Self-evidently there is a great deal going on. The US election is only days away. Rachel Reeves’ UK Budget, possibly the most consequential for a generation, is even sooner. The world is still waiting to see what the Israelis will do to punish Iran. In Tatarstan under the BRIC¹ umbrella, including with the Secretary General of the United Nations, Putin is making happy talk with 36 national leaders accounting for more than half the world’s population and a third of its GDP. What to make of it all?
Fixed Income: the crystal ball that is the yield curve
This week, breaking the habit of a lifetime and applying the adage “a picture paints a thousand words”, we are deploying charts to shed light on how fixed income investors are evaluating risk in the current environment and how the perceived risk for government financing is changing.
What are yield curves? Simply, they are the lines (‘curves’ in that they are seldom straight) delineating the yields of different maturities of government bonds² in a continuous time series. The theory is that for a bond with a short time until maturity, say one or two years hence, investors have greater certainty of the likelihood of being repaid their loan principal than they do over 10 years, and even less over 30 years. Rationally, the less the certainty, the higher the rate of return (as expressed by the yield³) that investors will require to reflect the increasing risk the longer into the future one is extending the commitment. Hypothetically, an illustrative yield ‘curve’ would travel from bottom left on the graph towards top right. When the line of the curve becomes flatter or in even more extreme cases ‘inverts’ (i.e. goes from top left to bottom right), it is a reflection that investors perceive the near-term risk to be greater than the long term risk. When looking at the economy, it is often said that an inverted curve is a harbinger of recession thanks to the likelihood that a high prevailing interest rate runs the risk of undermining the immediate economic prospects. Some insist an inverted curve is a predictor of a recession, as if it is an immutable law: it is not, but it is indicative of the heightened possibility of a recession happening, or could be a catalyst for talking yourself into one.
Below, for the US, the UK and Germany (using Germany as a loose proxy for the eurozone: despite monetary union with its single currency and a unitary interest rate dictated by the European Central Bank, in the absence of fiscal union there is no centralised bond issuing authority: each country’s treasury issues its own bonds to raise finance) we have depicted their respective yield curves at two chosen snapshots. 31 May 2024 reflects the markets’ perceptions of risk before the current interest rate cuts began for the major central banks, i.e. the US Federal Reserve, the European Central Bank (ECB), the Bank of England, and the Bank of Japan. We choose this date because the ECB was first to get the ball rolling with interest rate cuts in June, followed by the Bank of England in August and the US Federal Reserve in September. We have compared that with the yield curve as at mid-October.
As a reminder, in the fixed income world, bond yields and prices move in opposite directions. And to be clear, the lines depicted are snap-shots at fixed times; the reality is that the yield curve is dynamic and never static as bond prices are constantly changing. What we are illustrating using two fixed points is how risk perceptions can fluctuate with changing circumstances.
The US: Growth and Trump
US government bond yield curve – comparing May 2024 to October 2024
Source: Jupiter, as at 10 October 2024
Following the US Federal Reserve’s (Fed) initial cut in interest rates by half a percentage point to 5.0% in September, the yield curve has dropped. After months of prevaricating and teasing the markets, the Fed finally not only made its first move, but in doing so also seemed determined to make a splash: quarter percentage points are the usual run-of-the-mill gradation in policy changes; half percentage points or more are indicative of urgency verging on crisis. However, the Fed soon tempered market expectations and indicated a reluctance to repeat the performance, instead pointing towards its expectation for two sequential quarter point cuts in November and December.
But note also that the blue October curve has bulged out at 2 years (4.1%) and is steepening positively out towards 10 years (4.2%) and beyond to 20 years (4.6%) whereas only four months earlier the curve was inverted, falling from 4.9% at the 2 Year to 4.5% at 10. Not only is this indicative of the recessionary possibility receding, but it is also a direct recognition of the increasing possibility of Trump winning the election and embarking on a concerted growth splurge. His economic plan is to spend more, tax less and to grow the economy by 3% per year sequentially. In adjusting to this late surge in Trump’s electoral fortunes, markets are re-calculating the effects of what is becoming referred to as ‘The Trump Reflation Trade’ and the possibility of interest rates not falling as fast as had been anticipated (looked at another way, if he succeeds with fiscal policy and boosts economic growth, would the Fed be acting responsibly adding further stimulus on top by relaxing policy, thereby adding to the inflationary risk?).
‘Reflation’ is a term that was also linked directly with Biden in the 2020 election. Clearly there was also the aftermath of the pandemic to consider, and Putin’s invasion of Ukraine, but today, as then, it raises the obvious question: re-flation means higher in-flation; how much in-flation can you stand? Especially when today the interest rate used to temper inflation is 5% and not zero, and the US government debt is $35.5 trillion and not $23 trillion as it was at the time of the last election.
The Eurozone: disinflation and soggy growth
German government bond yield curve – comparing May 2024 to October 2024
Source: Jupiter, as at 10 October 2024
In Europe, the yield curve has also dropped in anticipation of further interest rate cuts by the ECB. It too has shifted over the 2-10 year range from inversion in May (top left at 3.1% to bottom right 2.7% on the red line), but its latter steepening is far less pronounced than the US equivalent, more akin to a flattening with only 0.2 of a percentage point (in market jargon, 20 basis points) separating the yield over that key interim 8-year outlook on the blue line. This implies that markets are less concerned than previously about recessionary risk and are anticipating a relatively muted recovery but a benign inflation outlook (at 1.7% the eurozone inflation rate is already below the ECB’s 2% target).
