Market Update: Central bank week

Central bank week 

It’s been another nervy week for investors. Month-end positioning may have had a part to play in creating ups and downs, but most markets were more focused on interest rate decisions. The Bank of England (BoE) cut, the Bank of Japan (BoJ) hiked, and the US Federal Reserve (Fed) stuck. Western central bankers now acknowledge that slower growth needs at least neutral, if not supportive, monetary policy, while Japan is at the opposite end of its cycle.

Equities rallied after the Fed meeting, but Fed chair Jerome Powell’s comments, that he was worried about softening US jobs data, put focus on the labour market. That data came in significantly weaker, with 4.3% unemployment triggering the “Sahm rule” recession indicator that we wrote about the week before last. Stocks ended last week downbeat in response. The much-watched  second-quarter earnings from US tech firms were also disappointing, when looking at free cash-flow. On Friday, we saw a nasty set from Intel, with the firm indicating a sharp retrenchment and lay-offs of 15,000 employees.

Interestingly, bond prices have started to move up, negatively correlated to equity prices. When this happens, it suggests a weakening in investors’ growth estimates.

Friday’s turbulence has carried through to today (Monday 5^th August) as investors start to get nervy about global growth prospects and weaker-than-expected earnings results for the bigger US tech companies in the ‘Magnificent Seven’. They may also be re-assessing the sky-high valuations of Tech, re-considering the risks that companies will be subject to or even overreacting and panicking.

The Bank of Japan’s recent rate hike, strengthening the Yen, combined with a less optimistic picture for domestic growth in Japan have formed part of Friday’s drawdowns.

Andrew Bailey’s hawkish cut?

Starting close to home, the BoE lowered interest rates for the first time since March 2020 on Thursday, but the decision was hardly emphatic. The bank’s Monetary Policy Committee (MPC) voted to lower benchmark rates from 5.25% to 5% but by the closest margin – a 5-4 vote. Bailey then downplayed any suggestion of a quick journey down in rates.

The governor warned that the MPC must be “careful not to cut rates too much or too quickly”. The BoE’s own forecasts suggest inflation falling below the 2% target within two years, even accounting for more than one rate cut this year (as markets expect). But more hawkish MPC members worry that these forecasts underplay the lasting effects of the inflation shock. Bailey seems at least sympathetic to those concerns.

The MPC no doubt has one eye on emerging fiscal policies from the new Labour government. Bailey downplayed the inflationary impact of last week’s NHS pay rise announcement (wage inflation has long been the BoE’s main fear) and MPC members are likely to see the signals from the treasury as sticking to its fiscal discipline promises. The Chancellor’s warning of a £22bn “black hole” in the budget, and how it might need to be plugged with higher than expected taxes, is a testament to this.

Fed shifts focus to employment.

If the BoE’s move was a hawkish cut, the Fed’s was a dovish stasis. The US central bank held rates steady at its meeting on Wednesday, but chair Jay Powell strongly suggested rates will soon be cut: “A reduction in our policy rate could be on the table as soon as the next meeting in September,” he announced, adding that the committee had a “real discussion” about cutting rates last week.

Powell even suggested that inflation was no longer the Fed’s primary concern. He emphasised the bank’s “dual mandate” to promote both price stability and maximum employment, highlighting that rising unemployment was now becoming a cause for concern. For two years, inflation has dominated policy, and the idea that the Fed would actually be worried about unemployment – rather than welcoming it as a disinflationary force – was far fetched.

As we wrote the week before last, though, unemployment metrics have moved close to a ‘tipping point’ (where job losses cause further losses in a spiral). The rise in the US unemployment rate to 4.3% shows soft current conditions, while the ISM Manufacturing Survey data showed a distinctly weak outlook in the sector.  Manufacturing tends to lead the much larger service sector, so next Monday’s service ISM data will be important.

So, as mentioned above, bond yields moved down through the week – almost as though Powell’s dovish tones were a de facto rate cut. The 10-year yield moved below 4% and money market futures now have the prospect of multiple rate cuts as more likely than they did the week before.

Yen strength a cause of rotation

On the same day the Fed pencilled in an upcoming cut, the BoJ raised rates for the second time this year. The new 0.25% benchmark is the highest Japanese rates have been in 15 years, and it signals that the BoJ is in a genuine rate-hiking cycle. That pushed the yen below ¥150 on the dollar for the first time since March, which had impacts on the domestic and foreign equity markets.

Firstly, domestic investors seemed spooked by Japan’s potentially slowing growth, after some weak signs. International investors benefitted from the surging yen early in the week, but Japan’s Nikkei 225 fell over 5% during Friday trading. Even with the currency benefit, Japanese stocks are the regional underperformer having fallen by 3% on Friday, followed by its largest daily sell off since October 1987 today where the Nikkei fell by a further 12.40%. This sell off has largely been triggered by concerns of US recessionary fears and that the Fed may has left it to late to begin cutting interest rates without damaging the world’s largest economy.

Secondly, we think yen strength has impacted US markets substantially. The yen had been consistently sliding all year, and was above ¥161 to the dollar as recently as the second week of July. Its strengthening since then has coincided with a stock market rotation away from US mega-caps, and that is no coincidence. In our round-up of July returns below, we note how leveraged institutional investors (i.e. hedge funds) have had large buy positions on US tech, and sell positions on mid-cap or non-US stocks. Loose Japanese borrowing conditions and a weakening yen have been an important source of funding for that trade, thanks to the chasm between US and Japanese rates.

The BoJ is now tightening while the Fed is loosening, so that source of funding will inevitably diminish. We suspect this was a trigger for the move out of US mega-caps and the sharply stronger yen. The question now is whether the trend of the last few weeks can continue. Market moves that are caused by the positioning of certain key players can often run out of steam – simply because those positions get evened out. There are reasons to think that might have already happened, such as the notable underperformance of small caps last week.

The wrap

If stocks – especially small caps – are to benefit from here, the Fed will need to pull off a ‘soft landing’ (inflation falls without damaging profits or employment too much). That is still the most likely outcome but, as Jerome Powell warned his fellow FOMC members, US employment is more fragile than it previously looked. We should hope the Fed has not missed its best time to cut.

If economic data worsens further before September’s meetings, the bond markets will discount further rate cuts before the Central banks can enact them. Lower yields should be enough to make equity valuations more attractive, and lower interest costs should spur growth. But US valuations are already high – based on optimistic earnings outlooks that are already somewhat challenged. Some Q2 results are not looking so stellar, and Intel’s massively disappointing numbers today don’t help. Yields would have to fall sharply to make those valuations look reasonable, so markets could struggle in the short-term.

This sort of turbulence is very normal although today’s huge sell off in Japan suggests a level of panic selling, although we feel this may have been overdone and given the valuations in some sectors of the market they could prove to be a buying opportunity for many active fund managers. A pullback from the equity market highs is always to be expected and trying to call the highs or lows is usually a losing game. It is, as ever, time in the market – not timing the market. Perhaps we should enjoy our holidays instead.

Periods of rotation present attractive buying opportunities and should not be a cause for panic. Vizion Wealth’s portfolios remain well positioned for long-term growth whilst focusing on diversification, risk-adjusted returns and lower investment drawdowns. Please contact your financial adviser for further information.