Interest rising?
Interest rising?
Unusually we start in the UK, where much of the market and press commentary is blaming Chancellor Rachel Reeves for higher bond yields and a fall in Sterling, whereas we suggest that UK markets are in fact reacting in-line with other global markets and the UK may be a victim of US economic growth.
We accept that the elevated valuations of US equities, in particular large cap technology stocks, pose a challenge to many investors. However, whilst they continue to deliver robust earnings growth the valuation risk may not translate into a decline in US equities. In contrast, non-US equities struggle to generate profits growth (when denominated in US Dollars) in part due to US Dollar strength, which explains the continued outperformance of US equities.
US economic growth has been better than expected. Inflation in the US may become the key risk for markets, as interest rates may not fall at all if inflation proves to be stuck at a higher level than 2-2.5%. The scale of interest rate cuts expected by the market is much lower than it had been as better economic growth and stronger inflation has altered interest rate expectations. Bond yields have risen on the back of this shift. Would the Federal Reserve be able to raise rates in 2025 and how would Trump and investors react to higher US interest rates?
US earnings have been strong over the past two years despite slowing economic growth. This may be tested in coming months with Q4 2024 earnings updates, which have just started, and particular focus will be on the guidance for 2025 provided by companies. But we await Trump’s presidency with hope due to potential tax cuts that may have a positive impact on earnings, but on economic growth and inflation we wait with trepidation.
The UK: A victim of US success?
Over recent weeks in the UK the daily commentary is about how the government has created a rerun of the Truss/Kwarteng gilt crisis. But that narrative is far too simplistic. UK Government bond yields are rising in tandem with US Treasury yields and indeed with yields in other developed world economies.
Government bond markets: 10 year bond yield rises through to 15th January 2025.
Source: Bloomberg, Artorius
As a reminder, in August-September 2022, through the period around the Truss/Kwarteng Budget issues, UK bond yields went up 2.5% and US yields went up 1.5% over the same period. Current moves are much smaller in scale and we believe the reason for the sell-off is quite different.
10 year government bond yields: rising in unison.
Source: Bloomberg, Artorius
From an investment perspective, higher bond yields do offer a potential source of inflation beating returns for those willing to ‘lock-in’ returns without the need for equity risk. In the UK, inflation has been higher than bond yields since a brief period between 2014-16, so it marks a welcome return to a more normal position that existed before the recession in 2007-09.
Higher bonds yields are being driven by inflation staying higher for longer and better than expected US economic growth. If higher bond yields are a new feature of the economic backdrop, this will in turn force governments to become more fiscally prudent (resulting in tax increases or spending cuts….or both), as the cost of finance will be too much to bear without Central Bank support. But, in the short-term, headlines will be written that appear to miss the real reason for higher bond yields which is stronger US economic growth.
This is also the reason for the fall in Sterling against the US Dollar in recent months. The chart below shows Sterling against both the US Dollar and the Euro. Against the Euro, Sterling is back to the average level it was through 2024, having had a period of strength in late 2024. Against the US Dollar, Sterling has fallen back to below $1.25, down from nearly $1.34 in September 2024. So, the story around Sterling’s weakness is really a story of US Dollar strength based on US economic strength.
Sterling is weak against the US Dollar but hasn’t really fallen against the Euro.
Source: Bloomberg, Artorius
US interest rates may not fall in 2025
In 2024, a source of stimulus for both markets and the US economy was the prospect and eventual cutting of interest rates by the Federal Reserve. At that time, investors thought that rates would fall to below 3% by the end of 2025. On the back of better than expected economic growth and inflation remaining higher for longer, investors now only expect rates to fall to 4% by the end of 2025.
The change in interest rate outlook is the reason that bond yields in the US (and UK and Europe) have moved higher over recent months. When interest rates were falling and looked set to fall further in 2024, equity investors’ risk appetite rose, pushing markets higher, aided by good growth in earnings. However, in 2025 the outlook for interest rates is less supportive so investors will require good earnings to be delivered in order to maintain their momentum.
US interest rates: Interest rates were cut in 2024 but the expectations for interest rates for 2025 have moved higher in recent months.
