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Markets Are Betting on Rates Staying Put. Are They Right?
Hoxton Blog • Markets Are Betting on Rates Staying Put. Are They Right?
Markets started this week with a little more confidence than they ended the last.
The reason is fairly simple. Some weaker economic figures from the U.S. have changed expectations about what the Federal Reserve might do next.
U.S. retail sales unexpectedly fell in July and consumer sentiment weakened. A week ago, markets were putting the chances of another U.S. interest rate rise in September at roughly 50%. By Monday morning, that had fallen to around 30%.
Shares responded positively. European markets opened higher on Monday, Asian equities made gains and U.S. futures pointed upwards. The dollar weakened and government bond yields eased.
All of this comes just days after the S&P 500 reached another record closing high.
On the face of it, that is a fairly comfortable position for investors. Growth is cooling enough to take some pressure off interest rates, while company earnings and equity markets remain strong.
But there is another side to the story.
Oil rose more than 5% last week, with Brent crude trading close to $90 a barrel as tensions around Iran and the Strait of Hormuz continued. Higher energy prices are exactly the sort of thing that can make inflation more difficult to control.
Markets want slower growth, but not too slow. They want inflation to fall, while energy prices are moving in the wrong direction. And they want interest rates to remain stable, knowing that a couple of stronger inflation readings could change the picture again.
That is the balancing act investors are dealing with as we move through the second half of August.
Why Friday Changed the Rate Conversation
For much of this year, investors have been trying to work out whether the Federal Reserve's next move would be to raise rates again.
Friday's economic data made that look less likely, at least for now.
U.S. retail sales fell unexpectedly in July, while consumer sentiment also weakened. Taken together, those figures suggest the American consumer may be becoming more cautious.
That matters because consumer spending is a huge part of the U.S. economy. If households start pulling back, economic growth can slow and some of the inflationary pressure the Federal Reserve has been fighting may begin to ease.
The Fed held its target interest rate at 3.5% to 3.75% at its July meeting, although three policymakers wanted to raise rates by 0.25 percentage points.
That disagreement tells you how finely balanced the decision has become.
Inflation is still above the Fed's 2% target, but policymakers also need to consider what higher borrowing costs are doing to businesses and households. Keep rates too high for too long and economic activity could weaken more than intended. Ease too early and inflation could come back.
For investors, the important point is not whether the Fed moves in September, October or later.
It is that expectations can change very quickly.
A week ago, markets saw a September rate increase as much more plausible. A few pieces of weaker economic data later and investors are reassessing that view.
Trying to build a long-term investment strategy around predicting each central bank meeting is a difficult game to win.
Oil and Inflation Remain the Complication
If weaker U.S. economic data gave markets something to feel better about, oil prices gave them something else to think about.
Brent crude rose more than 5% last week and has been trading close to $90 a barrel as investors monitor developments involving Iran and shipping through the Strait of Hormuz.
The concern is not simply what happens to the price of filling up a car.
Energy costs work their way through the economy. Businesses pay more to transport goods. Manufacturers face higher costs. Airlines spend more on fuel. Households have less money available for other spending.
Eventually, some of those costs can find their way into inflation.
That creates a headache for central banks because energy prices are largely outside their control. The Federal Reserve cannot produce more oil, and the Bank of England cannot resolve geopolitical tensions in the Middle East.
They can only respond to the economic consequences.
For investors, geopolitics is another area where prediction has its limits. Nobody can know with confidence what will happen next in the Middle East or where oil will be trading three months from now.
The better question is whether your portfolio is built to cope if the answer is different from the one you expected.
Corporate Earnings Are Still Doing the Heavy Lifting
Interest rates may dominate the headlines, but companies ultimately need to make money.
On that front, the latest U.S. earnings season has provided plenty of support.
Around 85% of the 456 S&P 500 companies that had reported by the middle of last week had beaten analysts' profit expectations.
That has helped the S&P 500 reach record levels despite the uncertainty surrounding inflation, rates and geopolitics.
Technology remains a major part of the story. Spending on artificial intelligence, semiconductors, data centres, cloud infrastructure and the energy required to support them continues at an extraordinary pace.
