Slowly slowly

Small steps 

The BoE reduced the Bank Rate by 25 basis points (bp) on 1 August. It was quite a grudged move with a very slim 5-4 majority in favour of the cut. It is the right thing to do though. Inflation has fallen in the UK and should remain close to target, which means that short-term real interest rates are high by the standards of the last 20 years. It is too soon to assess the macroeconomic impact of the new Labour government with the fiscal decisions taken so far not part of a coherent strategy – for that, we will need to wait for the Budget in September. Like the US Federal Reserve (Fed) and the European Central Bank (ECB) the message from the BoE is that all decisions will be very much data-driven. However, the market is convinced that more cuts are coming with another 100bp priced in over the next year. This modest cut in rates should have negligible impact itself on growth or inflation expectations with the initial response from sterling being quite limited. It is not enough to turn the dial on mortgage rates either, at least for now. Five-year fixed mortgage rates have stayed close to 4.5% this year, still double where they were in 2021. Not that this bothers the UK housing market. Building society Nationwide reported that average house prices were up 0.3% in July and 2.1% compared to a year earlier. You can never be too bearish on the UK when house prices are going up!

The BoE’s decision should add to the renewed confidence in UK equities and gilts. We think there is room for gilt yields to fall, which is also supportive for UK corporate bonds, particularly at the short end of the curve. The one-to-five-year sterling corporate bond index has delivered a total return of close to 3% this year to the end of July, and over 9% compared to a year ago.

Happy summer 

The UK equity market has responded positively since the general election, as I expected given the change in government. The mid-cap index was up 6.5% in July. Indeed, this July lived up to its positive seasonal history with global bond and equity markets delivering positive total returns. The S&P 500 had a total return performance of +1.22% while the ICE/BofA Global Bond Index delivered 2.90%. Despite some increased volatility in US equity markets, with the technology sector delivering a negative return last month, positive fundamentals helped a solid broad performance. The key themes continue to be stable economic growth, solid corporate earnings and prospects for lower interest rates. A 60:40 global allocation between equities and bonds would have delivered a gain of over 2.0%.

Cautious and sweaty 

Seasonally, August tends to be more mixed in terms of market performance. In the last 20 years, global equities – represented by the MSCI World index – have delivered positive returns nine times. Bonds have tended to do better, delivering positive returns 13 times, although not in the last four years. Given where we are in the cycle and the outperformance of equities so far this year, the risk is that bonds have a better month. Increased tensions in the Middle East might be a risk to risk appetite in the short term. Both the VIX index of equity volatility and indices of credit default swaps have tended to rise in the month of August. Those bank deposits might continue to look attractive a little longer. Despite the BoE rate cut, no further rate moves are likely until September.

Solid earnings 

On the earnings front, the news has been good. For the S&P 500, with around three-fifths of the market having reported, earnings have slightly surprised to the upside and aggregate reported growth is coming in at over 11%. All key sectors have seen positive earnings surprises so far with an even distribution across the market. For Europe, the picture has not been quite as good. Revenue misses have been evident in sectors like utilities, energy and materials, while overall growth in earnings has been negative. Disappointments from companies in the consumer discretionary and automotive sectors have cited weak demand from China as a major headwind in the second quarter. 

Industrial softness 

The theme of weakness in demand from China may also be a reason for lacklustre industrial data in Europe as well. Manufacturing Purchasing Managers’ Indices for France, Germany and the Euro Area remained below 50 in July, signifying contraction. The economics team at Citi publishes “surprise” indices which track actual economic data releases against consensus expectations. For Europe, the index turned negative in June. Hence, and despite the provisional estimate of core consumer price inflation for the Eurozone remaining at 2.9% in July, there is a strong expectation of further interest rate cuts by the ECB this year. Market pricing is for almost three rate cuts by the end of January 2025 and five cuts by the middle of next year. The key policy rate is expected to fall to 2.5% by then.

US labour market data in focus for the Fed 

It is not just in Europe where the economic data has been disappointing. The Citi Surprise Index for the US also turned negative recently. The Fed kept rates unchanged at its 31 July meeting but comments from Chair Jerome Powell suggest a cut in September is likely. The policy meeting concludes on 18 September and there are two employment and inflation reports published before then. If Powell’s suggestion that the Fed is paying as much attention to labour market data as it is to inflation is correct, then the risk is that weaker jobs data could make it look like the Fed is behind the curve by the time we get to the next policy meeting. I am writing this before the release of the July employment data but indications from the July ADP employment report and weekly jobless claims data do point to further weakening. There is certainly scope for rate expectations to move further on weak US data and this continues to be a reason to remain positive on US Treasuries.

The Fed has scope to reduce rates in the near term. The outlook for next year depends on what happens with the presidential election and the policy agenda. That is clearly uncertain now with opinion polls suggesting that Kamala Harris is at least neck and neck with Donald Trump. Yet the state of the economy will dominate monetary policy decisions – if growth is weak in the next six-to-nine months the Fed will need to act, irrespective of who wins unless there is a rapid implementation of growth-boosting fiscal policy, which seems unlikely.

But no real bad news 

At any rate, the economy is in decent shape and some modest easing will help sustain growth. This suggests the outlook for equities remains positive – as it typically should outside of a recession and an earnings downturn - even if we get some late summer wobbles. The latest consensus data on earnings growth expectations is for 13% growth over the next year for the S&P 500 universe. For Europe and Japan, the forecast is around 8% growth and for emerging market equities, it is around 18%. The last couple of months have seen more negative earnings revisions in Europe but for the US, earnings revisions are more even. On balance, macroeconomic data and corporate earnings outcomes do point to continued US equity outperformance, despite the valuation differences between the US and the rest of the world. Any late summer correction is likely to be seen as a buying opportunity, especially with the Fed likely to cut rates on 18 September.

Down in the south-west 

Many of my readers will already be on holiday. It is my turn now. I will be away from the laptop and office for the next two weeks enjoying coastal walks, sea swims and good British food and drink in Cornwall. If visitor numbers and the availability of tables at good restaurants is anything to go by, the UK consumer is not in a bad place. Nice to hear lots of French, Spanish and German voices too. I hope they like pasties!

(Performance data/data sources: LSEG Workspace DataStream, Bloomberg, AXA IM, as of 31 July 2024, unless otherwise stated). <Past performance should not be seen as a guide to future returns.