Divergence deepens

Investment Outlook

22 Mar

Divergence
Deepens

Investors are waiting patiently for interest rate cuts from most Central Banks. Expectations are that despite a better-than-expected economic growth outlook for the US, interest rates will be cut three times by the end of 2024.

Despite the poorer economic outlook in Europe and the UK, investors appear to expect a similar interest rate path to that in the US. The good news in the UK is that it is likely that inflation will fall sharply in coming months (as the high inflation months of Spring 2023 fall out of the composition).

Japan on the other hand is facing in a different direction to most of the western world. The Bank of Japan has taken a historic step, implementing its first interest rate increase in 17 years, and ending an eight-year stretch of negative interest rates.

Negative interest rates have resulted in a very weak currency. This has supported Japanese profits and equities. The rise in Japanese interest rates may mean that the support for Japanese equities may stall if the Yen strengthens, especially if other Central Banks cut their interest rates.

In the meantime, the divergence in economies is showing up in the divergence in profits. US profits continue to outstrip those of the UK and Europe. And investors appear to be willing to reward that by valuing US equities on a valuation premium compared to other regions.

If the US Central Bank can deliver lower inflation without tipping the US economy into a recession, then that premium may be justified for now.

Divergent paths ahead?

The difference in economic backdrop is quite stark. Unsurprisingly, post the Russian invasion of Ukraine, forecasts for economic growth were reduced across the world.

Quite strikingly, the US has bucked this trend over the past 9 months. Economists now expect the US economy to grow by around 2% in 2024, whilst the rest of the developed world may grow around 0.5%.

2024 economic growth forecasts through time: expectations remain lacklustre in most regions but robust in the US (GDP – Gross Domestic Product)

The difference between the US and the rest of the world is stark and reflects fiscal choices made by the Biden Administration in supporting investment-led growth.

That said, the inflationary backdrop is expected to be similar, with inflation of around 2-2.5% across most regions.

2024 inflation forecasts: Japan has seen inflation expectations rise over the past year, against stable inflation expectations in most regions (CPI – Consumer Price Index)

We will come back to talk about the rise in Japanese inflation later in the Outlook, but the increase in inflation expectations in Japan is striking.

Interest rates cuts to come?

The Federal Reserve and Bank of England both decided to hold off from policy changes at their March interest rate meetings. At the start of the year, investors had pencilled in a cut in interest rates in the US for the March meeting. This was expected to be the first of seven cuts through 2024 in the US.

The number of US interest rate cuts expected in 2024 has reduced markedly

Now investors have reduced the number of interest rate cuts to ‘merely’ three, with expectations of US interest rates falling to 4.6% by December 2024.

This shift away from rapid rate cuts is consistent with the better-than-expected economic growth now pencilled into economists’ forecasts.

Out of the East

The Bank of Japan (BoJ) has taken a historic step, implementing its first interest rate increase in 17 years, and ending an eight-year stretch of negative interest rates. Other aspects of Japan’s ultra-easy monetary policy were also abandoned, including a yield-curve control (YCC) policy aimed at keeping the 10-year government bond yield near zero.

Japanese interest rates finally rise over above zero with first rate rise in 17 years

The interest rate rise had been discounted by investors, as shown by the path of bond yields in the chart above, but the move followed further evidence that Japan’s decades-long struggle with deflation is coming to an end, which is good news. Core consumer price inflation has now been above the central bank’s 2% target for 22 consecutive months.

Meanwhile, the 2024 Shunto wage round—the annual negotiation between Japanese employers and unions—delivered an increase of 5.28% among large companies, the biggest pay rise in 33 years.

The BoJ announcement had largely been priced into the markets. The lack of any immediate reaction may be down to the BoJ maintaining a dovish stance in its statement as it looks to keep financial conditions accommodative “for the time being”.

The BOJ had been an outlier in the global monetary policy tightening cycle over the past couple of years, opting to stick with its ultra-loose monetary policy despite inflation remaining above-target for more than a year. But the interest rate change suggests that the policy is tightening, if only marginally.

Consequences unknown

There is plenty of discussion about what could happen in markets with the ending of negative interest rates. Japanese investors hold a lot of overseas assets and are collectively the largest foreign owner of US Treasuries.

One potential consequence of higher yields in Japan could be the repatriation of Japanese money back to the domestic market, although we are yet to see the start of this movement. If the negative interest rate policy and YCC are phased out and we begin to see repatriation flows, this could potentially have significant consequences for the US Treasury market as well as the Yen.