The UK: a ‘rollercoaster’ curve
UK government bond yield curve – comparing May 2024 to October 2024
Source: Jupiter, as at 10 October 2024
The most obvious distinction with the blue UK curve today is the relative depth of its trough and the steepness beyond. Also, compared with the US and Germany, the yield curve’s drop between May and mid-October (as measured by the gap between the red and blue lines) is far less pronounced. Note that in May, when Sunak called an election on the basis of better than expected economic growth figures, represented by the shallowness of the orange curve between 2 and 10 years, investors were sanguine about stable inflation. Today, in the period ahead of the publication of the Budget but without any of the detail being available, a much steeper gradient extending out for the next quarter of a century shows the markets beginning to factor in the risks of Rachel Reeves’s tax-and-spend strategy, her meddling with the government borrowing limits and the implications of greater than expected long-term debt, and speculating whether the whole package adds to inflationary pressure and heightened investment risk.
One final curiosity of this chart (because it extends twenty years beyond the US and German equivalents) is the pronounced reverse slope of the ‘hill’ to the right reflected in the half percentage point reduction in the yield between 2054 and 2074 and the way the gap has widened since May by 0.20%. Given we have little enough idea accurately predicting what might happen next year let alone in 2054 and perish the thought of a precise vison of economic conditions in half a century’s time, it begs the question ‘what do markets think they know that we don’t?’. Most of us will probably never find out: by 2074 even the youngest currently working in the markets will be in their retirement years; as for your author, he will be most likely pushing up the daisies or he’ll be 112 and too senile either to know or care.
Beyond the barometer of bond yields, three other brief perspectives on risk as markets see it:
Gold’s role in an uncertain world
Gold is unique as a mainstream investment asset: it is not an equity, sharing in the fortunes and profits of the company; it is not a bond with coupons and a promise of repayment; it is not cash with a rate of interest; it is an inert but solid shiny metal which since the dawn of humanity has come to be regarded as such a precious commodity and store of value that over the millennia it has provided the backbone supporting currencies, trade and governments’ reserves. In fiat4 economies its importance might be diminished today compared with history but that trust in the value of gold remains enduring.
As well as being a means of making absolute returns, in a diversified portfolio it has the intangible value of being a ‘non-correlated asset’: simply, its price is not directly related to what might be happening with the price behaviours of those other assets above (though for the technically-minded there is a relationship with real inflation-adjusted interest rates). Its value is most pronounced in times of uncertainty and stress.
Today with the gold price at an all-time high (at the time of writing $2734/oz, an appreciation in dollar terms of 32.3% so far in 2024), demand for it reflects investors’ desire to spread their risk in a very uncertain world. With war in Ukraine and the Middle East and the heightened risk of a broader global conflict, to which add the enduring fiscal incontinence of many western governments piling up mountains of government debt (remember Milton Friedman’s very accurate and apposite quip about borrowing: “if the government were to take over the Sahara Desert, there would be a shortage of sand”), for many investors holding gold in their portfolios is the equivalent of taking a hoard of coin back in the days of yore, and burying it as an insurance at the bottom of the garden underneath the mulberry bush. Just in case.
Oil: relative calm in stormy waters
Passing the anniversary of Hamas’ attack on Israel’s Kibbutzim, when a year ago it spiked to $90 per barrel, today the price of Brent Crude is $75. $5 higher since Iran launched missiles directly into Israeli territory three weeks ago, the reaction has been muted compared with when Putin invaded Ukraine in February 2022 when the oil price leaped to $120, or a year ago on the Hamas attack and April this year when the Iranians made their first direct missile attack on Israel and on both occasions it bolted up to $90 before falling back. Usually, the oil price is a reliable barometer of sentiment, particularly when the Middle East is the centre of attention. Examining the price behaviour, you would be forgiven for believing that there was a little local difficulty rather than, as is evolving, a conflict across the region that is not only literally exploding but spreading north into Lebanon and 2500km south into The Yemen as Israel takes on anyone and everyone inflicting harm on its homeland and people.
If this seems a contradiction to what is being indicated by the gold price, the dynamics are different. Unlike rare, supply-constrained, precious gold, oil is a readily available, mass-extracted, globally traded, globally consumed commodity: were Israel to disrupt the flow of oil from Iran (which is supposed to be 100% sanctioned but is in fact almost entirely going to China), markets are expecting that the 4% shortfall of global supply that is accounted for by Iran would be made up by Saudi Arabia and other OPEC countries. If the conflict were to become significantly greater, threatening production in other Arab countries, or preventing its distribution through the Straits of Hormuz (through which 20% of all global oil production passes to market), then a much bigger reaction in the oil price would be expected.
Equities
As represented by the MSCI World Index (1410 constituent companies comprising the world’s biggest listed businesses), global stock markets have enjoyed another bumper year over the past 12 months despite a pronounced wobble in August. However, it is important not to under-estimate the dominating effect of what has come to be known colloquially as the ‘Magnificent Seven’, the biggest beneficiaries of the technology revolution and the development of Artificial Intelligence (Apple; Alphabet/Google; Amazon; Meta; Microsoft; Nvidia; Tesla). These seven companies on their own have an aggregate market capitalisation currently worth 22% of the MSCI World total. In the first eight months of 2024, they accounted for one third of the total return of the market. Particularly when investing in index funds, when considering their downside risk investors need to bear in mind what a narrow base of companies it is which is contributing to what have undoubtedly been handsome returns of late.
The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.
²Government bonds are issued by governments. Bonds are a type of fixed interest investment, in which a company, government or other institution borrows money and, in most cases, pays a fixed level of interest until the date when the loan is due to be repaid.
³The rate of interest or income on an investment, usually expressed as a percentage.
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