In this week’s market update: as investors wind down to the holiday season, all eyes are on the final central bank meetings of 2023.
There’s really only one story this week. Central banks are firmly in focus as the Fed, Bank of England and ECB all get ready to make their final interest rate decisions of 2023. It looks likely that all three will leave rates unchanged again but that does not mean there is nothing to see here. What the banks have to say about the prospect of rate cuts in 2024 will be key to direction of markets over the next few weeks.
Investors are already pricing in good news with the S&P 500 having risen by 500 points, about 12% from 4,100 to 4,600 since the end of October. That has put the US benchmark back within striking distance of the 4,800 peak reached at the end of 2021. It suggests increasingly that the low point of around 3,400 in October 2022 really was the bottom in the current market cycle, something that looked questionable only six weeks or so ago.
The correction in markets from the recent peak in July to this October’s low has been unwound in double quick time in recent weeks as the interest rate narrative has turned more dovish.
The challenge facing central banks is that the markets are starting to form their own opinion about the likelihood of significant policy easing next year. Traders are taking the view that the onset of recession in 2024 will leave the Fed and others with little option but to cut the cost of borrowing aggressively. Concerns about inflation and worries about the need for governments to continue issuing bucket loads of bonds to finance their spending programmes seem to have evaporated for now.
Central banks are keen not to get sucked into that narrative because the credibility of monetary policy hinges on our willingness to believe the threat that interest rates could yet rise further if inflation fails to be brought under control. Although there has been considerable progress on that front over the past year, inflation remains above target in the US and Europe and the final mile for central banks is notoriously the hardest.
That said, there is little risk of rates rising this week. The Fed will most likely leave the US interest rate at between 5.25% and 5.5% for the third straight meeting on Wednesday. Here the Bank of England is expected to leave rates on hold at 5.25% on Thursday. And in Europe, a dramatic fall in inflation to just 2.4% last month makes any further interest rate hikes very unlikely in the current cycle. The ECB also announces on Thursday.
The fall in inflation has started to feed through into the public’s expectations about the future rate of price rises. Here in the UK, the average expectation of inflation over the next 12 months dropped to 3.3% in November from 3.6% in August. Back in the summer of 2022, after the invasion of Ukraine led to energy and food price increases, inflation expectations hit nearly 5%.
The fall is important because of the way it feeds into wage demands, which are a key driver of the overall inflation rate.
Not that the job is done on the employment and wages front. Over in the US last week the non-farm payroll data on Friday showed that American employers added 199,000 new jobs in November. That was stronger than expected and higher than the previous month’s figure of 150,000. As important, the unemployment rate fell to 3.7% from 3.9%.
That news had a big impact on expectations about the trajectory of interest rates in the US next year. Hopes that the Fed would start cutting rates as soon as the spring were reined in, and Treasury bond yields rose a bit on the news with the two-year yield standing at 4.73% and the 10-year at 4.24%. Both are below recent peaks, as hopes have grown that the peak in the current cycle is in and the cost of borrowing for businesses and households will fall next year.
The jobs data raised hopes that the Fed may be able to pull off the soft landing that investors have been wishing for. A soft landing refers to the desirable combination of getting on top of inflation without simultaneously pushing the economy into recession. Historically this trick has been very difficult to pull off.
Our in-house view remains that a mild recession is more likely than this soft-landing outcome. We put a 60% chance on a recession and just 20% on a soft landing. Crucially both of these would be better for investors than the less likely extremes of a hard landing or deep recession or no landing in which the economy keeps growing and inflation stays higher than target.
Both of these ultimately end up in the same place because no landing leads to higher for longer interest rates which in the end break something in the economy forcing a rapid retreat by central banks. Both outcomes, just 10% probability in our view, end up with a deep recession and are therefore not to be desired by investors.
The recent rally in stock markets to their highest level since the end of 2021 rests on those middle of the road outcomes – soft landing or mild recession – coming to fruition so as well as the interest rate decisions this week attention will focus on a handful of other economic data points. We’ve got US inflation numbers as well as UK GDP and also some US retail sales figures.
Apart from that it’s a thin week. There are almost no company results announcements of note as the corporate calendar winds down towards the holiday.
In other markets, the prospect of a recession next year is showing up in the oil price, which has fallen dramatically over the past 18 months since Russia’s invasion of Ukraine. In the aftermath of that the cost of a barrel of Brent crude rose as high as $130 a barrel but the same can be bought today for less than $80 as investors assume that economic slowdown will lead to less demand for oil.
That belief has been encouraged by extremely disappointing data out of China where the rapid recovery from Covid that we all hoped for a year ago has failed to materialise. Here, too, however, the mood music has changed recently as the authorities in Beijing seem to have realised that the economy requires further stimulus. President Xi Jinping said this week that the Chinese recovery is ‘still at a critical stage’ and leaders have pledged ‘proactive’ fiscal and ‘effective’ monetary policy in the New Year.
Where that prospect shows up most clearly is actually not in the Chinese stock market but in European shares where luxury goods stocks are a big beneficiary of growth in their biggest export market. European shares closed last week at their highest level since the start of 2022. European markets were first out of the blocks in October 2022 as it looked likely that China would rebound quickly from its pandemic lockdowns. Since then they have fallen back but, as in the US, markets have responded with enthusiasm to the more positive backdrop in recent weeks.
Another commodity in the spotlight recently has been gold, which has gained support on the back of expectations about lower interest rates next year. Gold pays no income so higher yields on alternatives such as bonds and cash tend to be bad news for the precious metal. Hopes for lower rates sooner than expected have therefore allowed investors to focus on gold’s other main attraction, its safe haven status at times of uncertainty. Gold has risen above $2,000 an ounce, close to its all time high.
Finally, the asset class that has blown all others away this year has been bitcoin. The most widely traded crypto-currency has soared on a combination of factors. First, it is seen like other more mainstream asset classes as a major beneficiary of lower interest rates. Second, it was starting from a low base, having fallen from a peak of around $69,000 to just $16,000. Third, crypto enthusiasts are getting excited about the prospect of a technical change next year in the amount of coins that successful mining can create. One of the main attractions of bitcoin over so-called fiat currencies is their limited supply because governments cannot simply print more of them as they can dollars or pounds. Finally, the introduction of spot bitcoin ETFs looks likely to bring crypto a bit closer to the investing mainstream.
Where this latest rally in bitcoin goes is anyone’s guess. Historically, rallies have always gone into reverse in due course. And until bitcoin starts to look more like a store of value or useful currency that volatility is likely to continue.
