March Market Update: interest rates set to rise – will this end well?

What's moving markets

March saw continued broad based rises in commodity prices. Brent Crude reached $128 per barrel while UK Gas prices broke through £3 a therm, after being 48p this time last year. Dramatically, the London Metal Exchange (LME) suspended trading in Nickel as the metal doubled in price over two days, trading above $100,000 per tonne, 5 times the highs of a few months ago. Elsewhere wheat prices have more than doubled in a year, breaching $12 per bushel.

Global demand for goods and services has risen as Covid restrictions have eased, but supply chains damaged during lockdown are not meeting the demand. This drove commodity tightness during 2021, but Russia’s invasion of Ukraine and subsequent embargos have supercharged these imbalances. Russia is a key trading partner for a whole range of commodities. It is the second largest oil exporter globally and combined with Ukraine also supplies 30% of wheat exports worldwide.

Economic data continues to point to GDP growth and prosperity. Earlier this month the US Bureau of Labour Statistics recorded over 11 million job openings, while PMIs across Europe and the UK confirmed strong broad-based expansion. Wage growth was also high; 4.8% in the UK and 5.8% in the US. Supply constraints coupled with demand growth and wage pressures elevated inflation to its highest levels for 40 years. Demand pull inflation was strongest within the US, helping overall inflation reach 7.9%. While energy was a key contributor, the inflation excluding energy and food was still an elevated 6.4%.

March also saw the Fed Funds rate increased from <0.25% to <0.5%, the first rise since action taken in response to Covid 2 years ago. This time last year central banks classified inflation as ‘transitory’, but that rhetoric has changed. The Fed’s dot plot (members’ projections for future interest rates) now implies 6 further rate rises in 2022 alone.

The market responded by pushing the 2 year Treasury yield to 2.31%, up from 1.41% at the start of the month. While the 10 year Treasury yield rose too, the yield curve flattened – the 2 year/10 year Treasury spread is now only 4bp having been 1.58% a year ago. Historically, when this spread turns negative a recession follows within 2 years.

A flat yield curve appears at odds with the Fed’s positioning for multiple rate rises. If a recession is around the corner, why is the Central Bank initiating a tightening cycle? It appears the bond market don’t believe the Fed can manage inflation without putting the economy into recession!

Asset class implications

During the quarter we’ve seen how commodity price rises, inflation and interest rate expectations affect capital markets.

The most direct impact on portfolios was within fixed interest, where higher inflation expectations devalued nominal coupon payments in conventional fixed interest products such as Gilts and Corporate Bonds. Upward yield curves compounded this further as central banks signposted rate rises ahead. Both events lead to negative returns for bonds.

The impact of duration is also felt across equity markets and has dominated returns over the last 3 months. Those (typically growth) stocks with high implied growth rates where much of their value is deemed to come from future earnings have a very high interest rate sensitivity. As the yield curve increases, the interest rate used to discount future earnings increases too, and these stocks become less valuable today.

In contrast, stocks with strong earnings today and slower future growth, as well as those that rely on a strong cyclical backdrop to drive earnings, are broadly classified as value stocks. An inflationary environment with solid economic growth is relatively positive for these types of stocks. Examples include banks and commodity companies.

Global equity markets differ by their breakdown of stocks that fit the broad categories of growth and value. The US for example is dominated by growth stocks, particularly in the technology sector, while the UK is made up of many value and cyclical sectors. Year to date returns mirror this – FTSE UK Equity Income is up 6.7% while FTSE USA is down 2.6%.

However March provided respite for the equity rotation seen so far this year, a pause in the value dominance. The FTSE USA recovered much of its underperformance from the start of 2022. This aligns with the flattening of the yield curve seen across the month, given bond markets are signalling a potential recession in on the horizon. Given the recessionary risk, growth stocks became less unattractive, particularly as this could mean lower long term interest rates.

Perhaps the most significant implication to arise in March is the outcome for relative equity performance being at a crossroads. Sustained higher inflation and interest rates could see value and cyclical companies outperform materially, driving UK Equities relatively higher with it. But were the Fed and other central banks to choke demand through excess monetary tightening, growth stocks and markets such as the US might continue to maintain the dominant position they’ve held for the recent past.

Asset classes in numbers

This article is for financial professionals only. Any information contained within is of a general nature and should not be construed as a form of personal recommendation or financial advice. Nor is the information to be considered an offer or solicitation to deal in any financial instrument or to engage in any investment service or activity. Parmenion accepts no duty of care or liability for loss arising from any person acting, or refraining from acting, as a result of any information contained within this article. All investment carries risk. The value of investments, and the income from them, can go down as well as up and investors may get back less than they put in. Past performance is not a reliable indicator of future returns.