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If you are worried that a recession might be on its way later this year then the newsflow and data this week should have given you some comfort. Last weekend China and the US announced a 90 day pause in tariffs at levels well below what the market had feared. We promptly saw a 4% bounce in US equities and some respite for the US dollar. US inflation also came in below expected on Wednesday and, in the UK, earnings, retail sales and Q1 GDP numbers were all strong. Putting that together, the economy still looks to be in decent shape both over here and over there. This is one reason why equities have recovered part of their recent losses (which were very sharp when compared to previous equity drawdowns):
I wrote last week that I thought that UK bank base rates might end up below the 3.5% or so level the bank might expect. As I wrote in that note, I remain pretty optimistic on the inflation outlook, but this week was a reminder to me that interest rates can stay high for other reasons. The first is, as we saw this week, basically good news. Positive growth surprises reduce the need to cut interest rates. Many investment portfolios are (at their heart) investments in equities with bonds as a (money-making) hedge. When equities do well – as they have done for the last few weeks – it feels pretty normal to lose a little on your bond investments (as the market prices in fewer central bank rate cuts). And I’d add that our core bond holdings remain up for the year. The 5% or so carry we earn (in GBP at least) covers some of the price volatility.
The other reasons that bonds may disappoint here are less investment friendly. Government deficits remain at levels normally seen in recessions even when the economy is growing and unemployment is at all-time lows. The government is borrowing a lot and this is pushing up the interest rates we all have to pay. In the economic jargon, the government is crowding out some of the private investment that would otherwise be happening.
A second problem for bond markets is entirely self-inflicted. The Bank of England continues to sell bonds it bought as part of its Quantitative Easing (QE) programme. This not only creates losses for the Bank but it also pushes up interest rates (and so indirectly the borrowing rates we all have to pay) as it floods markets with bond sales. And the National Bureau of Economic Research have calculated that the impact is larger for the UK than it is for other countries.
Given all the tariff headwinds and uncertainties, I am not sure the UK needs this extra drag created by its own central bank. And, of course, it remains a problem for our otherwise pretty constructive view on the attractions of UK bond markets today. Still, the main engine of our portfolios are equities and they are continuing their recovery from Liberation Day. And to end with a note of optimism, share buybacks continue to be strong (both in the US and Europe) and are running at their highest ever levels in the US. If you are wondering how the equity market can be strong even in spite of all that Trump is throwing at it my guess is this is at least part of the answer.
Chris Brown, CIO
cbrown@ipscap.com
The value of investments may fall as well as rise and you may not get back all capital invested. Past Performance is not a guide to future performance and should not be relied upon. Nothing in this market commentary should be read as or constitutes investment advice.
