The rally in risk assets continued strongly in February with almost all major share and credit markets making gains. The further...
The rally in risk assets continued strongly in February with almost all major share and credit markets making gains. The further rally was helped by more signs of soft economic landing for the US as well as hope of government initiatives to prime growth in China. Markets continued to look towards central banks starting to lower official interest rates later this year although slowing progress reducing inflation is causing central banks to caution that rate cuts are some ways down the track. The tempering of rate cut expectations caused government bond yields to push higher in February.
Major share markets in February ranged from flat performance (0.0% change) for Britain’s FTSE 100 to a 9.3% gain for China’s CSI. The big gain in China’s share market came after several months of decline and reflected some official intervention as well as hope of policy change towards stimulating growth. Most major share markets made big gains in February including Europe’s Eurostoxx 50, up 4.9%; the US S&P 500, up 5.2%; Australia’s ASX 200, up 6.2%; and Japan’s Nikkei, up 8.8%. Several markets made record highs in the month including the US, Japanese and Australian share markets.
The strong performance by share markets carried through to credit markets notwithstanding problems showing in the US commercial real estate market and the general problem of too much supply and weak demand continuing to beset China’s property sector.
In the US, continuing signs of unexpectedly strong economic growth in the face of high interest rates continued to limit credit quality concerns in February. Australian credit spreads also narrowed in February even though Australian households carry a much higher debt burden than elsewhere and mostly at variable interest. Sharply rising Australian house prices mean that default rates are likely to rise relatively slowly as economic growth slows.
An increasing issue is whether the rallies in risk assets so far this year are sustainable as they still appear to be built partly on expectations of lower official interest rates? In the US, economic growth is resilient, 3.2% annualised in Q4 2023, and is still generating strong employment growth, a low unemployment rate and annual wage growth above 4% y-o-y – too rapid for the Federal Reserve to achieve its 2% inflation target in a reasonable time frame. Indeed, the US economy looks as if it has been through a shallow softer phase and is starting to recover.
If the US economy is in early stage recovery it is likely that progress reducing US inflation still hovering around 3% y-o-y will stall providing almost no leeway for the Federal Reserve to start cutting the 5.50% funds rate in 2024 and even raising the possibility it may need to hike rates further. In February, the US bond market still clung onto albeit diminishing hope that modest rate cuts lie ahead later in 2024. In February the US 12-months bond yield rose by 29 basis points (bps) to 5.00% while the 2-year yield rose by 42bps to 4.26%. These shorter-dated US bond yields may rise further over coming months if relatively strong US economic reports continue and reduce further the possibility of lower official interest rates this year.
Relatively greater upward adjustment may be needed by longer term US bond yields. Firming US growth prospects usually go together with a positively shaped US bond yield curve. While the US 10-year bond yield and 30-year yield both rose in February by respectively 35bps and 21bps to 4.26% and 4.38% these yields sit below shorter-dated bond yields. A negatively shaped bond yield curve implies much weaker economic growth ahead promoting substantial cuts to official interest rates. The opposite seems to be occurring in the US early in 2024 opening the possibility that longer-term US bond yields could push up to 5.00% and more this year.
In Australia, economic growth is much softer than in the US mostly because household spending growth is under greater stress in Australia compared with the US. Australian Q4 GDP out this week is expected to show an increase of only 0.3% q-o-q reducing annual growth to around 1.5% y-o-y from 2.1% in Q3 2023. Employment growth took a noticeably weaker turn late in 2023 and the unemployment rate has started to rise. Wage growth above 4% y-o-y and inflation hovering well above 3% y-o-y are preventing the RBA from starting to cut its 4.35% cash rate, but the prospects of a rate cut later this year are higher than for the US.
Australian bond yields rose in February but by less than US counterparts. The Australian 2-year bond yield rose by 19bps to 3.79%, while the 10-year bond yield also rose by 19bps to 4.13%. The RBA at its first policy meeting for 2024 in early February reminded the market that the bar is still set high for starting to cut official interest rates requiring signs of moderating annual wage growth and rising labour productivity. While the bar could be cleared, it is unlikely to occur until later this year at earliest.
The softer growth outlook for Australia compared with the US growth outlook means that Australian bond yields will not be under pressure to rise much further and could rally sustainably later in the year if weaker economic growth and labour market signs persist. We pencil in one RBA rate cut late in the year taking the cash rate down to 4.10% by year end, but that first rate cut could be delayed by untoward wage growth (sticking above 4% y-o-y) or too little improvement in productivity.