The hard times equities and bonds went through in October now seem forgotten. November has had a strong start. What is behind this sharp rally: Is it a technical rebound; have scenarios changed in the aftermath of the slowdown in inflation; or should we look at the latest earnings reports?
Let’s just say it could well be a multi-factor phenomenon (and that things have probably not stabilised completely just yet).
US economy – This is it
The US employment report released on 3 November reassured many observers by signalling signs of a rebalancing of the labour market, as evoked by Jerome Powell, Chair of the Federal Reserve, at his news conference two days earlier.
150 000 jobs were created in November, which was slightly below market expectations, while the figures for the previous two months were revised down significantly.
The unemployment rate has been rising since July, when it stood at 3.5%, to 3.9% in October. It is now back at its December 2021 level due to an increase in the number of new labour market entrants. The rise in labour force participation remains gradual – indeed, this rate fell slightly between September and October to 62.7 – but there are growing signs that the supply of labour is increasing.
Furthermore, the ISM services survey surprised to the downside, with the index falling from 53.6 to 51.8, coming in significantly below the consensus expectation (53). It is now at its lowest in five months. The index has remained above 50, though, meaning that activity continues to expand.
The ISM employment sub-index, however, fell from 53.4 to 50.2. It is difficult to identify a clear trend for this indicator (see Exhibit 1) as firms (particularly small and medium-sized ones) have continued to report difficulties hiring.
“Bad news is good news”
Investors interpreted the poor employment and services reports as the first signs of a slowdown in US activity (after the economy grew by a strong 4.9% annualised in Q3) and concluded that the cycle of policy rate rises that started in the spring of 2022 is now over.
This assessment added fuel to the equity rally and the fall in bond yields that had started after the Fed’s 1 November policy meeting.
In October, yields at the long end of the curve had risen: by 39bp on the 30-year bond; 36bp on the 10-year bond and 4bp on the 2-year bond (from the end of September).
Since the beginning of November, the 2-year yield has fallen by 16bp, the 10-year by 44bp and the 30-year by 48bp (as of 8 November).
Market expectations with respect to the Fed’s monetary policy now appear to be driving bond yields lower and fanning the rise in equities (4.5% for the S&P500 index and 6.2% for the tech-heavy Nasdaq composite between the end of October and 8 November).
Such a rebound is not that much of a surprise after three consecutive months of declines in global equities, which had led to oversold markets and extreme investor positioning.
Markets vs. economic reality – Fixed income
Nor were we surprised by the fall in bond yields.
On the one hand, it is increasingly apparent to us that inflation is falling, not only at a headline level (due to base effects from last year’s spike in energy prices), but also in the non-food and energy segments.
On the other hand, the US economy should begin to slow more visibly as the factors behind its astonishing resilience disappear. Excess consumer savings are declining, and higher interest rates are crimping demand for goods and services as well as housing. Finally, there is the waning effect of US fiscal policy. This was expansionary in 2023, as evidenced by the budget deficit reaching USD 1 700 billion (for the fiscal year to 30 September). That is up by 23% on the previous year.
Exhibit 3 illustrates the expected change in fiscal policy based on International Monetary Fund calculations where short-term fiscal policy assumptions are based on officially announced budgets, adjusted for macroeconomic assumptions and projected fiscal outturns. Year-on-year changes show ‘the fiscal effort’ achieved: A positive figure indicates that the deficit has fallen.
Markets vs. economic reality – Equities
By refusing to declare victory on inflation, and issuing multiple hawkish comments in recent days, central bankers have tried to cool expectations of rapid rate cuts in 2024, but investors appear convinced that the cycle of policy rate hikes is over in the main developed economies (with the notable exception of Japan).
As the OECD wrote in its recent economic outlook report, “The global economy proved more resilient than expected in the first half of 2023, but the growth outlook remains weak”.
That view does not appear consensual and explains why conditions now look favourable for government bonds and, conversely, unattractive for equities.
The foreseeable slowdown in demand driven by a year and a half of monetary policy tightening is likely to weigh on corporate activity, earnings and margins. We thus remain cautious on equities, especially in eurozone markets whose economies have been flirting with recession for several quarters now. So far, the latest earnings reports have pointed to slower demand, particularly in Europe.
The sharp rally in bond markets since early November may trigger tactical adjustments in our positioning, but we still think the long duration in the bond bucket of our multi-asset portfolios is appropriate given the valuations.
Furthermore, we do not see the recent rises in (nominal and real) yields as a sign that bond investors consider public deficits to be much too high at this stage of the economic cycle. Expectations of policy rate cuts in 2024 should be accompanied by a fall in long-term bond yields.