Welcome to your August monthly market outlook from atomos
On 1 August, the Bank of England’s Monetary Policy Committee finally voted to cut the base rate of interest as a sign that the inflation dragon has perhaps been tamed. After holding interest rates steady for a year, the Bank will now enact a 25 basis point cut from 5.25% to 5%.
Policymakers had hiked interest rates to try to combat soaring inflation, and this has had the desired effect, although a narrow 5 to 4 vote by MPC members to cut rates suggests inflation remains a concern. Annual CPI inflation was at the Bank of England’s 2% target in both May and June. We had been predicting rates would start to fall from the third quarter of the year.
This week’s cut is good news for holders of mortgages and other debts, less so for savers who will start to earn less interest on their money.
Stark contrast in economic strength
In 2023 and 2024, we have seen both the UK and US economies returning to some degree of normality after a turbulent few years.
In the US, the economy was much stronger than we expected in 2023, and has now moved to a more normal range with annual real GDP growth of around 2.5%. Strong economic activity in the US was a marked contrast to other advanced economies including the UK, the Euro area, and Canada, which skirted recession for most of 2023. We see economic divergence as a key theme for 2024, and this will inform our investment decisions.
US household spending growth is resilient, supported by low unemployment and strong but slowing wage growth. The same is true in the UK. Importantly, in both countries, the labour market has found a better balance. For instance, in the US, the gap between job openings and workers has fallen, while hiring and quit rates and hours worked have also dropped.
Inflation has also come down, with some volatility. The Federal Reserve is increasingly confident that core inflation will fall close enough to its target by the end of 2024 that it will begin cutting interest rates – most likely in September, having held rates at its latest meeting on 31 July.
What are markets telling us about future interest rate moves?
If we look at what’s happening in bond markets, we get a clue as to what we can expect from central banks or, at least, what the market is predicting. In the US, bond markets are pricing in two to three interest rate cuts this year. In the UK, bond pricing points to two cuts this year, with the Bank rate coming down to 4%-4.25% within a year.
How does this affect investors?
Cash rates (the interest rate banks pay to borrow funds from other banks, which influences rates on mortgages and savings accounts) of 5.25% to 5.5% have been attractive both relative to the last 15 years and, in the last few months, relative to inflation as it has fallen. Unfortunately, both the macro big picture and financial markets are telling us that this about to end.
Government bonds are a good way of locking in higher cash rates for an extended period. We typically prefer government bonds over cash at this stage of the business and capital market cycles because of anticipated rate cuts. However, as with any asset, the price at which you buy or sell it is especially important.
The ups and downs of technology stocks
Equity volatility, meaning how much and how quickly share prices move, has jumped in the last week or so. The CBOE Volatility Index (VIX), which measures US equity volatility, had been largely trading between 13% and 15% over the year-to-date, with a bit of a spike in mid-April. However, it jumped to 18.5% last week and has remained in a higher range over the past five trading days.
A much more intuitive way to think about equity volatility is how long we have been without a major daily drop – defined as 2% - in equity index prices. Until 24 July, the S&P 500 (an index of the 500 largest listed companies in the US) had gone a staggering 356 consecutive trading days without a 2% fall. This is the longest unbroken winning streak the index had seen since 2007.
The equity market is driven by a huge number of different buyers, all with different motivations, so there is rarely a simple, single, reason for equity price moves. In this case, share price falls were led by a combination of caution in earnings for some of the ‘Magnificent Seven’ and wider technology stocks, and the outperformance of value and small-cap stocks over growth stocks, as expectations of future interest rate cuts began to increase. Semiconductor manufacturers’ share prices are also declining significantly on concerns of additional US export restrictions and rising competitive pressures.
That’s an interesting statistic and, in many respects, signals that equity markets were overdue a correction. At the close of 29 July, the MSCI World Equity Index was up 11.3%, the S&P 500 up 14.5%, and Nasdaq up 15.7%. Month-to-date both the MSCI World and S&P 500 were still up (just) and the Nasdaq was down 2%. So, we should also see this as a small correction, with big year-to-date gains.
Sector in focus: Utilities
The Dow Jones U.S. Utilities Index has been a quiet outperformer since mid-February, rising by around 20%. It was also unaffected by technology stocks and wider market volatility in the last week. This is a marked turnaround after the US utilities sector posted a large negative return in 2023.
Defensive sectors such as utilities had been performing poorly relative to world equities, which have been driven for much of the year by confidence in artificial intelligence (AI)-related developments in the IT and communication services sectors.
So why the sudden jump in US utilities stock prices, which don’t typically see such large short-term moves? Perhaps we can focus on US power companies especially and ask a slightly different question: what if the supply chain bottlenecks for the rolling out of new AI services aren’t, ultimately, going to be the availability of high-performance semiconductor chips? What if, instead, it is the capacity of the power network and distribution to meet future power demand from AI services?
The primary driver of power companies is power demand, and the AI theme has more recently begun to benefit these companies. AI uses an incredible amount of power – the industry could consume as much energy as a country the size of the Netherlands by 2027, one report predicted.(i) This is good news for energy producers, if not for the climate. Earnings reports from the big technology companies in Q1 and Q2 have shown big increases in AI-related capital expenditures, such as building new data centres. This is likely to continue, increasing US power demand and supporting US power company earnings on a long-term basis.
At the same time, the expected fall in interest rates has also lent some support to sector valuations - we expect lower policy rates to help ease debt related pressures, given the sector’s relatively high debt to equity ratios.
If you would like to discuss any of the topics covered in this month’s outlook, our door is always open. Contact us
(i) https://www.bbc.co.uk/news/technology-67053139
Content correct as of publication on 2nd August 2024
All investment views are presented for information only and are not a personal recommendation to buy or sell. Past performance is not a reliable indicator of future returns, investing involves risk and the value of investments, and the income from them, may fall as well as rise and are not guaranteed. Investors may not get back the original amount invested. Any views expressed are based on information received from a variety of sources which we believe to be reliable, but are not guaranteed as to accuracy or completeness by atomos. Any expressions of opinion are subject to change without notice.