Rate expectations
Rate
Expectations
A change in tone from the US Federal Reserve has prompted a swift revision to interest rate expectations for 2024. Markets have moved to price six interest rate cuts in 2024 (1.5% reduction in interest rates) whilst the Federal Reserve are themselves forecasting three interest rate cuts in 2024 (0.75% off rates). Yields have fallen sharply since the end of October, with 10-year US Treasuries falling from 5% to under 4%, resulting in a 9% return over two months.
Over the same period the US equity rally has been broad. After a year when the large technology stocks have led markets higher, with the rest of the US equity market subdued, the rally since the end of October has been widespread.
That markets and the Federal Reserve are pointing to lower interest rates in 2024 is consistent with the subdued economic backdrop and better outlook for inflation but is at odds with low levels of unemployment and high wage inflation. It seems that the market believes that inflation will continue to fall and the economy will avoid a recession.
Elsewhere, economic growth has slowed with Europe seeing recessionary conditions but despite this, and the increase in interest rates, European equities have returned 16% for a UK based investor year-to-date. In the UK, a recession appears to have been avoided, albeit economic growth is lacklustre in the face of higher interest rates, and UK equities have been subdued this year.
The question for investors, is that with markets pricing in a soft-landing (i.e. no recession in the US), is the balance of risks to the upside or to the downside over the next year?
An all-in rally
Since the 27th of October until the 18th December, a tremendous rally has taken place across most asset classes. The chart below shows the returns of various regional equity markets and the UK gilt and US long bond (20-year plus) market.
The rally in equities has been broad. In the US, a year in which the Magnificent Seven (Microsoft, Amazon, Meta, Alphabet, Apple, Nvidia and Tesla, a list that is maybe easier to remember as MAMA ANT), has dominated returns, it is noticeable that even the down beaten smaller companies index (Russell 2000) has returned 16.4% since 27th October. While despite the poor economic data in Europe, European equities have risen 11.8%, outperforming US equities.
Between 27th October and 18th December, equities and bond markets have generated strong returns, even for 2023 laggards
Source: Bloomberg, Artorius
Bond yields have fallen sharply since the end of October, with 10-year US Treasuries falling from 5% to under 4%, resulting in a 17.6% return over two months for the US long bond market.
The Federal Reserve has given an inch and the market has taken a mile
A change in tone from the Federal Reserve has prompted a swift revision to interest rate expectations for 2024. With inflation moving lower, but still above target, the Federal Reserve leadership has indicated that they are more likely to cut interest rates in 2024 than previously guided.
Markets have moved to price six interest rate cuts in 2024 starting in March (1.5% reduction in interest rates) whilst the Federal Reserve are themselves forecasting three interest rate cuts in 2024 (0.75% off rates).
The chart below shows the interest rates implied by market pricing in October 2023 and December 2023.
Implied US interest rates: since October markets have discounted the Federal Reserve cutting rates by 1.5% through 2024 and further still in 2025
Source: Bloomberg, Artorius
The next interest rate decision meeting at the Federal Reserve is scheduled for the 30th-31st January. Given the rate expectations of interest rate cuts through 2024, the fate of the year may be driven by decisions and guidance from that meeting.
Wages and unemployment
At our December Investment Committee meeting, we noted that the forecast for interest rate cuts struck a discordant note given the continued low rate of unemployment and the high level of wage inflation.
A very low unemployment rate, less than 4%, typically implies that the US labour market remains tight. Historically, unemployment has started to climb before US interest rates are cut.
The US unemployment rate is very low, and US interest rates are typically only cut when unemployment increases, which normally takes a recession
Source: Bloomberg, Artorius
Although wage inflation is falling, which eases the need for higher interest rates, the rate of wage inflation is high relative to historical norms. We suggest that for interest rates to be reduced by as much as the market is discounting either unemployment will need to rise or wage inflation will have to continue to fall.
Wage inflation is falling but remains high compared to the past 30 years
Source: Bloomberg, Artorius
Digital distraction
For most adults, smart phones have become ubiquitous. Likewise for our children and grandchildren who are digital natives in that they have grown up with phones and computers, and God forbid if the holiday location doesn’t have WIFI, or a flat battery prevents immediate connection with virtual reality.
