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Will the US equities rally continue?

market snapshot

Insight
4 August 2023 |
Active ESGMacro
The blue-chip S&P 500 index was up 3.1% in July. But stronger than expected US jobs data has added to speculation about future interest rate hikes.
  • The VIX volatility index – sometimes referred to as Wall Street’s ‘fear gauge’ – has plummeted 30% since the start of 2023 to reach historically low levels.
  • The Bank of England raised interest rates by 25bps this week to 5.25%, slowing the pace of increases amid signs that the UK’s stubbornly high inflation is beginning to ease.

US equities enjoyed a buoyant July as the economy demonstrated unexpected resilience, reigniting hopes for a soft landing. The blue-chip S&P 500 was up 3.1% last month. However, a surprise downgrade of the country’s debt ratingand stronger than expected jobs data2, suggest an extended period of higher interest rates may be on the cards, sparking a sharp 1.4% sell-off on Wednesday.

“Recent labour market statistics point towards an enduring strength in the jobs market, amplifying speculation around the potential for future interest rate hikes,” says Geir Lode, Head of Global Equities at Federated Hermes Limited. The US inflation rate fell to 3% in June, a two-year low3.

A number of indicators suggest investors have become more open to risk. The VIX volatility index – sometimes referred to as Wall Street’s ‘fear gauge’ – has plummeted 27.6% since the start of 2023 to reach historically low levels4. “This decrease signifies a favourable climate for investors to hedge their portfolios at a reduced cost but also highlights complacency among investors,” Lode adds.

Figure 1: S&P 500's rise mirrors fall in the VIX

The fall in the VIX contrasts with a 17.7% rise in the S&P 500 since the start of the year5.

“Year-to-date equity market performance has been driven by a few select mega-cap companies, but this will need to give way to wider participation across mid- and small-cap names, which are now holding more attractive valuations, for the market rally to continue,” Lode continues.

“Additionally, firms with a clear sustainability strategy are coming to the fore. These companies’ valuations, attractive when compared with their history, signal that they are poised to outperform the wider market. This trend aligns with the growing global emphasis on sustainable business practices and the long-term higher return potential.”

BoE remains exposed

On Thursday, the Bank of England raised interest rates by 25bps to 5.25%, slowing the pace of increases amid signs that the UK’s stubbornly high inflation is beginning to ease. Consumer prices fell to 7.9% in the year to June6, a sharper than expected drop from 8.7% in April and May. Nonetheless, price rises in the UK remain higher than in other developed economies such as the US, Japan and the eurozone, where hopes remain high that rates are close to a peak.

In addition, to the 25bps hike, the BoE delayed any changes to its quantitative tightening (QT) programme, which would reduce the money supply and withdraw liquidity from the financial system, until September.

“Going into the BoE meeting, the market was pricing in an even chance of either a 25bp or 50bp hike, with a small lean towards 25bp. The terminal rate has now dropped back to 5.65%, which still essentially implies another 50bps of tightening and we have seen a 15bp steepening of the curve,” says Orla Garvey, Senior Fixed Income Portfolio Manager, Federated Hermes Limited.

There is a risk the Bank of England will have to cut rates just as quickly through 2024 as tight policy starts to impact the economy.

“The policy statement in itself didn’t give the market much to work with. There were some new references to the fact that policy is restrictive and will likely stay that way until the 2% inflation target is convincingly reached, but that was largely what the market was already pricing.”

Garvey continues: “Looking ahead, the BoE is still in the suboptimal position of having to be reactive to spot service prints and labour market data, given volatility in the gilt market this year. This leaves it exposed to policy mistakes, and hence we continue to believe that there is a risk it will have to cut rates just as quickly through 2024 as tight policy starts to impact the economy.”

For further insights into the UK housing market, please see the latest Chartology.

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