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.
- 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.
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 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.
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.
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.
Chief Investment Officer