Source: Bloomberg, Artorius
Waiting for earnings
US companies begin their quarterly updates in the middle of January. So far, the few companies that have reported have delivered very good updates. But investors will be seeking assurance about the outlook, especially given the elevated valuation premium that is prevalent in the US equity market. Currently US equities trade on 22 times 2025 earnings, against the rest of the world that collectively trades on 13 times 2025 earnings. It is worth recalling that between 2000 and 2012 the valuations of the US and rest of the world were very similar.
This valuation gap does explain some of the outperformance of US equities over the past decade. But the economy has been stronger in the US since 2010 and on the back of it so have company profits. The chart below shows the nominal economic growth path since 2004. Nominal growth includes inflation as well as ‘real’ economic growth, the latter of which is what most economists concentrate on when talking about economic growth.
The reason nominal growth is important for equity investors, is that company revenues are nominal, in that they incorporate inflation in their make-up. When Tesco sells a loaf of bread, if prices rise then the revenue increases without the need to sell more loaves of bread. So an economy with stronger nominal economic growth provides the strongest base to grow corporate revenues.
Nominal economic growth: US growth has outstripped other regions since 2010, but before that US and European growth was similar.
Source: Bloomberg, Artorius
And regions with the strongest revenue growth tend also to have the most robust profits growth. The chart below shows the long-term growth from different markets. As inflation fell through the 1980s so profits growth (and revenue growth) slowed across the world. Interestingly, until 2018 Europe had stronger profits growth than the US. This may reflect the nature of European equity markets, which expanded rapidly in the 1990s, as well as the strength of the European economy in the 1990s and 2000s.
Long run US profits growth rates have been relatively stable unlike other regions where rates have fallen since 2010.
Source: Bloomberg, Artorius
However, post 2010, profits growth from Europe (and most other regions) have slowed sharply, from a steady 8-10% per annum to a modest 2-4%. By contrast, US trend profits growth has remained around 6%. The underlying profits growth explains why the US equity market has outperformed other regions over the past few years. Whilst the elevated valuations of US equities are unpalatable, investors are faced with the equally unpalatable prospect of modest profits growth if they avoid US equity exposure.
Over the past few years, much of US profits growth has been centered on the US technology giants. And we can understand some scepticism from investors over whether this rate of growth can continue (as is discounted in part by the elevated valuations). The chart below shows the earnings of the S&P 500 (US large cap) and S&P 400 (US mid-cap) and the Rest of the World (represented by the MSCI Ex US) since 2016.
The strength of US earnings has not just been a large cap technology phenomenon. The S&P 400 is a broadly diversified index without the domination of technology stocks that the S&P 500 has benefited from since 2023, but the S&P 400 has benefited from its exposure to the US economy and has delivered more robust earnings growth than equities from the Rest of the World.
Profits: US profits (measured by Earnings per Share (EPS)) have been strong across large (S&P 500) and mid cap (S&P 400) compared to the rest of the world, suggesting that it is not just technology that has driven US profits.
Source: Bloomberg, Artorius
The economic backdrop matters. The US economy has delivered stronger economic growth than the rest of the world, and in this environment the US equity market across the board has delivered stronger earnings growth. Whilst this continues it is hard to see US equities weakening, unless the interest rate backdrop changes.
Conclusion
Higher bond yields and a fall in Sterling are reacting in line with global markets and the UK may be a victim of US economic growth.
We accept that the elevated valuations of US equities, in particular large cap technology stocks, pose a challenge to many investors. However, whilst they continue to deliver robust earnings growth, the valuation risk may not translate into a decline in US equities. In contrast, non-US equities struggle to generate profits growth (when denominated in US Dollars) in part due to US Dollar strength, which explains the continued outperformance of US equities.
US economic growth has been better than expected. Inflation in the US may become the key risk for markets, as interest rates may not fall at all if inflation proves to be stuck at a higher level than 2-2.5%. The scale of interest rate cuts expected by the market is much lower than it had been as better economic growth and stronger inflation has altered interest rate expectations. Bond yields have risen on the back of this shift. Would the Federal Reserve be able to raise rates in 2025 and how would Trump and investors react to higher US interest rates?
US earnings have been strong over the past two years despite slowing economic growth. This may be tested in coming months with Q4 2024 earnings updates, which have just started, and particular focus will be on the guidance for 2025 provided by companies. But we await Trump’s presidency with hope due to potential tax cuts that may have a positive impact on earnings, but on economic growth and inflation, we wait with trepidation.
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