Interest rates matter

Interest rates matter because the lower companies’ (and countries’) borrowing costs are, the more profit is extracted from revenues (because costs are lower).  At the same time, all investments are valued relative to interest rates – the lower rates are, the more attractive relatively risky investments become, and the renewed demand forces up prices.  The earlier that happens, the more time there is for those excess returns to compound over time.

Reflecting that changing sentiment, US equities had their best month since October, the technology-oriented Nasdaq 100 rising almost 11% in dollar terms.  In early November 2022 Meta (better understood as Facebook and Instagram) had hit a historic low price as faith in technology companies’ growth prospects evaporated.  However, the company reported a successful 4^th quarter trading, with sales outstripping analysts estimates.  The share price rose over 20%, for a total rise of over 100% in less than 3 months. 

Biggest gains

It's worth noting that the biggest gains are occurring in those shares that suffered most in 2022, and yet the US market is still not cheap based on historic measures, trading at 18X earnings.  Realistically, for January’s US market strength to continue would require recession to be avoided, a significant drop in inflation recorded, and strong company profit margins to be evidenced along with commensurate earnings growth. Note that the last time the Nasdaq was up more than 10% in January was in 2001. This was similarly following significant falls the year before. On that occasion the Nasdaq subsequently fell by more than 50% for the rest of 2001.  As I write this, Apple, Amazon and Alphabet (Google to most people) have announced worse than expected results and are forecasting little if any growth in earnings this quarter, so this offers a dose of pragmatism.

Furthermore, the bond yield curve should be curbing market enthusiasm.  The US 3-month bond yield is now 1% more than the 10-year; as we’ve said before, historically this ‘inversion” (remember, short-term rates should rationally be lower than long-term) during a series of interest rate rises has been an almost fool-proof predictor of significantly below-average (but not necessarily negative) subsequent annual returns, if not outright recessions.

Share price rises

In the UK meanwhile, the share price rises of the UK’s medium and small companies outstripped those of our largest companies, the total market rising by over 4.5% during the month.  A major exception to this trend was Shell, Europe’s largest oil and gas company (perhaps unsurprisingly given the post Ukraine invasion energy crisis), which reported the highest profits in its 115-year history, doubling the previous year’s number. The share price reaction has moved Shell to take over the number 1 spot as the UK’s largest company.

Despite evidence implying core inflation may have peaked, the Bank of England (BoE) nevertheless raised interest rates to 4%.  This was served with a spoonful of sugar, the BoE suggesting this may be the ceiling, assuming no new evidence of prolonged high inflation came to light. However, while core inflation fell slightly, the UK BRC shop-price index continued to increase, with food prices rising rapidly. Annual food inflation is currently almost 17%, and prices rose a staggering 2.3% during January alone. Farm prices are generally falling or rising far less than food prices in the shops.  This implies companies are taking advantage of the inflationary background to increase prices to enhance profits. The US is having a similar experience; a report from the New York Times has found that more than 2,000 companies have seen greater profit margin increases this year than their pre-pandemic averages. Central Banks can’t control prices, so this aspect of inflation is unlikely to be affected by interest rate rises.  Only falling demand will do that, and demand seems to remain very strong in US. 

By contrast, wage growth in the UK is less than half that of food price inflation.  In January the International Monetary Fund (IMF) published its economic forecast for members of the G7 group of developed nations.  With the notable exception of the UK, all 2023 estimates had improved or remained unchanged since its previous report in October last year. The IMF expects the UK economy to contract by 0.6% this year – 0.9% worse than it forecast three months ago, and even worse than Russia, which despite sanctions is forecast to grow by 0.3%.

With an accompanying tax burden at a historic high, UK consumer demand is falling; the silver lining being that this should be a significant brake on inflation, while stimulating the need for the BoE to reverse the direction of interest rates.

And finally...

While the economic barometer might be depressed, nevertheless markets price on future expectations, and as I explained above, this has seen a significant uptick in both bond and equity returns in January. While 2022 saw any positive performance concentrated in very narrow investment areas, 2023 seems to have returned to ‘normal’ i.e. rewarding diversification incrementally. I trust that will continue.

Graham Bentley,
Chief Investment Officer