With the US, UK and EU potentially keeping interest rates where they are in coming months, where does this leave the equity and bond markets and where might opportunities lie? David Hambidge, investment director, Multi-Manager Funds, Premier Miton Investors, considers the current landscape.
Although the European Central Bank once again raised interest rates in September, both the Federal Reserve and Bank of England elected to hold, and the debate now seems to have moved on from how much further rates will rise to how long they will have to stay at current levels.
All three central banks have made it perfectly clear that defeating inflation is their overriding priority and while the upward pressure on prices has eased, both headline and core inflation remain uncomfortably high in the US, Eurozone and in particular the UK.
Given the rapid rise in interest rates, economic growth has also surprised on the upside with resilient data in the US offsetting weakness in China, with the latter disappointing since opening up its economy (following Covid) earlier in the year. Meanwhile in the UK, the latest data showed the economy continues to grow (just), nearly a year after many, including the Bank of England, forecast that UK GDP would decline every quarter this year. However, the data in the Eurozone has been much softer with the region closer to recession than the US and UK.
For much of this year it has been the strength in the labour markets that have caused the Fed et al the biggest headache and while the jobs data has softened a little of late, the strong numbers coupled with the high level of wage growth are still evident and could still result in rates going higher still.
However, this is not our central case and we believe that we have probably seen the last rate rise in the current cycle in the US as well as the UK and Eurozone. That said, it also looks that we are some way off rates being cut given the current data. This of course can change with tightening of monetary policy generally taking a long time to feed through to the broader economy. Jobs and wage data is a lagging indicator and we expect further softening over the coming months, albeit not necessarily enough to satisfy the central bankers.
Ironically, the pause in interest rate hikes in the US did not have the impact on the bond market that one might have expected with the yield on the US 10 year Treasury hitting a 16 year high in early October. This was because the market chose to focus on the higher for longer scenario rather than the fact that monetary tightening may well have peaked. However, yields have more recently headed south, partly due to the tragic events in Israel and Gaza but also because of some more doveish rhetoric from a few members of the Federal Reserve.
So where does that leave things from an investment standpoint? The answer I believe depends on your investment time horizon. For genuine medium to long-term investors, we think there is the opportunity to make good money in areas such as mid and in particular, small cap stocks in the UK and overseas. This area of the market has suffered more from higher borrowing costs than large caps but should benefit more when rates finally start to move lower.
As with small and mid caps, UK equities remain good value in our opinion and are certainly still unloved and under owned by both domestic and overseas investors. This may be unlikely to change in the short term but in the meantime, a healthy dividend yield is providing ample compensation.
In the bond markets, returns are clearly much more attractive these days, although with central banks no longer the dominant buyer and with plenty of supply, the technical factors supporting the market are perhaps not as favourable as they once were. However, higher yields more than compensate for this and as long as you believe that inflation will ultimately come under control, you don’t need to look beyond investment grade bonds to lock in a decent yield with the prospect of some capital growth.
Reference to any particular investment does not constitute a recommendation to buy or sell the investment.
