Punch Drunk

We said last week the fate of the Xmas market rally lay in the hands of the central banks and so it has proven. To be more precise, it was the Fed, rather than the ECB or BOE, which was behind last week’s gains.

Global equities returned 2.1% in local currency and 1.3% in sterling terms. Small and mid-cap stocks fared best, rising 3% or so in the UK and 6% in the US. Meanwhile, government bonds saw yields drop some 0.3%, leading to UK Gilts and US Treasuries posting returns of as much as 2.8% and 2.0% respectively.

So, what was behind this cheery response? All three central banks kept rates unchanged as everyone expected. But the Fed unexpectedly completely abandoned its recent mantra that rates need to stay higher for longer, pivoting instead towards policy easing. It upped its forecast for the number of 0.25% rate cuts pencilled in for next year from two to three and is now projecting rates to fall from 5.4% to 4.6% by the end of next year.

Importantly, Chair Powell reinforced this dovish shift in his press conference. He stated that the Fed would need to start cutting rates well before inflation returned to the 2% target. The Fed is also no longer saying a period of below trend growth is needed to reduce inflation, reinforcing hopes of a soft-landing.

Buoyed by its recent success in predicting the Fed’s actions better than the Fed itself, the market has duly upped its forecast for policy easing next year. It now sees rates being lowered as soon as March and as many as six cuts next year, rather than the three forecast by the Fed.

The message from the BOE and ECB was rather less gung-ho than that from the Fed. Both continued to emphasise the battle against inflation was far from won and rate hikes could not yet be ruled out. Indeed, three members of the MPC continued to vote for another rate hike.

However, the market is hearing none of it. It expects the ECB to start cutting in March and rates to fall by a similar amount as in the US from 4.0% to 2.5% by next December. It is a bit more cautious in the case of the UK but still sees rates being cut in May and declining to 4.1% from 5.25% currently by end-2024.

The weaker state of the economy in the UK and Eurozone than in the US would certainly argue for the ECB and MPC not lagging too far behind the Fed in cutting rates.  Business confidence in December fell deeper into recession territory in the Eurozone whereas it strengthened a bit further into expansion land in the US.

Confidence also improved in the UK but the latest GDP numbers came in weaker than expected. Activity declined in October and was unchanged over the last three months. The picture remains one of the UK economy flat-lining unlike the US where growth is holding up well.

On the inflation front, the UK is the outlier with the core rate still running at a high 5.7% versus 3.5-4% in the US and Eurozone. Continued inflation worries mean expectations that rates will fall more slowly in the UK than elsewhere look correct.

Market forecasts for rate cuts more generally do now look rather on the optimistic side. Indeed, various Fed officials have already been arguing against US rates falling as soon as March. A June start for Fed easing looks more plausible.

Even so, rates do now look set to be reduced significantly next year in all three regions. And monetary easing is generally a positive backdrop for risk assets, unless it is accompanied by a marked economic downturn which we are not expecting.

The markets may be a little punch drunk following Powell’s move to top up the punch bowl, rather than remove it as is the central banker’s more normal duty. But risk assets still have scope for further gains over the coming year and should outperform cash, where returns look set to fall rather faster than expected.

I very much hope you take the lead from the markets and, on behalf of Kingswood, wish you a very merry Christmas.

Rupert Thompson – Chief Economist