October 2023 MPS Market Review

• Global stock markets remained under pressure in October, as a stronger dollar, higher bond yields and geopolitical developments served to constrain risk appetite.
• No doubt the burgeoning human tragedy in the Middle East weighs most heavy on our minds, and we hope the international community can work together to bring an end to the conflict and the tragic loss of innocent lives.
• In the cold and unforgiving world of investment however, the continued march higher for bond yields has likely been the most troubling development. 
• Higher bond yields can aggravate markets for several reasons, but two key issues relate to the ‘cost of capital’ and ‘valuation’.
• Government bond yields are often considered a benchmark for borrowing costs, with consumers and businesses paying a premium beyond this (or ‘spread’) depending on their credit worthiness. 
• Higher government bond yields, therefore, typically increase financing rates for all entities, weighing on both profitability and the desire for future borrowing.
• The swift increase in the ‘cost of capital’ raises concerns of a more punishing growth downturn ahead, damaging risk appetite. 
• As it relates to ‘valuation’, bond yields are often used to discount the value of an asset’s future cash flows to determine a ‘present value’.
• Higher bond yields, therefore, raise the discount rate and lower the present value of an asset, such as a share price.
• Before speculating why bond yields have climbed so dramatically, and what lies ahead, we first remind ourselves of the inverse relationship between bond prices and yields. 
• Using a theoretical example, an asset paying a fixed amount of £5 a year will have a higher yield as its price falls and a lower yield as its price rises i.e., at a lower price of £50 the 1-year yield is 10%, and at a higher price of £100 the 1-year yield is 5%.
• Returning to catalysts for bond yield changes, we suspect weaker bond prices (and higher yields) will have been influenced by both supply and demand factors.
• On the supply side, large government deficits mean plenty of bond issuance, whilst quantitative tightening will also see central banks place lots more bonds back into the market.
• From a demand perspective, an inversion of the yield curve has resulted in short-dated bonds offering higher yields than longer dated equivalents, encouraging sales of those ‘higher priced’ longer dated bonds. 
• We are also seeing continued antipathy from international buyers, such as China, to fund US economic activity through the purchase of Treasuries and, accordingly, appear to be withdrawing from doing so. 
• Of likely greater impact than supply and demand, however, has been the realisation that economies can withstand a higher interest regime than previously thought.
• This view is supported by the apparent start date for the market’s accelerated reappraisal of bond yields, namely the ‘dot plot’ released in September.
• This data release represents the individual interest rate projections for each US Federal Reserve Board Member and President and revealed a desire to keep rates ‘higher for longer’. 
• This projection informs an extended period of higher interest rates may be needed to sufficiently cool demand and return inflation back to target. 
• On this basis, a more persistent and restrictive interest rate regime raises the prospect of a US/UK & European recession at some stage in 2024 and encourages investors to brace themselves for volatility in the coming year.
• At the margin, however, our view remains positive toward equities, indeed we would not preclude the potential for an equity market recovery in the months ahead; something that would become increasingly probable if inflationary pressures continue to abate and the growth backdrop remains resilient.
• And looking at the disinflationary pressure within the goods and housing/rental sectors, there are reasons to believe such an outcome may occur.
• Admittedly the labour markets give rise to concerns of more persistent inflation but, even there, some leading indicators suggest a moderation in wages is possible; specifically falling Job Openings and a decelerating Quits rate.
• These factors also convince us the interest rate hiking cycle in the US, Europe and the UK is, for now, over; limiting the potential for further increases in bond yields.
• Yet, whilst we would be courageous enough to say the ‘tide has turned’ on inflation, we would not be so confident to suggest ‘the battle is won’.
• Unfavourable geopolitical developments which disrupt commodity supplies are a stark risk to a more benign inflationary environment.
• Strong labour markets coupled with fading inflation could also sow the seeds of its own demise, as firmer than expected demand drives prices higher.
• Inflation, therefore, remains a clear and present danger, in so much as its resurgence could illicit hawkish policy responses that raise the recessionary threat. 
• Investors should brace themselves for the prospect of a prolonged inflationary battle, though again we would argue all may not be lost for equity investors if recession is the ultimate outcome.  
• Of most comfort would be the hope any such recession wouldn’t be as severe as more recent episodes.
• This more benign view hinges upon the apparent absence of major economic imbalances i.e. corporations and households don’t (in aggregate) appear to be facing quite such daunting refinancings challenges (except maybe UK mortgage holders) as in prior economic cycles.
• We should also remind ourselves that having moved off the zero bound, there are now some interest rates to cut! Such policy options might prevent a more pernicious downturn and prove sufficient to reignite economic and investor enthusiasm. 
• Central bank’s hawkish intent doesn’t necessarily mark a death knell for equities either. Should inflationary pressure recede, then the hawkish rhetoric might fade with it, particularly if unemployment starts to rise.
• Recognising how uncertain the outlook remains, however, as well as our philosophical belief in the need for humility when investing, MPS portfolios strive to seek appropriate levels of diversification to meet the investment challenges ahead.
• Relative to stocks for example, high quality corporate and government bonds might offer a more defensive return profile in the face of less encouraging growth outcomes, particularly given the increase in yields observed over recent months.
• Alternative asset classes also assist Invesco in its efforts to help diversify portfolios in a more troubling period for stock markets. 
• Stay safe, stay well, and please get in touch if you wish to discuss any part of the Invesco MPS strategy further.

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