Mind the Reality Gap

Neil Birrell, Premier Miton’s Chief Investment Officer and lead manager of the Premier Miton Diversified Fund range, has a look at why financial markets might be at risk in the short term after a very strong end to 2023

For information purposes only. Any views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.

Premier Miton is unable to provide investment, tax or financial planning advice. We recommend that you discuss any investment decisions with a financial adviser.

In brief

  • The final quarter of last year was a very strong one for many financial assets
  • Expectations are now that interest rates will fall sooner and further than previously expected
  • However, there is room for disappointment in those expectations

The Reality Gap – a definition

The Reality Gap is a term used in psychology and science and has a few different definitions, but this is the one I liked best; the space between the actual reality of our lives, and the world of our desires. In other words; the gap between what actually happens and what we think or hope will happen.

I think it has got a real pertinence to what is going on in financial markets at present.

Let me explain

The final quarter of last year was a very strong one for many financial assets; bonds and company shares (equities) in most parts of the world jumped as the view hardened that the battle against inflation was being won and that interest rates would start coming down as a result. This was given a turbo charge in November when the US central bank, the Federal Reserve (Fed) effectively said as much.

It was the same but different in the UK and Europe, where the hopes were the same, but the strength of the US economy was not replicated. Indeed, recession is possible, if not probable on this side of the Atlantic, albeit in a modest way, meaning that it was assumed that interest rates would be reduced in order to provide support to the economy, to keep recession at bay and stimulate economic growth.

Markets moved far and fast, possibly too far and too fast. The Fed, the Bank of England (BoE) and the European Central Bank (ECB) have constantly counselled against expecting interest rates to fall quickly and have kept emphasising the need to beat inflation. However, investors didn’t listen and that is what has created The Reality Gap.

The hopes

In terms of interest rate expectations, just before Christmas, in the US market prices had moved to expect (or discount) the first cut to be almost certainly in March, and if not, then definitely at the Fed’s next meeting in May, with steady and consistent falls through the rest of the year.

In the UK, they were not expected until a little later, starting in May or June and again falling through the rest of 2024, maybe getting down to 4.0% at the end of the year, from the prevailing 5.25%. In Europe it was similar, with a cut expected in April or May and continuing downwards in the following months.

Those hopes were reflected in equity markets; the MSCI World Index rose by 6.7%, in sterling terms, in the final 3 months of 2023, meaning it was up nearly 17% for the year as a whole (source: FE Analytics). Please note that past performance is not a guide to future returns. Bonds were strong as well; US government bonds are usually thought of as a good indicator of world bond markets, with the one maturing in 10 years’ time considered to be the benchmark example. Bonds are valued according to the yield they provide, so they can easily be compared to cash deposits and it reflects the return they provide. The yield on the US 10 year government bond fell from 5.0% to 3.9% during the final quarter, (the yield moves inversely to the price, as the yield falls, the price rises); moves of that speed and scale are rarely seen (source: Bloomberg 30.09.2023 to 31.12.2023).

The Reality

The Fed publishes the interest rate expectations of the members of its monetary policy committee. From its last meeting in December, their median expectation was for the interest rate to be around 4.5% – 4.75% at the end of 2024 and 3.5% – 3.75% at the end of 2025.

As I sit here writing this on 17 January, Christine Lagarde, the President of the ECB, has cautioned against calling the war against inflation a victory and said of the interest rate expectations “it is not helping our fight against inflation, if the anticipation is such that they are way too high compared to what is likely to happen”. Also today, the UK inflation data for December was released and came in higher than estimated, which will not be seen as a positive sign by the BoE.

The gap

Since Christmas, the expectations for when and how fast interest rates will fall have been reigned back as a result of the economic data being not quite as good as anticipated and, frankly, because everyone had got a bit overexcited.

However, The Reality Gap is exists. In the US, interest rates are currently expected to be around 4.0% at the end of 2024, many months before the Fed thinks that will be the case. In the UK and Europe it is a similar story, with the UK base rate still predicted at 4% at the end of this year.

Bond and equity markets have not really taken the reality on board, so far this year the MSCI World Index is unchanged and the US 10 year government bond yield has only risen from 3.9% to just over 4.0%.

So there is some room for disappointment between the reality of the path of interest rates and what investors are hoping for.

However….

Investors look through the present and focus on the future. It is clear that inflation is heading back towards levels that central banks are targeting and that interest rates will be falling. It just may be that it is not a smooth journey, but that will provide opportunities for the active investor.

