plenty of evidence to suggest that they will, notably the fact that we will be lapping higher readings from the past. Specifically, energy prices are behaving well, and the biggest element of last week’s month-on-month reduction in the UK Consumer Price Index was the cut in the energy price cap.

Obviously, energy prices are more susceptible than most to geopolitical events, with the Middle East currently a focal point. On that front it is notable that the oil price is lower than it was the day before Hamas attacked Israel. Remarkably, it’s also lower than it was before Russia invaded Ukraine. There seems to be no underlying supply shortage relative to demand. In fact, members of the OPEC+ producer cartel have had to reduce production to support the price. Many of them (including Saudi Arabia and Russia) cannot afford for prices to fall too low because they need the revenue to finance themselves.

In equity markets last week, it was sectors most at a business risk from the effects of higher interest rates that rallied hardest. Smaller companies did particularly well. Real Estate, which is also exposed to valuation risk, topped the charts in the US and the UK. Our analyst’s opinion is that there are several companies in this sector where the market is applying a much higher discount rate to their cash flows that he thinks is deserved, effectively pricing in a much deeper recession (and a limited probability of cheaper money ahead).

Bottom of the pile in those markets were Consumer Staples. They’re seen as quality defensives, so there was no way they were going to be at the top of buy lists, but these stocks have also been hit hard by being the potential losers against the winners from the development of appetite-suppressing drugs. There is an interesting test case ahead in the form of the US Thanksgiving holiday later this week. This is a celebration that is characterised by excessive consumption, but it will be the first year in which drugs such as Novo Nordisk’s Wegovy have been available.

Consumer Staples companies have excelled themselves during the period of higher inflation by being able to impose heavy price increases on consumers. For the last year or so, sector revenue growth has been driven almost entirely by price increases, with volumes pretty much flat. It certainly speaks to resilient underlying demand and to the power of their brands, with the heritage of some of them stretching into centuries. As inflation falls, it is harder to play the price card, but one would hope that lower inflation might create a better environment for real wage growth, which would, in turn, support consumer demand. It’s certainly an area to keep an eye on.

We continue to believe that we are navigating the final stages of what has been a long and difficult cycle for inflation, interest rates, economies and financial markets. To quote Queen again from the same song: “the waiting seems eternity” (sic – Roger Taylor chose rhyme over grammar). Concrete evidence of declining inflation is very helpful. Although we expect central banks to remain publicly cautious around the prospect of rate cuts for fear of prematurely declaring victory over inflation, the outlook is beginning to look rosier. And we should always remember that financial markets try to anticipate future developments and not to price off what is going on today.

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