Market Update: US, not UK battening down the hatches

Another benign month of recurring themes as rebounding bond yields raise equity valuation pressure and investors return to their previous safe havens –  the US tech mega caps.

Demographics and economics
Last week’s report from the Office of National Statistics revealing a historic low UK birthrate was a timely reminder changes in population materially impact economic growth.

Rachel Reeves’ autumn budget dominated the UK news last week, but global investors were yet again preoccupied with the US election. Both created market jitters for UK investors, culminating in a noticeable fall in global stock prices on Thursday. We wrote theweek before last that traders were bracing for a consequential and uncertain election – which could create volatility as trading volumes thin. That is exactly what we see happening. The good news is that the underlying economic picture has not changed. The bad news is that nerves will stay high until we know who the next US president will be – and we might not know that for a while after 5 November.

Budget was more bark than bite.
After so much anticipation, the budget delivered substantial tax rises and meaningful new spending. Our weekly updates are about markets and the economy, so we will stick to the budget’s impacts on these areas, rather than the implications it may have on individual tax positions. Many people framed it as a fundamental change, but ironically the main economic effects will probably be short-term and cyclical, rather than structural. The Office for Budget Responsibility said as much, noting that public investment should boost growth over the next two years, but without the supply-side reforms needed to boost long-term productivity.

I (CEO Lothar) attended an event on Wednesday night where the Chancellor sold her budget plans to City of London executives. She emphasised that this budget is just a starting point – the medicine before genuine reforms later. We hope that is true, but only time will tell. Her announcement to Sky news that the tax-raising elements were a “once in a parliament budget” were encouraging at least. If nothing else, a consistent approach to fiscal policy – after a decade of chop and change in Westminster – should bring some stability.

Markets reacted negatively, but not horribly. Stocks fell on Thursday (though that was part of a broader downturn in global equities) and government bond yields rose notably. We said in the build up to the budget that UK bond movements were more about the US, but most of last week’s yield increase was undeniably budget-related. UK bond yields are around 0.2 percentage points higher than US yields at the time of writing, having been equal just a couple of days ago. This was because the treasury changed how public debt is counted – which is not an unjustified switch, but allows for looser fiscal policy. Still, the yield pick-up currently looks manageable and, all in all, probably leaves the treasury with more fiscal headroom than before it changed the rules.

Markets de-risk ahead of knife-edge election.
Higher UK bond yields were partly about the budget, but problems were compounded by another move up in US bond yields. This is most notable for longer-dated US bonds, for which investor risk perceptions have increased (measured by the difference between long-term yields and interbank swap rates). Some of this is about the possibility of Donald Trump’s tax cuts if he wins this week’s election.

We warned that these cuts could worsen the US fiscal position and potentially destabilise the world’s largest bond market. Markets mostly ignored this risk for months, but traders are getting more nervous as we approach election day. We suspect foreign investors also worry about US political stability. Measures of the extra yield that US treasuries require (to compensate investors for those risks) have been rising in recent days, while over the week, the US dollar has been stable. Usually, relatively higher US yields attract money into US bonds, but that is not yet happening.

Meanwhile, US corporate earnings reports from the third quarter have been underwhelming. We knew the US economy had a soft patch in the summer, so this is not surprising. But tense markets are easier to upset, as we saw on Thursday. The equity sell-off was almost mechanical: bond yields went up, which makes stocks with drawn out earnings prospects less attractive – then mildly disappointing quarterly earnings come through, making stocks look too expensive.
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This does not tell us much about underlying market sentiment. It looks more like investors hedging against risks – as you would expect before a pivotal but deeply uncertain election. In growth terms, we already know that US activity has recovered from the summer soft patch, so looking ahead we should expect decent earnings from this quarter to make up for last quarter’s disappointment. But we have to get past this week’s big unknown first. The worst case would be a contested result and a protracted post-election fight – legal or otherwise. Assuming that does not happen, the world’s largest economy is in a good position.

Wait and see how the mixture of global risks play out.
European company earnings are looking even more disappointing, with average expected profit growth for the next 12 months turning negative. Problems with forward-looking indicators are worse for market sentiment than problems with past results. So, while markets were disappointed with US earnings because they showed how soft the summer was, investors are negative on Europe because of how bad things could become. Growth prospects look very tough, and the main positive right now is that the European Central Bank takes these struggles seriously – so should cut interest rates more sharply than elsewhere.

Europe’s outlook is made even tougher by Russia’s recent gains in Ukraine. It is hard to know what this means for the war, and for European energy security, but it does not look like a positive. Again, the geopolitical outlook depends on the US election. Russian gains (or Ukraine formally ceding territory) seem more likely under Trump than Harris.

On the other end of the geopolitical risk spectrum, Middle Eastern tensions have simmered down in recent weeks. Israel’s eventual response to the Iranian missile barrage seemed to be calibrated to avoid damaging civilian or energy infrastructure – which makes a full Iranian retaliation unlikely. Oil prices have fallen since the week before last, which is an encouraging sign. Lower oil prices could be even more positive for global growth than markets currently realise – but again we will have to wait for the US election outcome for positivity to manifest. We just hope the outcome is known by the end of the week.