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Investor Insight 127

Investor Insight, November 2023

The conflict in the Middle East and concerns around stubborn inflation have led to more volatility in investment markets during October. Historically, October is often a weak month for markets and 2023 is no exception, with the S&P500 in the United States down approximately 3 per cent and long-term bond yields rising markedly.

Inflation is back in focus. Energy prices as well as sticky services prices are boosting headline inflation, but also raising concern that inflation expectations could become entrenched.

The focus is very much on headline inflation, whereas core inflation is falling, and we expect will continue to do so, as wages growth, especially in the US, is abating.

The much debated and forecast recession has not materialised, thanks to the rundown in household savings that had been built up over COVID, as the chart below highlights.

The supply shortages we all experienced also appear to be behind us.

Whilst inflation is a focus, tight monetary policy is doing what it was supposed to and will continue to do so, and financial conditions have tightened dramatically, with credit growth slowing.

The positive is that Capital Economics in London are looking at global GDP growth of 3.1 per cent in 2023 followed by a slowdown to 2.5% in 2024, as a result of the tighter monetary policy.

What does this all mean?

  • Average interest rates going forward will be higher than the decade before. Remember though that we did have zero rates for some time and before that, rates at extremely low levels. Nominal interest rates will be higher, but as we have said for the last few months, we are at or near the peak in interest rate levels.
  • Whilst bonds have sold off as investors have been concerned over financial instability and excessive bond supply due to loose fiscal policy, we do believe that Treasury yields will eventually rally from these levels however, as with short term interest rates, they will remain higher than in the past and also higher than originally forecast.
  • The correction in equity markets is not unexpected after the strong gains earlier in 2023 as a result of the large drop in the equity risk premium. Artificial Intelligence or AI is for real, and we believe this will underpin further gains from these levels in the S&P 500 in the US, and as a result in other developed markets in 2024 and 2025.

The devastating and sad news in the Middle East has put markets in wait and see mode.

Whilst the market impacts of the conflict are clearly far less important than the personal toll being suffered, Capital Economics points out that there are three things which determine how geopolitical shocks flow through to markets:

Commodity prices, especially energy – if the conflict widens to include Iran, this could send the oil price significantly higher, at least in the short term.

Stage of the Economic Cycle – with economic activity slowing and inflation abating, policy makers are in a position to “look through” any short-term inflation spike due to a spike in energy prices.

Fiscal Policy Context – advanced economies’ fiscal and monetary policy frameworks are more flexible than in the past and, although the fiscal outlook for the US and some other developed countries is a concern, the costs of providing support in the Ukraine and the Middle East are not overly significant relative to their fiscal capacity.

That said, should the Middle East crisis deepen, then

  • Expect equities to sell off.
  • Expect US Treasuries to sell off.
  • Expect the USD to strengthen.
  • Expect the gold price to rally.
  • Expect further upwards pressure to oil prices.

For now, we sit back and wait, and our thoughts are with all those who are impacted.