Welcome to your October monthly market outlook from atomos
In his address to the Labour Party Conference in Liverpool last month, the Prime Minister said the first step of his long-term plan for Britain was “stabilising the economy”. This will involve “unpopular decisions” such as the controversial cuts to winter fuel payments for pensioners already announced.
With less than a month to go until the Budget, the government has hinted about what to expect but we haven’t seen much in the way of policy specifics yet. The headlines have focused on the winter fuel payment as well as the prospect of higher taxes, including changes to capital gains tax and removal of non-domiciled tax status. These policies on their own are unlikely to dramatically influence the financial markets, but the direction of policies point to tighter fiscal policy from here.
Fiscal policy - how the government taxes and spends - has the potential to stimulate or dampen economic growth. Fiscal tightening means spending less and taxing more. Fiscal expansion means spending more and taxing less, and is seen to be more favourable for the economy. However, it comes at the cost of running a higher budget deficit (the gap created when a government’s spending outweighs its tax take) and is met with market disapproval if it means the government is borrowing at potentially unsustainable levels.
What does the likely policy mix mean for markets?
The government appears committed to controlling and reducing the fiscal deficit.
Chancellor Rachel Reeves has pledged to follow two key rules:
- The current budget must move into balance (i.e. no more deficit) such that all day-to-day costs are met by tax receipts.
- National debt must be falling as a share of GDP by the fifth year of the forecast (defined by the OBR).
This has potential implications for a range of UK assets. Ranked by sensitivity (most to least) these are: UK government bonds, sterling, real estate, and equities. The upcoming Budget could bring greater belt tightening, prompting markets to expect a weaker UK economy over the next year. This could also mean a faster pace of interest rate cuts by the Bank of England. We think this would likely support good performance from UK government bonds and push sterling lower.
Specifically, in the case of sterling, the currency has appreciated against the dollar quite significantly this year. However, a more substantial and rapid series of UK rate cuts relative to the US would be less supportive of sterling. In this scenario, domestic investors may favour holding higher-yielding US assets (such as US treasuries) to lower-yielding UK assets (like UK government debt), decreasing the demand for sterling relative to the dollar.
UK economy shows surprising strength
UK economic growth has been stronger than expected so far this year. After a technical recession, defined as two consecutive quarters of negative economic growth, in the second half of 2023, the UK economy has shown resilience. In fact, it has exceeded expectations and performed strongly relative to other G7 nations. The OECD, in its most recent Economic Outlook, lifted its forecast for 2024 UK GDP growth from 0.4% to 1.1%, which gives the UK the second-fastest growth rate (alongside Canada and France) within the G7 economies. If a strong economic outlook translates into greater tax revenues, it could offer more future fiscal flexibility.
What to watch
Accompanying the Budget statement will be forecasts from the Office for Budget Responsibility (OBR). The official watchdog for public finances provides five-year projections for the economy, and these will be very interesting to markets. While the Chancellor deliberates on ways to free up fiscal headroom through decisions on taxes and public spending, the OBR will deliver the final verdict on the full impact of the Budget. It’s possible that its forecasts for UK GDP in 2024/25 may be revised upwards given the UK’s recent stronger economic performance.
US joins the global interest rate-cutting party
Across the Atlantic, US central bank the Federal Reserve has begun cutting interest rates in a long-awaited move. In September the Fed made a 50-basis point cut to its key policy rate, ending the sharpest, fastest monetary tightening phase in over four decades. It lowered the federal funds rate (the interest rate banks charge to lend to each other) to 4.75%-5.0%, following a 14-month pause at the peak rate of 5.25%-5.5%.
This means the Fed has now joined other major advanced economy central banks (except Japan) in beginning to loosen policy. We expect this stance to support asset prices by underpinning ongoing good economic growth conditions.
What has driven the policy shift? Historically, a cut of greater than a quarter point has often coincided with major fears of a recession or a sharp fall in equity markets. Examples here would be January 2001, September 2007, and the March 2020 COVID shock. However, this year, US economic conditions have remained healthy, albeit normalising to a slower growth rate.
Real GDP in the US grew at an annual rate of 3.0% in the second quarter of 2024. Consumer spending, which makes up over 60% of the US economy, remains resilient despite interest rates at multi-decade highs.
Simultaneously, US equity markets have continued to reach new heights, reflecting the market's confidence in a ‘soft landing’ for the economy. A soft landing is a slowdown in economic growth, usually caused by a rise in interest rates, that doesn’t end in a recession.
Meanwhile, inflation has eased, with consumer and wholesale inflation near or below the Fed's 2% target. Greater scrutiny will be placed on labour market data in the coming months to gauge the pace of future rate cuts in the US.
What is the likely impact on the economy and financial markets?
Monetary policy typically operates with a six- to 12-month lag. Many corporations locked in debt at low rates during the pandemic period, and most US households have 30-year fixed-rate mortgages, which insulates them from the immediate impact of higher rates. This means a pre-emptive easing will not necessarily provide a large and immediate boost to the economy. It may help maintain confidence, however, and allow businesses and consumers to invest and spend at reasonable rates.
China launches major round of stimulus to boost growth
As the US cuts rates, China is also pulling other levers to kickstart growth. Chinese authorities have just announced a range of stimulus measures designed to shore up the economy and ease pressures in the property market.
The People's Bank of China lowered a key policy rate by 20 basis points to 1.5%.
The central bank lowered borrowing costs for outstanding mortgages and eased deposit requirements for second home purchases. It also announced plans for special bond issuance to fund capital injections into the banking sector and to stimulate consumption.
Overall, Chinese equity prices were up sharply over the week following the announcement, and Chinese government bond yields fell.
You can read about this in more detail in our weekly market commentary here.
Sector in focus: Equity small cap
Small-cap stocks refer to companies with a market capitalisation ranging from $250m to $2bn. Market capitalisation (market cap) refers to the value of a company that is traded on the stock market, calculated by multiplying the number of shares by the current share price. Small-cap stocks have gained around 11% in total return terms year-to-date – a very good return. However, they have significantly lagged behind the returns from the MSCI World Index and S&P 500.(i)
Why have small companies underperformed larger ones this year and in recent years? First, since central banks started their rate hiking cycles, small-cap stocks have struggled more. This is largely due to the higher-interest-rate environment and increased borrowing costs. Many small caps rely on floating-rate debt and have higher levels of borrowing, which makes them particularly vulnerable to rising interest rates. As borrowing costs increase, these companies face higher financial strain which reduces their ability to invest in growth and impacts their profit margin. Second, on the other side of the coin, US large-cap technology stocks have massively outperformed almost everything else.
We see the onset of the Federal Reserve and wider central bank easing cycle as likely to improve the outlook for small-cap stocks. As interest rates fall, borrowing costs will drop, allowing companies to allocate more resources towards growth.
If you would like to discuss any of the topics covered in this month’s outlook, our door is always open. Contact us
(i) Source: FTSE Russell 2000 Index, MSCI Indexes, S&P Dow Jones Indices.
Content correct as of publication on 4th October 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.