Neil Birrell

Chief Investment Officer

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Risks

Risks

Past performance is not a guide to future returns.

The level of income paid may fluctuate and is not guaranteed

Forecasts are not reliable indicators of future returns.

Glossary

Assets

Different groups of investments such as company shares, bonds, commodities or property.

Bonds (or fixed income): Types of investments that allow investors to loan money to governments and companies, usually in return for a regular fixed level of interest until the bond’s maturity date, plus the return of the original value of the bond at the maturity date. The price of bonds will vary and the investment terms of bonds will also vary.

Bond yield: This is calculated by taking the level of interest paid by the bond, divided by the price of the bond, expressed as a percentage. As the price rises, the yield falls and vice versa.

Maturity

The set date on which a bond or similar loan will be repaid by the borrower.

IMPORTANT INFORMATION:

For information purposes only. Any views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.

Whilst every effort has been made to ensure the accuracy of the information provided, we regret that we cannot accept responsibility for any omissions or errors.

Investing involves risk. The value of an investment can go down as well as up which means that you could get back less than you originally invested when you come to sell your investment.  The value of your investment might not keep up with any rise in the cost of living.

Premier Miton is unable to provide investment, tax or financial planning advice. We recommend that you discuss any investment decisions with a financial adviser.

Reference to any stock, fund or investment should not be considered advice or an investment recommendation.

All data is sourced to Premier Miton unless otherwise stated.

Source: MSCI. Neither MSCI nor any other party involved in or related to compiling, computing or creating the MSCI data makes any express or implied warranties or representations with respect to such data (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of such data. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates or any third party involved in or related to compiling, computing or creating the data have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages. No further distribution or dissemination of the MSCI data is permitted without MSCI’s express written consent.

Issued by Premier Portfolio Managers Limited which is registered in England no. 01235867, authorised and regulated by the Financial Conduct Authority and a member of the ‘Premier Miton Investors’ marketing group and a subsidiary of Premier Miton Group plc (registered in England no. 06306664). Registered office: Eastgate Court, High Street, Guildford, Surrey GU1 3DE.

011977/190124

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Premier Miton Investors has expressed its own views and opinions on this website, and these may change and there is no obligation to update them. Nothing in this website should be construed as investment, tax, legal or other advice. The information contained herein is subject to change without notice.

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By clicking accept you acknowledge that your use of this website is subject to our privacy policy, cookie policy and our general legal and compliance information available on our website.

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The content of the pages of this website is for your general information and use only. It, and the products and services described within it, are subject to change without notice. We shall not be liable to you, or any third party, for any amendment, modification, suspension or discontinuance of any product or service described on our website. Neither we, nor any third parties, provide any warranty or guarantee as to the accuracy, timeliness, performance, completeness or appropriateness of the information and materials made available on this website.

You acknowledge that such information may contain inaccuracies or errors and we expressly exclude liability for any such inaccuracies or errors to the fullest extent permitted by law. Your use of any information or materials is entirely at your own risk, for which we shall not be liable.

The information contained on this website does not constitute an offer or solicitation to sell shares in the funds or portfolio or to provide you with other products or services. Any application or investment must only be made on the basis of the relevant documentation of the investment, such as, for example, terms and conditions. The information on this website does not constitute any investment, tax, legal or other advice. Persons who do not have professional experience in matters relating to investments should always consult with an independent financial adviser before making an investment decision. Any opinion expressed on individual funds, services or products, represent the views of the individual at the time of preparation and should not be interpreted as a personal recommendation to buy or sell or otherwise trade all or any of the investments that may be referred to.

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The information contained in this website is directed at persons who are resident in the United Kingdom and complies with appropriate UK legislation and regulations and is not directed at, nor intended for distribution to, or use by, persons in any jurisdiction in which the dissemination of such investment related information is not permitted.

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Premier Miton Investors has expressed its own views and opinions on this website, and these may change and there is no obligation to update them. Nothing in this website should be construed as investment, tax, legal or other advice. The information contained herein is subject to change without notice.

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By clicking accept you acknowledge that your use of this website is subject to our privacy policy, cookie policy and our general legal and compliance information available on our website.

