Market update report from Graham Bentley, Chief Investment Officer

Last week the Bank of England’s Monetary Policy Committee (‘MPC’) increased UK interest rates by 50bps to 5%. This was the 13^th consecutive increase, reaching the highest level since 2008. The higher-than-expected rise was enacted following stronger inflation for May than expected.

Inflation remains high and was unchanged from the previous month at 8.7%. Economists had expected this to fall to 8.4% on the back of lower energy costs. The MPC commented, “There has been significant upside news in recent data that indicates more persistence in the inflation process, against the backdrop of a tight labour market and continued resilience in demand.”

The question remains as to how far interest rates will rise, as the MPC continues to try to squeeze inflation out of the system. Markets are now predicting rates will reach 6% before the end of the year.

Whilst the higher rate benefits savers, borrowers with mortgages on variable rates will feel the pain of the increase. Those on fixed rate mortgages due to end soon will also feel the impact when they come to remortgage; with the prospect of further rate rises, decisions on choosing short-term fixed or variable rates may be difficult.

The rate rises have pushed up yields on UK gilts (by lowering their prices), especially those with shorter terms to maturity, to levels above those reached during the aftermath of Liz Truss’s failed budget in September last year. The chart below shows how much the yield on the UK 2-year gilt has risen over the last 12 months:

Source, Factset

With the expectation of further rate rises in the short term, the risk of a recession is increasing. The market believes that rate cuts will be needed if the economy struggles under the pressure of the sharp increase in interest rates. Consequently, longer-term gilts have risen less than shorter term, and the 10-year gilt is still below the peak reached in October 2022:

Source, Factset

This means that the capital value of these bonds has fallen as the yields have increased, and shorter-dated bonds have been impacted more than longer-dated ones; the more an investment portfolio is exposed to short-dated bonds, the greater impact the recent moves will have had. However, money market funds continue to offer increased returns on the back of the higher interest rates, giving the asset class a worthwhile place in diversified portfolios. With the prospect of a recession in the UK increasing, the more economically-sensitive sectors of the stock market - housebuilders and consumer discretionary (products and services that consumers could cut back on) could underperform defensive sectors such as consumer staples (necessary products and services, e.g. Food and toiletries), healthcare and utilities.

Across the Atlantic, the Federal Reserve (Fed) held rates at the most recent meeting (14^th June) on the back of falling inflation. The market had anticipated this decision, however the surprise came from the ‘guidance’ given on future rates. Whilst the market expects rates to remain around the current level before retreating in the medium term, the Fed has indicated two further increases to rates may be made later this year. Markets reacted negatively initially, with stock markets easing back and shorter-term bond yields rising, before shares returned to their recent upward momentum.

At the risk of repeating ourselves, this impetus has been driven primarily by the ‘hype’ around artificial intelligence (‘AI’) and has shown little sign of letting up. Valuations of stocks impacted by this are reaching extremely high levels. We have previously highlighted Nvidia Corporation, which has seen its share price increase by almost 200% so far this year and pass the $1 trillion market capitalization level. At the current levels the company’s share price is trading at more than 200 times the earnings the company makes per share. Even against its five-year average of 71 times (which is still extremely high) this looks incredibly expensive. This, in our view, calls for continued vigilance around stock market valuations at present.