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The shift in overall market sentiment came about largely as a result of the communication from the Federal Reserve (Fed) following its September policy meeting. A stronger than expected economy caused US rate setters to revise higher their projections for future interest rates and although they have been guiding higher than market expectations for some time, the messaging caused a repricing among investors who had previously been expecting a lower path for rates. One of the clearest indications of this repricing came with the US 10-year Treasury yield closing above 4.6% for the first time since 2007, in the days following the Fed communication.

Either side of the Fed communication the Bank of England (BoE) and European Central Bank (ECB) announced their latest policy decisions, with both banks giving the surest sign yet that they are closing in, if not already at, the end of their interest rate increasing cycles. The UK and Eurozone economies have fared worse than their US counterpart during this cycle and although inflation continues to run well above central bank target, the recent messaging suggests that rate setters are starting to feel they may have done enough.

The BoE voted narrowly in favour of keeping its key interest rate unchanged at 5.25%, the first pause at a policy decision since December 2021. The move ended a run of 14 consecutive interest rate increases.

An unexpected drop in the latest inflation data published the day before the announcement no doubt played a part as the Consumer Price Index (CPI) showed a third consecutive decline in annual terms. The print of 6.7% was well below the consensus forecast and also represents a significant drop from last year’s peak of 11.1%. 

UK equities outperformed on the quarter returning just over 2.5%, supported by the BoE refraining from another rate rise and the fall in sterling. The pound ended September at 1.22 against the US dollar, a near 4% drop.

Wall street sold off into quarter end as US yields reached new multi-year highs, sending US benchmarks down 3.5% in local currency terms. Still, total returns (including dividends) year-to-date remain higher in the US (13.1%) than global indices (10.5%), the UK (+5.2%) and Europe ex UK (9.2%).

An interesting dynamic has developed in the relative performance of growth and value stocks, with the former outperforming in the US and the latter doing better in Europe. Although the Artificial Intelligence (AI) hype has clearly boosted a number of US tech stocks, the outperformance of growth as a factor can also be attributed, at least in part, to the strength of the economy. Rising interest rate environments are typically seen as negative for growth stocks.

However, there is a nuance in that this dynamic depends upon why rates are rising. If rates are rising because the economy is stronger than forecast, there’s a case to be made that companies expected to grow more in the future will fare even better and this can offset the negative of a higher discount rate. This has seemingly transpired in the US thus far in 2023.

In summary

Heading into the final quarter of the year, most developed stock market benchmarks are sitting on respectable year-to-date gains, even after the recent weakness. The latest leg higher in yields has provided a headwind for further advances and there is a sense that investors are waiting for an easing in this respect before they feel emboldened for another push higher.

Economic activity in the Eurozone and UK is clearly starting to feel the adverse effects of the monetary policy tightening cycle and while the US is an outlier in continuing to perform well, real interest rates are now well into positive territory and will provide a slowing effect going forward.

China’s economy is showing some signs of stabilisation following central bank stimulus measures, although the outlook remains clouded by the ongoing property downturn, high debt levels and geopolitical tensions with the US. The oil price rose sharply in the third quarter, with international benchmark Brent crude gaining 25% to move back to around the US$96 a barrel, its highest level since November 2022. As we head into winter attention will grow on natural gas prices and we are closely watching energy markets for signs of another rally which would apply upside pressure to inflation.  

Stocks are not expensive with valuations broadly in line with long-term averages after last year’s de-rating. However, bonds are increasingly looking good value compared to previous years and therefore diminishing the relative attraction of equities. Our Fixed Interest positioning is a little bit overweight duration, given our view on where we are in the monetary policy cycle and slightly underweight credit versus sovereign, a reflection of our view on the current position in the economic cycle.

Author: Damien Maltwood, Investment Director, Quilter Cheviot International Limited.