“The rates change everything”: MGP recommends caution in the markets

The data that the financial markets had been waiting for during these past two months of relative calm has begun to arrive over the last month. This new light shining on investors has led stock markets to end the first half of the year with returns that compare very well to those of late 2022. Meanwhile, in fixed income, although returns are still insufficient to make up for a bad past year, they are more than welcome, especially for more conservative investors.

Everyone knows that this light is coming from a storm, and it remains to be seen whether that storm will end up buffeting the financial markets, as many analysts and macro-economists have been predicting since the beginning of the year. In fact, and as the latest macroeconomic data would suggest, the storm seems to be heading more towards Europe, which has begun to show signs of less resilience than the U.S. economy. What also remains to be seen is whether this storm will blow over soon, or if, on the contrary, it will have more lasting effects in the form of a recession.

 

Optimism continues in the stock markets

The performance of different assets so far this year corresponds to a market environment in which everything is going reasonably well: the stock markets are up due to the momentum of economies that so far have held up much better than expected. Add to this the rise of artificial intelligence and what it may mean in the coming years for companies’ income statements.

Moreover, given the strength of employment, companies are improving their outlook for the coming months, which the stock markets are celebrating with double-digit returns on the major exchanges.

We already mentioned in the previous report the “hidden” part was being concealed by the performance of some exchanges. But over the last month, optimism has been spreading to management styles and sectors that had received little support since the beginning of the year. This optimism, which is excessive in some cases, also stems from an increase in risk in portfolios with a view to recovering part of lost (or unearned) returns due to cautious positioning since the beginning of the year. Be that as it may, the stock markets are reflecting the better macroeconomic scenario we have encountered in this first half of the year. It is in fixed income where we find even greater uncertainty, and where the “carry” (or collecting of coupons) is the only factor supporting bond prices for now.

 

Inflation and growth are holding up

Inflation is the variable that has worried us the most (and still worries us) since it erupted last year. The latest figures continue to point in the right direction, although they are still at rates far from the targets set by central banks. Aside from any positive or negative surprises, the deflation trend seems clear, at least in its overall calculation. The same cannot be said for core inflation, which remains anchored at average levels of 5%, causing inflation forecasts for 2024 to be gradually revised upwards.

If we focus on growth, national economies have remained quite strong so far, proving Nobel laureate Milton Friedman's theory that it takes time for the effects of a hard/lax monetary policy to be reflected in the real economy. Services and employment are continuing to ward off fears of a recession. This is undoubtedly the variable to follow in order to determine exactly where we are in the cycle from a macroeconomic point of view.

For now, growth forecasts beyond 2023, despite being revised downwards, remain at levels that would keep economies free of recessionary turbulence and give central banks no reason to lower interest rates.

And all this at a time when the divergence between the United States and the rest of the world is once again widening. If we look at how the latest macroeconomic benchmarks have been performing, we find that the country once again surprised on the upside with much better than expected macro figures across a broad spectrum of references.

However, on the other side of the Atlantic, we can see how the figures have remained much worse than expected, taking the European index to levels not seen since the financial crisis. This is just a reflection of how difficult it may be for the eurozone to live with higher interest rates. Europe is being joined in this downturn by the Chinese economy, for which the market is still awaiting a seemingly overdue monetary and fiscal stimulus.

 

What should we expect from the central banks?

Until inflation and/or growth show further signs of weakness, the scenario remains the same from the point of view of monetary policy decisions. The current levels of the main macroeconomic indicators and their future outlook are incompatible with any further central bank support for increases in financial asset prices. Moreover, an analysis of each of Christine Lagarde's or Jerome Powell's speeches at Sintra would lead to the conclusion that both the Federal Reserve (Fed) and the European Central Bank (ECB) have become “insensitive” to growth, as they are focusing all their efforts on curbing inflation. In reality, this is not a new message. They have been making statements along the same lines since they began to raise interest rates in 2022, but it has allowed the market to price in the fact that there will be no rate cuts in 2023.

On the liquidity side of the market, beyond occasional variations, no change in dynamics are likely to be seen. And this is consistent with economies that, for now, have no need for monetary stimulus, and with a central bank that is rushing to withdraw the excess liquidity that has built up in recent years. Therefore, in the short term, and looking ahead to the summer until the annual meeting in Jackson Hole, we do not expect any major headlines from the monetary authorities.

 

Conclusions

The first conclusion is that central banks are being more aggressive than expected, as inflation is persisting and growth remains in positive territory, albeit divergent between the United States and Europe. As a result, the flat trend in fixed income exchanges is likely to continue for a few more months if nothing changes.

Our second conclusion comes from what companies and investor relations teams are telling analysts: most businesses are looking forward to a good earnings season in the second quarter. This will undoubtedly provide a new tailwind for share prices, given that at the macroeconomic level, ROE, corporate margins, and debt levels will remain at least at optimal levels in the short term.

The last conclusion is that, although we have entered a new market paradigm, the pattern is the same as in the last five years: the United States and technology will play a dominant role in leading market rallies. The market still does not seem to acknowledge that interest rates change everything and that such demanding price/earnings valuations are incompatible with positive real interest rates. We therefore continue to recommend caution and steering clear of risks arising from over-concentration partly caused by passive management.