THE UNITED STATES OF AMERICA:The investment products referred to on this website have not been and will not be registered under the United States Securities Act of 1933, as amended. They may not be offered or sold in the United States of America, its territories and possessions, any State of the United States of America or the District of Columbia or offered, sold or transferred to US Persons (as defined below). The investment products referred to on this website have not been and will not be registered under the United States Investment Company Act of 1940, as amended. Premier Portfolio Managers Limited has not been and will not be registered under the United States Investment Advisers Act of 1940.

“US Person” generally includes the following: (a) any natural person resident in the United States; (b) a partnership or corporation organised or incorporated under the laws of the United States; (c) any estate of which any executor, or administrator, is a US Person; (d) any trust of which any trustee is a US Person; (e) any agency or branch of a non-US entity located in the United States; (f) any non-discretionary account or similar account (other than an estate or trust) for the benefit or account of a US Person; (g) any discretionary account or similar account (other than an estate or trust) held by a dealer or other fiduciary organised, incorporated or (if an individual) resident in the United States; and (h) any partnership or corporation if: i. organised or incorporated under the laws of any non-US jurisdiction; ii. formed by a US Person principally for the purpose of investing in securities not registered under the 1933 Act. In addition, a Shareholder must qualify as a “Non-United States Person” as used in the US Commodity Futures Trading Commission (“CFTC”) Rule 4.7.

Investment products referred to on this website may not be sold or transferred to a US citizen, or an entity taxed as such or required to file a tax return as such under the United States federal income tax laws (a “US Tax Resident”).

The information in this site is solely for the purpose of acquiring information as, or for, an Institutional Investor (a corporate or other non-retail investment professional acting for their own account). This information must not be used or relied upon by anyone that may be considered a “retail investor” by the home regulator of the country from which this site is accessed.  

The information contained in this website is directed at persons who are resident in the United Kingdom and complies with appropriate UK legislation and regulations and is not directed at, nor intended for distribution to, or use by, persons in any jurisdiction in which the dissemination of such investment related information is not permitted.

The information or opinions contained herein should not be construed as an offer, or solicitation to deal in any investment or fund nor shall any such investment products or services be offered or sold to any person in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful or in which the person making the offer solicitation is not qualified to do so or to anyone to whom it is unlawful to make such offer or solicitation.

Premier Miton Investors has expressed its own views and opinions on this website, and these may change and there is no obligation to update them. Nothing in this website should be construed as investment, tax, legal or other advice. The information contained herein is subject to change without notice.

Neither Premier Miton Investors nor any of its group companies or affiliates accepts any liability for any losses arising directly or indirectly from any information accessed from this website, to the fullest extent permitted by law.

By clicking accept you acknowledge that your use of this website is subject to our privacy policy, cookie policy and our general legal and compliance information available on our website.

THE UNITED STATES OF AMERICA: The investment products referred to on this website have not been and will not be registered under the United States Securities Act of 1933, as amended. They may not be offered or sold in the United States of America, its territories and possessions, any State of the United States of America or the District of Columbia or offered, sold or transferred to US Persons (as defined below). The investment products referred to on this website have not been and will not be registered under the United States Investment Company Act of 1940, as amended. Premier Portfolio Managers Limited has not been and will not be registered under the United States Investment Advisers Act of 1940.

 “US Person” generally includes the following: (a) any natural person resident in the United States; (b) a partnership or corporation organised or incorporated under the laws of the United States; (c) any estate of which any executor, or administrator, is a US Person; (d) any trust of which any trustee is a US Person; (e) any agency or branch of a non-US entity located in the United States; (f) any non-discretionary account or similar account (other than an estate or trust) for the benefit or account of a US Person; (g) any discretionary account or similar account (other than an estate or trust) held by a dealer or other fiduciary organised, incorporated or (if an individual) resident in the United States; and (h) any partnership or corporation if: i. organised or incorporated under the laws of any non-US jurisdiction; ii. formed by a US Person principally for the purpose of investing in securities not registered under the 1933 Act. In addition, a Shareholder must qualify as a “Non-United States Person” as used in the US Commodity Futures Trading Commission (“CFTC”) Rule 4.7.

 Investment products referred to on this website may not be sold or transferred to a US citizen, or an entity taxed as such or required to file a tax return as such under the United States federal income tax laws (a “US Tax Resident”). If those investment products are held by a US Person, a US Tax Resident or a person who does not qualify as a “Non-United States Person” within the meaning of CFTC Rule 4.7, Premier Portfolio Managers Limited shall be entitled to redeem such Shareholder’s entire holdings.