Murky at the Top

Global equities dropped last week, more than reversing their gain the previous week and ending down around 2.5% in both local currency and sterling terms. Markets are now down some 7% and 3% respectively from their end-July high.

While worries of an escalation of the war in the Middle East clearly remain, the impact on oil prices has so far been quite limited. The Brent oil price is currently $92/bb, well up on its mid-summer low of $72 but still below its September high of $97. A surge in oil prices would be the main way in which a broadening in the conflict to Iran could inflict damage on the global economy.

Investor flows into traditional safe havens have also been decidedly half-hearted. Gold has continued to benefit, rising a further 4% last week and is back up close to $2000/oz. But the US dollar, which one would have expected to strengthen, is down a bit. As for government bonds, they have seen yields continue to march higher rather than decline on the back of safe haven flows.

Indeed, the main source of downward pressure on equities has come from bonds. 10-year US Treasury yields rose a sizeable 0.3% last week and are now testing the 5% mark for the first time since 2007. The rise has caught almost everyone by surprise and in good part reflects the continued unexpected strength of the US economy.

Last week provided further evidence on this front, with retail sales surprising on the upside in September and initial jobless claims falling to a 9-month low. Third quarter GDP data released this coming Thursday should show growth running at an annualised pace of 4% or more. This is over double the economy’s trend growth rate and a big surprise given the Fed has hiked rates by as much as 5% over the previous eighteen months.

This continued strength has cast doubt over whether interest rates really have peaked, even if the Fed does still look very likely to leave rates unchanged on 2 November. Upward pressure on yields has also come from increased concern over the large amount of government debt needing to be absorbed by the market. Despite the lack of clarity near term and possibility of some overshoot, we believe bond yields should finally be at or close to their peak and have scope to fall back over the coming year.

The rise in yields has been led by the US but 10-year UK gilt yields have also risen significantly to 4.7% and are back to their highs seen earlier in the year. The latest batch of data on UK inflation pressures provided no big surprises. Inflation came in slightly higher than expected in September, following the big undershoot seen in August. The headline rate was unchanged at 6.7%, while the core rate edged down to 6.1% from 6.2%.

Meanwhile, wage increases have yet to slow significantly. Underlying average earnings growth excluding bonuses was unchanged in August at 7.8%. Although wage gains are now outpacing price increases, consumers still remain under pressure. Retail sales dropped a larger than expected 0.9% in September and consumer confidence fell in October, reversing some of this year’s recovery. As in the US and the Eurozone (the ECB meets on Thursday), the expectation remains that the BOE will most likely keep rates unchanged at their next meeting.

On the other side of the world, last week’s Chinese crop of numbers suggest the recent pessimism over the strength of the post-covid rebound got overdone. The economy grew at a faster than expected 5.2% annualised clip in the third quarter, up from 3.2% in the second. Retail sales and industrial production also beat expectations in September.

Lastly, there is the US earnings season which is now in full swing. As yet, earnings are coming in broadly in line with expectations and look set to be up around 1% on a year earlier. The tech titans, however, will be a major focus to see if their earnings numbers justify their relative resilience so far in the face of higher bond yields. Alphabet, Amazon and Microsoft all report over the next few days while Apple reports next week.

Rupert Thompson – Chief Economist