There is clearly a significant economic change taking place.
Investors still need to distinguish between a good business and a good investment at a particular price.
When valuations become stretched, expectations rise with them. A company can report strong profits and still see its share price fall because investors expected even more.
We saw something similar during the growth of the internet.
The technology changed almost every part of our lives and created some of the world's most valuable businesses. That did not stop plenty of companies becoming overpriced along the way.
The lesson is not to avoid new technology. It is to avoid assuming that an exciting story makes valuation irrelevant.
The UK Has Its Own Test This Week
Attention in the UK now turns to inflation.
The next official figures are due on Wednesday, 19 August and will be watched closely for signs of where interest rates might go next.
The Bank of England held Bank Rate at 3.75% at its July meeting. Six policymakers voted to leave rates unchanged, while three preferred an increase to 4%.
UK CPI inflation had fallen to 2.6%, but the Bank expects it to rise again later this year as higher energy costs feed through.
The Bank therefore faces much the same problem as the Federal Reserve.
It needs to keep inflation under control without putting more pressure on the economy than necessary.
Wednesday's inflation figure will inevitably generate headlines and could move markets. It may also change expectations for the next Bank of England meeting.
It should not change a sensible long-term investment plan.
One inflation reading is a snapshot. What matters more is the direction of travel over several months and how policymakers respond to it.
The same applies to UK equities.
The FTSE 100 had a more difficult end to last week, falling to a two-week low on Thursday before recovering some ground at the beginning of this week. Mining shares played a significant part in those movements.
That is a useful reminder that the FTSE 100 and the UK economy are not the same thing.
Many of the index's largest companies generate a significant share of their revenues overseas. Commodity prices, currencies and global demand can therefore have as much influence on the index as conditions at home.
Investors Are Starting to Look Further Afield
Another interesting feature of this year's market has been renewed interest in emerging markets.
Foreign investment into emerging-market debt reached $214.4 billion through July, according to figures reported by Reuters, the strongest level in more than two decades.
Part of that reflects investors looking for opportunities outside the U.S. after several years in which American assets, particularly a relatively small group of large technology companies, dominated attention.
That does not mean emerging markets are suddenly an easy investment.
Different countries face very different economic and political conditions, while currency movements can have a significant impact on returns.
But the shift is a useful reminder of why diversification matters.
It is easy to look at whichever market has performed best over the past few years and wonder why you own anything else.
The problem is that the winner changes.
Sometimes leadership changes slowly. Sometimes it happens before most investors have had time to notice.
A diversified portfolio means you do not need to predict precisely when that change will happen.
What This Means for Investors
There is always something happening in markets.
This week it is weaker U.S. economic data, changing interest rate expectations, oil prices and UK inflation. Next week it will be something else.
The danger is allowing each new piece of information to feel more important than it really is.
Market movements can still be useful prompts for reviewing your position.
Strong returns in one part of a portfolio can leave you more concentrated than you intended. Currency movements can alter your exposure. Your income requirements or personal circumstances may have changed.
Those are reasons to review a portfolio.
A difficult few days in the market are not.
It is also worth making sure you have enough cash available for known short-term spending. If money is likely to be needed in the near future, relying on having to sell investments at exactly the right moment introduces unnecessary risk.
For money invested towards long-term objectives, patience remains one of the most useful tools available.
Nobody knows whether the next major market move will be up or down. Nobody knows exactly when the Federal Reserve or Bank of England will next change rates. And nobody knows how the geopolitical picture will develop over the coming months.
You do not need to know.
You need a portfolio that reflects what you are trying to achieve, the level of risk you are comfortable taking and the length of time you have available.
If recent market movements have made you question whether that is still the case, this is a sensible time to speak to your adviser and review your position. You can also contact the Hoxton Wealth team at client.services@hoxtonwealth.com or via WhatsApp on +44 7384 100200 to discuss your wider financial plans and whether your current strategy remains appropriate.
The value of investments can fall as well as rise, and you may get back less than you invested. Past performance is not a reliable indicator of future results.
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