The challenging period experienced by stocks and bonds in October appears to have been disregarded. November has witnessed a robust commencement. The reasons behind this substantial rally: Is it a technical bounce-back; Has the perception of inflation altered following the deceleration; Or should we give consideration to the most recent earnings statement?Thank you for reading this post, don't forget to subscribe!
Let’s hypothesize that this could be a multi-dimensional occurrence (and it’s likely not entirely settled yet).
US economy – the Current State
The US labor market, as depicted in the employment report circulated on November 3, provided reassurance to numerous observers, aligning with the sentiments expressed by Federal Reserve Chairman Jerome Powell in his press briefing two days prior.
November witnessed the creation of 150,000 jobs, marginally below market projections, while the figures for the preceding two months were significantly adjusted upwards.
Starting from July, there has been a gradual escalation in the unemployment rate, rising from 3.5% to 3.9% in October. Subsequently, owing to an increment in new entrants to the labor market, it has returned to levels seen in December 2021. The escalation in labor force participation is progressing gradually, albeit there are growing signals indicating an augmentation in the labor supply.
The ISM Services Survey delivered an unexpected downside, with the index plummeting to 51.8 from 53.6, considerably below the consensus expectation (53). Consequently, it currently stands at a five-month low. Nonetheless, the index remains above 50, implying continued expansion in activity.
Conversely, the ISM employment sub-index slumped from 53.4 to 50.2. Identifying a discernible trend for this indicator proves to be challenging (refer to Exhibit 1), as companies, particularly small and medium-sized enterprises, persist in reporting challenges in recruitment.
The Interpretation of “Negative News is Favorable”
Investors interpreted the lackluster employment and services reports as initial indications of a deceleration in US activity (after a robust 4.9% expansion in the economy in the third quarter) and concluded that the cycle of raising policy rates, which commenced in the spring of 2022, has ceased. Above.
This interpretation fueled the surge in equities and the decline in bond yields that commenced subsequent to the Fed’s policy meeting on November 1.
During October, yields on the long end of the curve surged: by 39bp on the 30-year bond; 36bp on the 10-year bond and 4bp on the 2-year bond (since the end of September).
Since the beginning of November, 2-year yields have diminished by 16bp, 10-year by 44bp, and 30-year by 48bp (as of November 8).
Anticipations in the market regarding the monetary policy of the Fed are currently driving bond yields lower and amplifying gains in equities (up 4.5% for the S&P 500 index and the tech-heavy Nasdaq from the end of October to November 8. 6.2%) for composites.
This resurgence is not surprising after three successive months of decline in global equities, which led to oversold conditions and extreme investor sentiment in the markets.
Market Dynamics vs. Economic Realism – Fixed Income
The decline in bond yields did not catch us off guard.
It is becoming apparent that inflation is decreasing not only at the headline level (attributed to base effects from the escalation in energy prices last year) but also in non-food and energy sectors.
Consequently, it’s foreseeable that the US economy will commence a more pronounced deceleration as the factors underpinning its surprising resilience dwindle. The surplus in consumer savings is diminishing, and elevated interest rates are diminishing the demand for goods, services, as well as housing. Ultimately, the effectiveness of US fiscal policy is receding. The policy was expansionary in 2023, as evidenced by the budget deficit reaching US$1 700 billion (fiscal year till September 30). This reflects a 23% surge from the preceding year.
Exhibit 3 illustrates the anticipated modification in fiscal policy based on IMF assessments, where short-term fiscal policy assumptions are grounded on the officially announced budget, adjusted for macroeconomic assumptions and anticipated fiscal outcomes. The year-on-year changes signify the success of the ‘fiscal effort’: a positive figure suggests a reduction in the deficit.
Market Dynamics vs. Economic Realism – Equities
By abstaining from proclaiming victory over inflation and making numerous pointed statements in recent days, central bankers attempted to temper anticipations of a sharp decrease in rates in 2024, yet investors are evidently confident that the cycle of raising the policy rate has concluded in most economies (with the notable exception of Japan).
As articulated in its recent Economic Outlook report, the OECD stated, “The global economy demonstrated more resilience than anticipated in the first half of 2023, yet the growth outlook remains feeble”.
This perspective seems to lack consensus and elucidates why the current conditions appear favorable for government bonds and, conversely, unattractive for equities.
A prospective reduction in demand due to the tightening of monetary policy for a year and a half is expected to impact corporate activity, earnings, and margins. Consequently, we advocate caution with regard to equities, particularly in Eurozone markets, whose economies have been mired in recession for several quarters. To date, the latest earnings reports signify decelerating demand, especially in Europe.
The substantial rally in bond markets since early November may initiate a strategic adjustment in our position, yet we deem it appropriate, given the long-term valuations in the bond segment of our multi-asset portfolio.
Moreover, we do not interpret the recent surge in (nominal and real) yields as an indication that bond investors perceive public deficits as excessively high at this phase of the economic cycle. Long-term bond yields should diminish in anticipation of a rate decrease in 2024.
Please note that articles may contain technical jargon, hence may not be suitable for readers lacking professional investment experience. Any opinions expressed herein are those of the author as of the publication date, are based on available information, and are subject to change without notice. Different portfolio management teams may harbor divergent perspectives and make dissimilar investment decisions for various clients. This document does not constitute investment advice. The value of investments and the income derived from them may decrease, and it is plausible that investors may not recoup their initial outlay. Past performance does not guarantee future returns. Investments in emerging markets or specific or restricted sectors are likely to exhibit higher-than-average volatility due to a greater concentration, heightened uncertainty due to limited information availability, reduced liquidity, or heightened sensitivity to variations in market conditions (socioeconomic and political circumstances). Certain emerging markets provide less protection than the majority of internationally developed markets. Consequently, portfolio transactions, liquidation, and safeguarding services may entail increased risk for funds invested in emerging markets.