The OECD’s Programme for International Student Assessment (PISA) assesses the learning outcomes of 15-year-olds in mathematics, science and reading. The 2022 PISA results have a section on the use of technology in education.
Those who cannot navigate through this digital landscape are increasingly unable to participate fully in social, economic and cultural life. The good news is PISA shows the majority of students have embraced learning through digital technologies. On average across OECD countries, around three out of four students reported being confident using various technology, including learning management systems, school learning platforms and video communication programmes.
Some of this change has been accelerated through the pandemic. Remote lessons, digital tools and educational apps have radically transformed learning. One of the most visible benefits has been greater personalisation where computer tests can capture instantly where a pupil can be weak and can promote targeted exercises to improve learning.
While learning outcomes were often better for students who used digital devices for learning between one to five hours a day than for those who never used them, students who used them for more than an hour a day for leisure – social media apps, browsing the internet or games – saw a big drop in maths scores. On average across OECD countries, students who spent up to one hour a day at school on digital devices for leisure scored 49 points higher in maths than students whose eyes were glued to their screens for between five and seven hours per day, after taking into account students’ and schools’ socio-economic profile.
Some mobile phone use is ok, but beyond two hours a day leisure use impacts educational achievement
Source: OECD, Artorius
For the past few years, parents, researchers, and the news media have paid closer attention to the relationship between teenagers’ phone use and their mental health. Researchers such as Jonathan Haidt and Jean Twenge have shown that various measures of student well-being began a sharp decline around 2012 throughout the West, just as smartphones and social media emerged as the attentional centerpiece of teenage life. Some have even suggested that smartphone use is so corrosive, it’s systematically reducing student achievement.
And it’s not just educational attainment, but mental health appears to be significantly impacted by social media usage (which is likely to be done on the phone).
As can be seen in the graph, at around 3 hours, the rate of increase in depressive symptoms rise until more than five hours when it rockets up, with girls tending to have higher levels of depressive symptoms.
Social media use appears very damaging for teenage girls’ mental health
Source: Kelly, Zilanawala, Booker and Sacker, Artorius,
As evidenced by the Covid Inquiry, one may be generous in the spirit of the season to suggest that the loss of phones and WhatsApp messages by the UK’s Prime Ministers would be a boost to their performance and mental health.
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Rate expectations
A change in tone from the Federal Reserve has prompted a swift revision in interest rate expectations for 2024. Markets have moved to price six interest rate cuts in 2024 (1.5% reduction in interest rates) whilst the Federal Reserve are themselves forecasting three interest rate cuts in 2024 (0.75% off rates). Yields have fallen sharply since the end of October, with 10-year US Treasuries falling from 5% to under 4%, resulting in a 9% return over two months.
Over the same period the equity rally has been broad. After a year when the Magnificent Seven (MAMA ANT: Microsoft, Amazon, Meta, Alphabet, Apple, Nvidia and Tesla) has led markets higher, with the rest of the US equity market subdued, the rally since the end of October has been widespread.
That markets and the Federal Reserve are pointing to lower interest rates in 2024, is consistent with the subdued economic backdrop and better outlook for inflation, but is at odds with the low level of unemployment and high wage inflation. It seems that the market believes that inflation will continue to fall and the economy will avoid a recession.
Elsewhere, economic growth has slowed with Europe seeing recessionary conditions but despite this, and the increase in interest rates, European equities have returned 16% for a UK based investor year-to-date. In the UK, a recession appears to have been avoided, albeit economic growth is lacklustre in the face of higher interest rates, and UK equities have been subdued this year.
The question for investors, is that with markets pricing in a soft-landing (i.e. no recession in the US) is the balance of risks to the upside or to the downside over the next year?
Important Information
Artorius provides this document in good faith and for information purposes only. All expressions of opinion reflect the judgment of Artorius at 21st December 2023 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.
The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested. Past performance is not a reliable indicator of future results.
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