Peak rates: a moving target

Peak rates: a moving target

Counterpoint - August 2023
Peak inflation is now well behind us, especially in the US, but interest rates continue to rise. Central bank messaging of late has been quite clear: the battle against inflation is not won. But, even though the peak in interest rates is a moving target, we believe it’s now in sight, just slightly delayed from our initial expectations.
Higher for (not too much) longer
In our market outlook, we predicted that the middle of the year would mark the peak in rates. However, given inflation has continued to surprise investors – particularly in the UK – central banks have kept up their messaging of higher rates for longer. Despite this, we expect the peak in rates to be close, just a little later than we anticipated earlier in the year.

As economic growth and headline inflation ease, the prospect of higher interest rates for longer becomes increasingly unlikely. US inflation is now about 3% – down more than six percentage points from the peak last year and lower than in Japan. In the Eurozone, inflation is almost half of 2022’s peak of 10.6%. However, central banks have chosen to keep their cards close to their chest on potential future rate changes, opting instead to buy more time to assess incoming data. This is because core inflation (which strips out food and energy) is still high, particularly in the UK where it has declined minimally. 

So, despite the positive market reaction to falling headline inflation, the fight is not won yet, but we believe we’re entering the final round. We expect the US Federal Reserve (Fed) likely has one rate increase left, or perhaps it won’t even have to raise rates any further. The European Central Bank (ECB), however, is poised to continue to push interest rates higher for a little while longer. The Bank of England (BoE) has a much tougher job on its hands to combat persistently high inflation in the UK. It has acknowledged that a recession may be necessary to make meaningful headway in bringing down inflation. While there’s significant uncertainty on the level BoE rates will likely reach in the UK, we now expect a peak of 6%.

Like the West, Asian economies are also grappling with the impact of slowing manufacturing and global growth, compounded by lingering trade tensions. Nevertheless, without the worry of high inflation, a glimmer of hope remains with potential policy support through low rates and fiscal stimulus, particularly in China. Japan, on the other hand, is experiencing a period of economic and earnings recovery, as well as positive inflation trends and structural reform. 

Overall, things remain quite uncertain out there. This is why we are sticking to our cautious approach to portfolio positioning of high-quality bonds, coupled with quality dividend payers in the US and low-volatility equities in the US and Europe. This, plus a slight tilt towards Asia-Pacific including Japan equities, should help capture some of the upside while protecting portfolios if market volatility was to pick up.

Daniele Antonucci, Co-Head of Investment & Chief Investment Officer

Top Chart
The more inflation eases, the closer the peak in rates
Central banks are still likely to pause interest rate hikes, just at a higher level than initially expected. We think the Fed has scope to hike just one more time and the ECB two more times, but the Bank of England will likely raise further as inflation hasn’t eased as decisively in the UK.

Headline inflation is slowing across the globe, but core inflation (excluding food & energy) remains elevated. Pandemic constraints have eased and manufacturing activity has slowed, pushing headline inflation lower. While slowing too, the level of core inflation is still too high, mainly because services activity has been resilient. The US has seen a bigger inflation decline and so the Fed looks set to pause sooner rather than later. Despite the latest inflation report showing a slightly bigger decline versus expectations in the UK, the level of inflation remains very elevated, suggesting more Bank of England rate increase ahead. The ECB is in between.


Source: In-house research, Refinitiv; dotted lines = own forecasts.

Investment Focus
The already poor risk-reward for equities could worsen
Market and economic uncertainty is persisting. As such, high-quality bonds continue to look more attractive relative to equities.

What’s happening?

In our Mid-Year Outlook, we touched on the fact that a 6-month T-Bill was yielding slightly more than the S&P 500. Since then, the gap in the US has grown and the UK has joined the party with the 10-year gilt yield overtaking the FTSE 100 dividend yield. So, despite the current low levels of volatility, the risk-reward of equities appears to have worsened in the near term.

As central banks continue to increase rates in response to inflation, short-term sovereign bond yields are also increasing. But given that inflation is continuing to ease, we believe the upside is limited. This makes high-quality bonds attractive at their current levels.

What we’re watching

In the UK, the inflation outlook is still uncertain, and we now forecast that the Bank of England will raise rates to 6%. Market pricing has been swinging wildly, from 6.5% to about 5.85% at the time of writing. Gilt yields have risen over the past weeks, providing a higher yield compared to the FTSE 100 dividend yield. Despite this, we’re not raising our exposure to gilts just yet, though we acknowledge that they look increasingly more attractive, and instead wait for the inflation outlook to become clearer. 

The near-term risk-reward for equities is poor relative to short-term government debt.
What we’re doing in our flagship portfolios
Sticking to our cautious positioning
Considering the uncertain economic landscape, we’ve decided to give our current position more time to play out. So, for now, we’re keeping our increased exposure to high-quality bonds, defensive US and European equities, and Asia-Pacific including Japan equities.

Against our expectations, Asia-Pacific equities have lagged global equities. Japan, Taiwan, South Korea, and lately Indian equities have performed well, but Chinese equities have disappointed. The post-Covid activity surge has recently slowed in China. This is driven by a global manufacturing slowdown and renewed property weakness. 

Despite the mixed performance, we still hold our positive view on Asia-Pacific equities. The lack of inflationary pressures compared to the West means that central banks in the region can support economies by keeping rates low without fear of spiralling inflation. This, coupled with relatively attractive equity valuations, supports our positive outlook, especially in the context of our more defensive positioning. 

In the fixed income space, we are keeping a watchful eye on the UK gilt market. With strong wage growth and accelerating core inflation, the BoE could be forced to raise rates to 6%. This means UK gilts look increasingly attractive. At the time of writing, they provide a higher yield than the FTSE 100. However, at this stage we’re not raising our gilt exposure just yet. Instead, we’re waiting for a clearer picture to emerge on the path to easing inflation. 

Year-to-date, our flagship portfolios continue to perform positively, driven by our long-term allocations to global equities and bonds. Despite this positive performance, our 12-month view remains cautious. We continue to prefer high-quality bonds over riskier equity markets and high-yield bonds.

Government bonds
Cash & Gold

N = neutral weighting of asset class vs strategic (long-term) asset allocation 

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Information correct as of 1 August 2023.

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