Multi-Manager People’s Perspectives

Solid economic data combined with comments from the central banks have seen equities and bonds continue to reprice for a higher interest rate environment.

The largest market moves came in the aftermath of Federal Reserve Chair Jay Powell’s testimony to the US Senate Banking Committee. Powell said that “the latest economic data have come in stronger than expected, which suggest that the ultimate level of interest rates is likely to be higher than previously anticipated. If the totality of the data were to indicate that further tightening is warranted, we would be prepared to increase the pace of rate hikes”. This assessment of the potential for the size of rate hikes to re-accelerate shifted market expectations for the next Fed meeting in March, with markets now seeing a 50-basis point hike as more likely than another 25-basis point hike as we saw at the previous meeting. This seems to be a shift in tone from the Fed who seemed comfortable in easing the pace of hikes after softer economic data in November and December but are less comfortable with the more recent data, which has been quite a bit stronger. There also seems to be a recognition that bringing down inflation without creating job losses or recession will be extremely challenging. Jay Powell said, “the process of getting inflation back down to 2% has a long way to go and is likely to be bumpy”. Futures markets repriced both the size of the next rate hike and the peak or ‘terminal’ rate, which is now expected to be 5.6% in September.

We have seen some big moves in these rate expectations since the end of last year – in mid-December the terminal rate was seen at 4.9% in May, with rates easing by 50 basis points by the end of 2023. Given the current Fed language and economic data, this now seems highly unlikely, hence the sizeable moves. We have also seen yield curves flattening, with the closely watched 2 year – 10 year yield curve spread over 100 basis points – the lowest level for 42 years.  This has happened only 4 times since the 1940s, and each time (in 1969, 1979, 1980 and 1981) the economy has been in recession or on the brink of it. A reminder that in healthy economic times the yield curve is upward slowing – longer term rates are higher than short term rates.

When the curve is ‘inverted’ as we are seeing now, it suggests investors have greater concerns over the short-term economic outlook than the longer term. An inverted curve tends to reduce lending activity and combined with the liquidity hangover from the Covid stimulus, it points to an economic slowdown. But for now, the economic data is defying gravity, and giving the Fed, and financial markets, quite the headache. The eurozone has also witnessed markets pricing in higher interest rates, with an additional 156 basis points of rate hikes expected. This came after Robert Holzmann of the European Central Bank’s governing council said that he assumed “core inflation will not weaken significantly in the first half of the year” and that “I expect we’ll hike rates by half a percentage point four more times this year”. If Holzmann’s expectations are correct, markets still have some way to go to catch up with ECB policy.

Higher rates always have consequences and we saw evidence of that yesterday with a sharp selloff in US banks as a result of Silicon Valley Bank (SVB) falling 60% after warning on losses from bond sales and announcing a capital raise to shore up their balance sheet. This dragged the wider banking sector down, though it appears to be a profits issue rather than a liquidity one – famous last words but on first glance this does not (yet) appear to be a Bear Stearns type moment. SVB services technology companies that are usually backed by venture capital firms and had a large amount of cash on deposit held in long dated bonds – as rate expectations have risen in recent weeks, they have taken some losses in this part of their balance sheet as bonds have been sold to meet client withdrawals. The issues are a stark reminder of the consequences caused by higher interest rates and given the amount of leverage in the system, rising rates and a likely recession point to further stresses ahead – we don’t know where but the dramas at SVB will certainly unsettle some investors.

One place where higher interest rates remain elusive, despite inflation at 4%, is Japan, where the Bank of Japan this morning kept rates unchanged at -0.1%. This was Haruhiko Kuroda’s last meeting as Governor; the baton is now passed to Kazuo Ueda to navigate the Bank back into positive interest rate territory and broaden the range of Yield Curve Control, a policy which is currently costing the Bank billions to keep Japanese Government Bond yields artificially low.

There has been plenty of economic data to digest with another key data point to come today – the monthly US employment report. This, and the next inflation report, are even more important given the strength of recent data has given the Federal Reserve cause to point to stronger than expected economic growth potentially needed a more aggressive pace of rate hikes to slow the economy and bring inflation down to target. The second tranche of the monthly PMI data – for services – showed strength across the US, eurozone, and even the UK where the data moved back into ‘expansion’ territory. In the US, the employment and new orders subcomponents both accelerated, giving more weight to the narrative that after weaker data at the back end of 2022, the US economy has actually picked up somewhat at the start of this year. Much like in Europe, despite the odd blip, the overall mild winter in the US has helped push energy prices substantially lower, removing a potentially significant headwind for growth.

In China the National People’s Congress set the economic growth target for 2023 at a somewhat underwhelming 5% – this compares to expectations of a target of around 5.5%. The government set out policy priorities that include expanding domestic demand, attracting foreign investment, preventing systemic risks and support for state owned and private enterprises. The new jobs target was increased to 12 million for 2023 in part to absorb the record number of graduates – 11.6 million – who will look to enter the workforce this year. The government also reiterated their support for the housing market and for first time buyers. They intend to help ‘high quality’ developers improve their balance sheets and will curb “disorderly expansion” to prevent systemic risks arising.

It seems the government is for now taking a relatively conservative approach to economic growth, though it is likely that they would like to see the data settle somewhat in the aftermath of the Covid reopening before looking to boost growth to try and avoid some of the inflationary issues seen in the west through too much monetary and fiscal stimulus. In the absence of the inflation issues faced in developed markets, there remains scope for China to increase levels of stimulus should they see economic momentum easing.