Rose Tinted Glasses

Markets cheered up considerably last week with increased hopes of a soft-landing driving significant gains in both equities and bonds.

Global equities reversed a good part of their declines in recent weeks, rising as much as 4.8% in local currency terms and 3.3% in sterling terms. They are now down only 4.5% and 1.9% respectively from their end-July high.

The US led the gains with a 4.0% increase, while the UK rose 2.4% and Asia and Emerging markets lagged with gains of just under 1%. But small and mid-cap stocks were the star performer both in the UK and US. UK mid-cap gained as much as 7.6% while small-cap rose 4.8%, as their cheap valuations overrode the latest downbeat economic outlook from the Bank of England.

Meanwhile, bonds unwound a sizeable part of the recent run-up in yields which had been undermining equities. 10-year US Treasury yields, which were testing the 5% level all of ten days ago, fell back a further 0.25% to 4.6%. US Treasuries and UK Gilts duly returned 1.5-2% over the week.

So what was behind this marked improvement in market sentiment?  The central banks had a big part to play with the Fed, ECB and BOE all keeping rates unchanged last week. This was leapt on by markets as a sign that rates had finally peaked.

While this is very likely the case, the central banks themselves were rather more circumspect about the matter. Their messaging was actually little changed from of late; namely that rates have probably peaked but it is dependent on the data and they are prepared to raise rates again if necessary.

More surprising is the new found conviction of markets that rates will be falling again by next summer despite continued central bank warnings that they will have to remain higher for longer. The market is now pricing in rates in the US and UK being cut from 5.25% currently to around 4.5% by the end of next year.

The Bank of Japan too did its bit. It is currently in the process of stepping back from its super easy monetary policy and took another step in this direction last week, watering down the importance of its 1% cap on 10-year government bond yields. So far, it has managed to pull off this difficult balancing act without causing the market disruptions that had been feared.

The latest US data also helped fuel the market rally. Hard on the heels of the previous week’s news that third quarter GDP growth was a surprisingly strong annualised 4.9%, last week’s numbers undershot expectations and pointed to a slowing economy.

Payrolls, which were much stronger than forecast in September, slowed considerably in October and the unemployment rate ticked higher to 3.9%, up from a low of 3.4% earlier in the year. Wage growth also slowed a bit further to 4.1% and business confidence deteriorated more than expected. This all helped bolster hopes that the economy will slow sufficiently to bring inflation down without the need for further rate hikes.

Finally, there is the US third quarter reporting season. Despite the odd disappointment, including Apple on Thursday, results have generally beaten expectations. With around 80% of the S&P 500 now reported, earnings look set to be up 6% on a year earlier, rather more than the 1% rise anticipated at the start of reporting and distinctly better than the 2% decline seen the previous quarter.

So how sustainable is this latest rally? The truth is that the macro outlook continues to be unusually uncertain and markets are likely to stay volatile as a result.

Key questions/conundrums remain: Does there need to be a US recession to bring inflation back under control? How much of a downturn would the Fed be willing to tolerate before cutting rates?  A recession would allow rates to be cut but how much damage would it do to corporate earnings?

We have our views on these various issues. But if there is one lesson to be learnt from the experience of the last few years, it is that these are particularly uncertain times and not an occasion for putting all one’s eggs in one basket based on just the one forecast. While we certainly tilt our portfolios to what we think are the areas of greatest opportunity, we continue to believe diversification is more important today than ever.

Rupert Thompson – Chief Economist