In addition, there is some evidence that investors have been borrowing in Yen (at zero interest rate) and investing into higher interest rate bonds (i.e. US Treasuries). This is known as the ‘carry-trade’. While Japanese interest rates have been negative and the Yen has been weak, this trade has been very profitable for investors.

If the interest rate differential narrows, either though US interest rates falling or Japanese interest rates rising (or both) and/or the Yen starts to strengthen, then this historically profitable trade could become loss-making quite rapidly.

Weaker Yen has been a deliberate choice

The Japanese Yen is also arguably very cheap, having gained an advantage given its mercantilist leanings, which is reflected in the strong performance of the Nikkei 225.

Post 2008, and especially since 2011 (Yen touched ¥76 to the US Dollar in late 2011), weakness in the currency has aided the equity market by enabling a surge in profits from Japanese companies.

The weak Yen policy has enabled Japanese companies to become globally competitive and apparently undergo structural changes to enhance profitability.

A challenge for the Japanese equity market may arise if the Yen strengthens as the BoJ raises interest rates whilst other Central Banks reduce their interest rates. This may impinge on Japanese corporate profitability.

Nikkei 225 has reached record high, aided by the Yen’s fall from ¥76 in 2011 to ¥150

It is worth putting the record highs of the Japanese equity market into context. Whilst in Yen terms the Japanese market has reached new heights, when you account for the Yen weakness returns from Japanese equities are more modest and in line with European (ex UK) equities over the past 5 years when seen via the US Dollar.

Japanese equities have been good, but less good in US Dollar terms in recent years due to the weakness in the Yen

UK inflation falling

As mentioned in the weekly investment comment of the 15th March, UK inflation could well come in lower than expected in coming months.

UK Consumer Price Inflation (CPI), released 20th March, fell to 3.4% year-on-year, the lowest reading since September 2021. UK inflation has fallen sharply but seems to have got stuck around 4%, with core inflation (stripping out the more volatile energy and food prices) running higher. However, inflation is likely to keep falling from here as the high inflation months of February, March and April 2023 start to drop out of the annual inflation number.

This should enable the Bank of England (BoE) scope to cut interest rates. The current market consensus is for 2 or 3 rate cuts this year (that is a reduction of 0.5% or 0.75% in the headline rate) starting in August. But, if inflationary pressures subside that may prove too cautious. Unlike the US, where economic growth has proved to be robust (and inflation lower but still too high for comfort through 2022-23), the UK economic backdrop is much weaker.

Interest rate expectations in the UK are suggesting that the Bank of England may cut rates 2-3 times in 2023. With recent and expected falls of inflation and continued subdued economic growth, rates may have room to fall further than discounted

With lower inflationary pressure, it will be interesting to see if real terms consumer spending picks up and the consumer ‘feel-good’ factor returns to benefit the economy, and potentially come to the rescue for the government in time for an autumn election.

The better-than-expected inflation data also comes on the back of signs of a recovery in the housing market. Will the UK be the surprise package for 2024?

Equity valuation and earnings update

Just like the economic growth data is quite divergent, with the US data positive and everywhere else a bit stagnant, so it is with the profits backdrop.

US profits continue to climb higher, albeit the positive backdrop is dependent on the technology behemoths. In Europe, the weak economic growth backdrop continues to result in cuts to earnings expectations.

US earnings growth has been stellar over the past decade in contrast with the stagnant earnings backdrop in other regions

Strong historical corporate profitability has resulted in investors appearing to be willing to value US equities at a premium to non-US equities.

But for that strong earnings base, investors are now having to pay significantly higher valuation multiples

Both economically and on an earnings backdrop, it does appear that the US is on a different growth path.

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Divergence deepens

Both economically and profitably, the US continues to dance to a different beat. The good news is that the reduction in inflationary pressure will enable most Central Banks to cut rates through 2024.

Perversely, Japan has sought to engender inflation via its weak Yen policy. This has benefitted Japanese profits and equities over the past decade. With the Bank of Japan raising rates for the first time for 17 years investors may have to get used to ‘normalisation’ in Japanese policy, which may have unintended consequences for markets globally.

The UK could enjoy a bout of lower than expected inflation in coming months, which combined with signs of a recovery in the housing market, may mean that the stupor of the past few years will be lifted in time for a new government.

Important Information

Artorius provides this document in good faith and for information purposes only. All expressions of opinion reflect the judgment of Artorius at 22nd March 2024 and are subject to change, without notice. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete; we do not accept any liability for any errors or omissions, nor for any actions taken based on its content.

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FP20240322001

Mili Pavitt

Divergence deepens