Several noteworthy financial events have happened since the beginning of 2023: what have they taught investors? 5 lessons from the financial markets that should not be underestimated.
Arriving in mid-2023, the financial markets have left important lessons for investors.
As pointed out in an analysis by The Economist, 2022 ended in the deepest pessimism, as asset prices plummeted, consumers were gripped by distrust and recessions seemed almost inevitable. Yet, so far Germany is the only major economy to have actually experienced one, and a mild one at that.
In a growing number of countries, it is now easier to imagine a "soft landing," in which central bankers manage to appease inflation without stifling growth. The markets have therefore spent months in rally mode. Taking the summer break as an opportunity to reflect on the year so far, here are 5 lessons investors have learned.
1. The Federal Reserve was serious
Regarding the rise in interest rates to combat high inflation, the Fed has shown that it really means it.
Interest rate expectations started the year in an ambiguous position. The Federal Reserve had spent the previous nine months tightening its monetary policy at the fastest pace since the 1980s.
Yet investors remained stubbornly unconvinced of central bank aggressiveness. In early 2023, market pricing implied that rates would climb below 5% in the first half of the year, then the Fed would start cutting. Central bank officials, by contrast, thought rates would end the year above 5% and that cuts wouldn’t happen until 2024.
The officials eventually prevailed. Continuing to raise rates even during a banking crisis, the Fed finally convinced investors that it was serious about curbing inflation. The market now expects the Fed’s key rate to finish the year at 5.4%, only marginally below central bankers’ median projection. This is a big win for a central bank whose previous deadpan reaction to rising prices had damaged its credibility.
2. High rates: is the worst still ahead?
Since the start of 2022, the average interest rate on a risky debt index (or junk) of American businesses has risen from 4.4% to 8.1%. However, only a few have failed. The default rate for high-yield borrowers has increased over the past 12 months, but only to around 3%. This is much lower than in previous stressful periods. After the 2007-2009 global financial crisis, for example, the default rate soared to over 14%.
This could simply mean that the worst is yet to come. Many companies are still running out of cash reserves built up during the pandemic and relying on cheap debt secured before rates started to rise.
Yet there is reason to hope according to the analysis of The Economist. Interest coverage ratios for junk borrowers, which compare profits to interest costs, are close to their healthiest level in 20 years. Rising rates may make life more difficult for borrowers, but it hasn’t really made it risky yet.
3. Bank failures did not become a new 2008
The collapse of Silicon Valley Bank spread panic in the spring. Signature Bank and First Republic Bank also collapsed, and a global contagion has apparently unfolded. Credit Suisse, a 167-year-old Swiss investment bank, has been forced into a shotgun wedding with its longtime rival, UBS. At one point it seemed that Deutsche Bank, a German lender, was also faltering.
Thankfully a full-blown financial crisis was averted. Since First Republic failed on May 1st, no more banks have failed. Stock markets shrugged off the damage in a matter of weeks, though the KBWR index of US bank stocks is still down about 20% since early March. fears of a lasting credit crunch have not materialized.
The happy outcome, however, was far from free. US bank failures have been curbed by a large improvised rescue package from the Fed. One implication is that even mid-sized lenders are now considered “too big to fail”. This could encourage such banks to indulge in reckless risk-taking, assuming that the central bank will fix them if it goes badly.
4. Big bets on Big Tech are back
The past year has been a mixed one for investors in the US tech giants.
These companies started 2022 looking decidedly unassailable: just five of them (Alphabet, Amazon, Apple, Microsoft, and Tesla) make up nearly a quarter of the value of the S&P 500 index. However, rising interest rates have hindered the process. During the year, the same five companies decreased value by 38%, while the rest of the index fell by only 15%.
Now, the giants are returning. Along with two others, Meta and NVIDIA, the Magnificent Seven dominated US stock market returns in the first half of this year. Their stock prices soared so much that, in July, they accounted for more than 60% of the value of the Nasdaq 100 Index, prompting the Nasdaq to scale back its weights to keep the index from becoming heavy.
This big tech boom reflects the huge investor enthusiasm for AI and their more recent belief that bigger companies are best placed to take advantage of it.
5. An inverted curve is not a sign of a recession
The equity market rally means that it is now bond investors who are predicting a recession that is yet to come.
Yields on long-dated bonds typically outpace short-dated ones, compensating long-term lenders for increased risk. But since last October the yield curve has been "inverted": short-term rates have been higher than long-term rates. This is usually the financial markets’ sure signal of an impending recession.
In summary, this is the reasoning: if short-term rates are high, it is presumably because the Fed has tightened monetary policy to slow down the economy and curb inflation. And if long-term rates are low, it suggests the Fed will eventually succeed, inducing a recession that will require it to cut interest rates in the more distant future.
Usually, this indicator is considered to be a surefire predictor of a recession. However, to date, it has not occurred and the US economy and markets have rather shown resilience.
Analysts are cautious: Something else could still break before inflation drops enough for the Fed to start cutting rates. But there is also a growing possibility that a seemingly foolproof indicator has failed. In a year of surprises, it would be the best of all.
Original article published on Money.it Italy 2023-08-02 11:47:50. Original title: Cosa ci hanno insegnato finora i mercati in 5 punti
