Financial Update from Brewin Dolphin - 29 September 2023

September 2023

The Weekly Round-up

Friday 29 September 2023

In her latest weekly round-up, Janet Mui, Head of Market Analysis, discusses higher-for-longer interest rates and encouraging inflation data from the eurozone.

As the third quarter draws to a close, global stocks are heading for the worst month in a year in September, despite a bit of a reprieve in sentiment on the last trading day of the quarter. US ten-year Treasury yields topped 4.61% this week, the highest in 16 years. The rise in long-dated bond yields shows markets are readjusting to the higher-for-longer rate environment. Yes, we are at or near the end of the interest rate hiking cycle. But markets are moving on to debate how long rates will remain high in the current cycle, as well as rethinking the optimal interest rate level in the long run (the ‘neutral rate’).

The spike in US bond yields is mostly driven by real (inflation-adjusted) yields, while inflation expectations remained stable. The medium to long-term inflation outlook is obviously important, but investors are increasingly focused on structural considerations that are impacting the case for higher-for-longer interest rates.

For instance, a higher budget deficit, higher Treasury issuance and quantitative tightening get investors thinking about the higher yields needed to entice demand. As a result, ‘term premium’ – the extra compensation required for holding longer-dated bonds – has risen back to positive territory, according to the Federal Reserve Bank of New York’s calculation.

The debate on the level of ’neutral rate‘ will be ongoing and may keep upward pressure on long-dated bond yields. That is why we prefer short-dated bonds with attractive yields on offer, instead of taking ultra-long duration risks.

In the near-term, cyclical factors are more at play. We think another hike is still on the table in the US. Whether the Federal Reserve goes ahead with another hike or not this November or December should be entirely determined by the data. The latest release of the core personal consumption expenditure (PCE) price index is encouraging. It rose by only 0.1% month-on-month (MoM) while the year-on-year (YoY) rate slowed from 4.3% to 3.9%. That said, looking from a glass half empty perspective, core PCE remains close to twice the 2% target, which means rate cuts are premature.

The latest US data remains mixed. Home sales fell sharply as higher mortgage rates impacted transaction volumes, yet home prices actually picked up on tight supply. The labour market remains rather strong, as initial jobless claims are still hovering at low-200,000 levels. Meanwhile, there are signs that consumers are starting to hold back as personal spending slowed in August. That said, rising energy costs, the resumption of student loan repayments and a potential government shutdown are all headwinds for consumption in the fourth quarter.

The recession debate remains heated, and the data remains ambiguous. The US economy will slow, but it’s evident that the US is able to handle higher rates better than the other major economies. The higher-for-longer rate environment, particularly pertinent to the US, adds to growth headwinds and poses risks to valuations.

$100 oil?

Just when central banks are at or approaching the end of the interest rate hiking cycle, analysts are warming up to the idea of ‘$100 oil’ again. We are getting close to that level with Brent crude oil prices topping $96 per barrel this week. The latest data showed a decline in oil inventories and critically low stockpiles at the Cushing hub in the US.

Oil prices have gained 30% alone in the third quarter. The latest rally in oil prices is mainly driven by extended production cuts caused by Saudi Arabia keeping supply tight. At the same time, the Energy Information Administration’s (EIA) estimate for oil demand for this year has been revised up. It looks like oil consumption will outpace supply for the reminder of the year, so oil prices are likely to remain supported.

It is best to avoid the embarrassment of incorrectly forecasting where oil prices will be in six to 12 months’ time, let alone in five to ten years’ time. There is a saying that “the cure for high oil prices is high prices”. That is certainly true on the demand side of the equation, as higher oil prices are a direct erosion of purchasing power. Were oil to hit $100 or higher, it will act to reduce demand and ultimately bring prices lower.

But with ongoing supply constraints due to the significant scale back in fossil fuel-related investments, and the challenge of a smooth transition to net-zero carbon emission, it’s fair to expect that energy price volatility will be with us for longer than we wish.

For portfolio diversification purposes, few think that having near neutral exposure to global energy sector stocks may act as a hedge in case of an oil price shock and in the high likelihood of future price volatility. It is true that interest rates may have reached their peak in major economies, but we are likely to be in a higher-for-longer interest rate environment. Against this backdrop, the energy sector is a low-duration play, which can hedge against the more interest rate or inflation-sensitive secular growth exposure that investors may have elsewhere in their portfolios.

One policy rate, 20 economies

This week saw some positive news for the eurozone. The eurozone flash consumer price index (CPI) has slowed from 5.2% to 4.3% YoY, below estimates of 4.5%. Core CPI, which excludes energy, food, alcohol, and tobacco, also slowed from 5.3% to 4.5% compared to the expected 4.8%, with services inflation moderating. This is certainly music to the ears for the European Central Bank (ECB). Equally, it does not make the ECB’s job any easier. We have highlighted before that there are divergent trends among the eurozone’s 20 member states. For instance, Spain’s CPI rebounded from 2.4% to 3.2%, German CPI slowed meaningfully from 6.4% to 4.3%, and Italy’s CPI picked up from 5.5% to 5.7% in September.

This fragmented nature of the eurozone sheds a light on the fact that different member states react differently to the level of central policy rates, and there are national idiosyncratic factors, too. This means they have different tolerances to high interest rates, which should lead to more caution at the ECB when determining the next steps. On that front, we think the ECB has probably finished hiking interest rates but will keep monetary policy in restrictive territory.