January 2024

Market Commentary

Is the year-end rally overdone?

(2 min read)

Since October, the markets have rallied strongly into the year end, predominantly driven by the prospect of lower interest rates with the first cut priced for the first half of this year. As we wrote in December 2023, we are a little sceptical that the market pricing on interest rate cuts is warranted given that we believe inflation is likely to be structurally higher in the decade going forward than it was in the past.

Deglobalisation, decarbonisation and demographics, or DDD as these themes have become known, have changed the inflation outlook significantly. The cost incurred to achieve net zero will be immense and the combination of deglobalisation, an ageing population and a shrinking supply of labour is likely to keep upward pressure on wages and core inflation. The chart below illustrates the extent that the prospect of falling interest rates have been reflected in the sharp decline in the US Treasury government 10-year bond yield.

Two factors that we think are worth considering as reasons for caution for those investors relying entirely on lower yields and the interest rate cycle as the key driver for investment performance are 1) inflation and 2) debt issuance going forward.

Last week’s US inflation data for December 2023 saw a rise to 3.4% from 3.1% at the headline level and close to unchanged at 3.9% at the core (‘core inflation’ excludes food and energy prices). Inflation has fallen significantly from a year ago, but the hardest task is reducing it from current levels to the 2% target. The risk for central banks like the US Federal Reserve and the Bank of England is to cut interest rates early before the job is complete, particularly as economies remain resilient.

The second factor of concern is the busy issuance calendar for government bonds to fund deficits. With central banks no longer buying bonds under their QE programmes as they have been in abundance for the last 10+ years, crowding out at the longer end of yield curves could put upward pressure on yields, thereby pushing bond prices downwards.

It is worth noting that our client portfolio investments are driven by strong fundamentals rather than by the hope that we are returning to a lower interest rate environment.

Peter Geikie-Cobb | Head of Investment Research
Montgomery Associates
16th January 2024

Source: FT.com showing the US 10 year Treasury yield as at 11/01/2024.
https://markets.ft.com/data/bonds/tearsheet/summary?s=US10YT