Sticky US inflation causes bond yields to rise
It has been a choppy week for markets as expectations for a pause in the US interest rate hiking cycle weakened following the release of data pointing towards sticky inflation. US consumer prices, despite coming in weaker versus the previous month, exceeded forecasts at 6.4% for the year to January. US retail sales rose by 3% for the month of January, far stronger than the 1.8% increase forecast. US producer prices, which monitor wholesale price increases, came in at 6.0% for the year to January, once again, a downward trend, but much higher than the estimate of 5.4%. Government bonds sold off, whilst equity markets, having started the week on a strong footing, gradually gave up more of their gains as the week progressed, whilst the dollar staged a rally.
As of 12pm London time on Friday, US equities were flat for the week, whilst the US technology sector rose 1.2%, although it had been up as much as 3% intra week. European equities increased by 0.8% and UK stocks were up by 1.1%. The UK market benefitted from inflation data that although remaining very high, was actually lower than forecast, and therefore, contrary to the US, raised expectations for a pause in the rate hiking cycle. The Japanese market rose by 0.3%, whilst Australian stocks fell by 1.2% on the back of declining sentiment in the US and the Reserve Bank of Australia warning that further rate increases would be needed. Emerging markets fell 0.3%, with Asian stocks falling by 0.9%, whilst Latin American stocks rose by 2.6%.
US Treasury yields, which move inversely to price, rose over the week, with 10-year yields now trading at 3.89%. Similarly, German bunds and UK gilts also rose, with yields now at 2.51% and 3.54% respectively.
Gold fell by 2.1%, now trading at $1,834 as expectations of further US rate rises dented investors’ appetite for the precious metal. Energy commodities also dropped, with Brent crude falling by 4.4%, now priced at $82.6 a barrel and European natural gas prices fell by 7.9% to trade at $49.8 per Mega Watt Hour. Contrastingly, some industrial commodities made gains, with copper rising by 1.8% and iron ore 1.4%.
The dollar index rallied by 0.9%, with the US currency now trading at $1.06 versus the Euro and $1.19 versus Sterling. The Euro strengthened slightly versus Sterling, now trading at €1.12.
Issues under discussion
Sticky inflation is raising the prospect of further US interest rate rises, or at least rates staying higher for longer. This seemingly feels more likely with several US central bank governors coming out in support of higher rates over the week. Futures markets are increasingly pricing in US rates coming down at a slower rate than was priced in at the beginning of the year, with rates now expected to peak at 5.3% and still be around 5.1% by the year end.
However, there remains a great deal of uncertainty over the passage of rates, with markets knowing that monetary policy acts with a lag on the one hand, but also knowing that the level of rates set over the past decade was an aberration. In the decade up to the financial crisis of 2008, it was not uncommon for US rates to be close to twice that of the inflation rate. Whilst ever since the financial crisis, rates were typically much lower than inflation as central banks tried, often in vain, to lift economic growth rates across the developed world.
Investments that are cheap today and could be rerated upwards in a higher rate environment, are often also more economically sensitive in nature and more susceptible to sharply lower earnings in a recession Growth companies, despite valuations having fallen, are still not cheap, and remain at risk of further valuation falls should rates stay elevated for longer, but are often less sensitive to the economic cycle, with earnings that might be expected to be more resilient.
The portfolios are diversified in exposure between the two, with a preference for cheaper, more cyclical investments. Whilst our exposure to government bonds has increased as bond yields have risen materially, and we believe they offer greater diversification benefits should central banks raise rates too much and tip economies into a recession.