JP’s Journal: Chopping down the ‘Magic Money Tree’

Sometimes markets see what they want to see. The interpretation of the latest statements from the Chairman of the Federal Reserve (Fed) was a case in point.

Jay Powell's remarks were balanced: inflation remains well above target, but there are signs that growth risks are increasing. This was taken to be the ‘pivot’ and gave a boost to risk assets. This was exemplified by the performance of emerging markets, with equity and debt asset classes recording some of their best monthly returns in 10 years.

Investors seem to be preparing themselves for a soft global landing, led by the US. Further tightening of 50bps is now expected from the Fed in December, followed by rates peaking at around 5% in the second quarter of next year. However, labour markets are posing a problem, as shown by the latest non-farm payrolls which came in above expectations. While the unemployment rate was steady at 3.7%, pay growth was strong at 5.1% indicating a pretty tight labour market.

I feel that central banks will not want to let up on inflation. The experience of the UK in recent months is a sobering lesson. If investors lose faith in fiscal and monetary policy or the desire to keep to inflation mandates, then the cost of borrowing can rapidly escalate. Given the level of government debt and the size of budget deficits, higher borrowing costs will mean much less is available for other areas – a vicious circle that needs to be avoided. So, we should pause to note the passing of Modern Monetary Theory – or the more prosaically named ‘Magic Money Tree’. A briefly-touted theory that governments could spend until inflation became a problem and then turn off the taps. Given its short shelf-life, it’s unlikely to make it into economic history textbooks.

Markets more optimistic

The benchmark 10-year US treasury yield shrugged off the labour market data and finished the week below 3.5% with the real yield equivalent heading towards 1%. I prefer the latter as a better insurance hedge, given the level of uncertainty around growth, inflation and interest rates. In the eurozone, German yields consolidated below 2%, while Italian 10-year rates ended at 3.75%. In the UK, nominal and real yields were broadly unchanged, with the 10-year nominal rate resisting a move below 3%. On the currency front, the stronger than expected US labour data only gave a brief respite to the recent weakness in the dollar, with sterling ending the week just below $1.23 – at the moment, it is defying the many experts who were predicting parity by year end.

Credit continues to see rehabilitation from the September sell-off. In sterling investment grade markets, spreads were broadly unchanged but there was better sentiment, with a wide range of new issues being brought last week. Financial issuance continued to catch the eye, with some attractive coupons being offered. In high yield credit, spreads were tighter and are now over 100bps lower, on average, than in early October.

So, where is the best value at the moment? I would be cautious on going too long duration. The rally we have seen looks premature from my perspective. I would prefer to keep interest rate sensitivity relatively low. And there are good opportunities to be found in shorter-dated strategies. I like the combination of attractive credit spreads and government bond yields that embed quite of bit of tightening in monetary policy – this applies to both investment grade and high yield markets. I also like positive real yields. Perhaps I have been brainwashed by the long period of negative real rates in the UK, but positive real yields in the US look reasonable and I would be tempted by UK index linked bonds if yields got back towards 1%.

And finally…

…a comment on the Football World Cup. Despite the pessimism going into the tournament, it is turning out to be the most thrilling and unpredictable that I can remember. The compressed fixture list will put pressure on players, but it creates a great spectacle. As always, the hype around England swells after a good result, but there are reasons to be optimistic. In Saka, Bellingham and Foden we have some of the best young footballers around. The problem is that France has the best in Kylian Mpappe. Roll on Saturday.

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.