Throughout the second quarter of 2023, the overriding hope was that rates were close to their peak. Fast forward to the third quarter and inflation concerns have persisted in developed markets, resulting in both equities and bonds posting declines.
It was a challenging summer for both US stocks and bonds amid an uncertain macro-economic climate. Economic growth surpassed expectations throughout the quarter, despite the Federal Reserve’s (Fed) efforts to cool the economy with its multi-year aggressive rate hiking cycle. As such, prospects of rate cuts moved further into the future. After registering highs in July, both the Nasdaq Composite and S&P 500 sold off in August and September, finishing the quarter down 4% and 3.3% respectively.1
Concerns mounted in August when ratings agency Fitch downgraded US government debt over expected fiscal deterioration in the next three years amid ballooning government debt. Rising borrowing costs hurt equity markets and put pressure on government budgets, creating larger budget deficits.
Over the quarter, we saw August CPI in the US rise to 3.7% year-on-year (vs 3.2% in July), largely due to higher oil prices.2 However, we did see core CPI (excluding energy) broadly move in the right direction, a welcome sign for central banks that have been attempting to dampen inflation through the most aggressive rate hiking cycle in decades. The Fed paused its interest rate hiking in September, though it indicated that another rate hike may be necessary later this year, and it expects to maintain higher rates for longer. This provided no comfort to markets, with global developed market indices selling off after the Fed’s meeting. With commodity prices rising, inflation is expected to remain high. At the same time, Fed members now expect fewer rate cuts next year, resulting in a spike in Treasury yields.
Despite the Fed’s efforts, in late September the US 10-year Treasury yield rose above 4.5% for the first time since 2007.3 The sharp move in the 10-year is partly because investors are pricing the higher for longer rhetoric, and partly due to the realisation that Treasury supply will remain elevated over mounting budget deficits.
For equities, the UK was a bright spot, with the FTSE 100 rising 2.1% in the quarter, benefiting from higher commodity and oil prices and a weaker pound.4 Following a rate hike in August to 5.25%, many forecasted that the Bank of England (BoE) would raise rates by a further 0.25% in September. However, lower-than-expected inflation led them to hold rates, although with a 5-to-4 split – clearly the members remain divided and have lingering concerns over future inflation. The European Central Bank (ECB) meanwhile carried on its rate hiking cycle throughout the summer taking deposit rates to 4%. This is widely expected to be their peak.
In China, property market concerns mounted over the summer, prompting further government support measures, such as lowering mortgage rates for first-time homebuyers and reducing downpayment ratios. These latest efforts by Chinese authorities are meant to restore confidence and boost growth in the economy, which has had a lacklustre post-pandemic recovery. Despite these efforts, sentiment towards Chinese and Hong Kong equites was negative. As a result, both these markets were down over the quarter.
There are, however, reasons to be optimistic when it comes to China. Equity valuations in the region trade at a significant discount to US equities, and recent data suggests the Chinese economy may have bottomed during the quarter. It is probable that the Chinese authorities’ recent stimulatory actions - reducing rates, help with childcare and the elderly, a cut in stamp duty for stock trades, among others - have not yet filtered through to the economy. As such, we expect growth to pick up in the coming quarter.
In summary, both the Fed and BoE delivered a rapid series of rate hikes to bring their respective rates to over 5%. Economic resilience has surprised them, but interest rates have now reached levels to put sufficient pressure on the economy and dampen inflation. Interest rates will remain higher for longer until growth and inflation show significant signs of cooling. Rising borrowing costs mean businesses with strong balance sheets should be in a better position to weather a downturn. We continue our selective approach of quality companies that display long-term compounding of earnings.
[1] Bloomberg
[2] US Bureau of Labor Statistics
[3] Bloomberg
[4] Bloomberg
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