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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
A strange thing happened this week: calm. US inflation data showed that prices were rising faster than analysts had expected or hoped in February — an outcome that, on the margins at least, bolsters the case for keeping interest rates higher for longer.
At one point last year, “higher for longer” were the three scariest words in the English language for investors — enough to strike terror in to any portfolio manager. This time around, however, government bonds wobbled only slightly and both US and global held it together around record highs.
This is a sign that interest rates are shedding their suffocating dominance over global markets, and that stocks are climbing not because they are huffing the speculative fumes of imminent and aggressive potential rate cuts but because they’re worth it. We are in a new era where the apparent need to keep interest rates high in an effort to suppress inflation (now running at 3.2 per cent in the US) is a bullish signal for risky assets like stocks, not a reason to panic.
This is always an unstable little dance in markets. Sometimes bad news on the economy is good news for markets, because it suggests lower interest rates ahead. And sometimes the relationship flips around again. Now we are back to good news being good news.
Well, sort of. You can argue we have been in this era for quite some time, and that in a brutal 2022 and largely also brutal 2023, nervy stocks investors, spooked by a recession that never came and still blindsided by the supply shocks of the Covid era, misread high rates as a threat, rather than as a sign that the economy was humming along nicely. This year, by contrast, stocks have proven to be perfectly able to sail higher without the fuel of low rates.
“We’ve seen a breakdown in correlations since January,” said Greg Peters, co-chief investment officer at PGIM Fixed Income. “I always felt it to be a spurious correlation anyway. The equities folks were worried when rates were going higher without understanding why they were. Today, rates being higher is a byproduct of much stronger than expected growth. The market has smartened up.”
Life would be very boring — and markets would cease to function — if everyone agreed with each other. So naturally enough, doom mongers are still doing their thing.
“Complacency is dangerous,” proclaimed Albert Edwards at Société Générale in a note this week. “Now that almost every market guru has walked back their recession call, wouldn’t it be just typical if the US economy now slides into recession?”
Some economic data still looks fragile, and echoes with previous run-ups to market shocks are striking, he said. Record highs in stock markets have also “buoyed the economic narrative”, he said. “Something does not look right.”
Something always looks skewiff to permabears like Edwards, but he does have a point. One recent academic paper argued that animal spirits or bubbles in markets can themselves be responsible for as much as an additional 0.8 percentage points on US inflation rates. Feedback loops like these can make it even harder to predict what’s coming next.
In addition, investors know that markets are on a tightrope. (Pictet Wealth Management has clearly been investing in thesauruses — it has labelled this “the year of the funambulist”.)
A resurgence in growth and inflation strong enough to restart rate rises is unlikely, though impactful enough to take seriously, while the chance of a recession in the US, also improbable, also obviously matters.
Neil Sutherland, a fixed income portfolio manager at Schroders in New York is not in the recession camp, but he does suspect some of the gloss on the US economy will start to fade soon. “Risk assets could struggle,” he said, and he’s not referring only to stocks. Sutherland said any deviation to the idea that US inflation will generally keep sinking while the economy holds up “could be a negative scenario, particularly when you look at valuations in credit”. The extra premium that corporate debt offers on top of super safe government bonds is close to its slimmest on record, reflecting runaway demand for this asset class.
Still, the market’s mindset is shifting around higher rates. “I’m surprised when investors are still so nervous about rates staying high,” said Karen Ward, chief markets strategist for Europe at JPMorgan Asset Management. “Zero interest rates were a sign of the ill-health of the economy. Rates were low because economies were really struggling. Good riddance.”
As this past week has proved, we now know for sure that for stocks to keep demolishing record highs (in nominal terms at least) and for corporate debt to remain so firmly in favour, clearly does not require the Fed to cut rates six times, as the market had been anticipating just a few weeks ago.
It might not even hinge on the Fed cutting rates three times — the path it has outlined. That leaves fund managers able to cheer positive news as and when it lands. Stop worrying and learn to love higher rates.
