Julian Howard: The interest rate bear threatening Goldilocks

Rising rates remain the chief impediment to investors being able to engage meaningfully in risk assets


2022 was a torrid year for markets. Inflation rose, monetary policy started to tighten and the value of most mainstream assets adjusted downwards as a result. Nevertheless, a benign set of conditions that began in autumn, culminated in an improved picture at the start of this year.

Inflation has cooled, global supply chains are stabilising and consumers are seeing improvements in spending power. Recessionary fears appeared to be excessively pessimistic. Commentators have seized upon all this as evidence of a new ‘goldilocks’ period in the economy, with the promise of accordingly better returns for investors.

So what is a ‘Goldilocks’ economy? Perhaps the best example was the US in 1983, where – after the recession of 1981/82, inflation dropped as low as 2.5%, unemployment fell from 11% to 9% over the course of the year and the economy grew a healthy 4.6% in real terms. The stockmarket liked these ‘not too strong, not too weak’ conditions, with the S&P 500 index adding a whopping 22.5% that year and going on to deliver a positive return until the early 1990s recession.

Comparisons with today are understandable – up to a point. US unemployment is just 3.6%. Consensus GDP growth for 2023, as surveyed by Bloomberg, rose to 0.75% at the end of February – from just 0.3% at the start of the year. US headline inflation fell to 6.4% from the 9.1% peak in the middle of last year.

And the stockmarket has been positive over this period too, with the S&P 500 and MSCI AC World indices gaining 14.5% and 18.4%, respectively, in USD terms between 12 October 2022 and January this year. This, however, is where the comparison ends.

Risks of an ‘interest rate bear’

With low inflation, the US Federal Reserve of 1983 was able to drop rates from a heady 15% to 8.5% over the course of the year. That may still be high by today’s standards – but, back then, inflation was still heading in the right direction.

Fast forward to 2023, and both the Fed and the market are now in broad agreement that interest rates will still need to rise to above 5%. The so-called ‘dot plot’ and interest rate futures show significantly higher rates compared with barely a year ago and that two more additional rate hikes may be expected from here.

A strong US labour report and a sideways (rather than outright lower) inflation print during February forced markets to take note. The S&P 500 was down by more than 2% on the month and the inflation-sensitive 10-year US Treasury yield touching nearly 4.0%.

For the stockmarket, the interest rate issue is clearly now getting in the way of further progress. The S&P 500’s forward earnings yield stands at 5.5% which, although not unreasonable, is still insufficient compensation for the volatility associated with stocks, given that nearly 4% can be earned virtually risk-free from holding US government bonds.

For investors, the interest rate issue therefore remains the chief impediment to declaring a ‘Goldilocks economy’ and being able to engage meaningfully in risk assets. The anticipation of such a scenario justifiably propelled stocks from October last year to end of January this year – however, ETF and mutual fund flows suggests low investor participation and that the rally was poorly attended, amid scepticism that higher inflation had been severe and rates could safely revert to pre-2022 levels.

Sustaining the Goldilocks scenario

Both central bank and market-based interest rates will need to come down meaningfully and make stocks look relatively more attractive to capital allocators once again. This requires a faster and more linear pace of disinflation than current levels, likely coupled with substantial weakness in the labour market too. The problem is, inflation is notorious for being hard to accurately predict.

Markets have already seen multiple phases in a short period of time since 2020 – working from home, re-opening, inflation and now supposedly Goldilocks has arrived. The challenge for investors is that, by the time one phase has been identified and portfolios adjusted, the next one may already have taken place.

This may be disheartening for those looking to add value over the short term but, whatever happens over the next few months, some form of Goldilocks scenario seems inherently likely over a much longer horizon.

Economic growth is likely to be suppressed in the coming years given the challenging state of demographics and inequality. This could ‘naturally’ cap inflation and interest rates. That should be sufficient support for long-dated assets like US equities and bonds to make further progress.

In the meantime, however, investors need to watch out for that interest rate bear.

Julian Howard is lead director, multi-asset Solutions at GAM Investments


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