Market Comment 17/05/2018
Is 3% a Magic Number?
Cornelian's Investment Director, David Appleton examines the '3% effect' and suggests that, for the US at least, cash is back as an asset class!
The 10-year US Treasury yield rose above 3% on 24 April to much fanfare. This data point has become something of an obsession amongst financial market commentators, viewed as a ‘psychologically important’ staging post on the long journey to more normal monetary conditions. While this sort of fixation on an arbitrary number is illogical in many ways, the fact that the world’s largest economy and capital market appear to have adjusted relatively painlessly to a view of long term interest rates that is broadly ‘normal’ (i.e. above inflation expectations) is arguably a major positive signal. For the majority of the post-crisis period, the key question for investors has been whether economic growth rates in the developed world could ever be strong enough for interest rates to rise. In the US at least this question has now morphed into whether the economy is growing too fast. Are investors never happy?
Before getting too carried away, it is worth remembering that it is still too early to predict with any great confidence what impact monetary tightening will have on the real economy and asset prices over the medium to long term. For now most lead indicators of economic activity remain robust and core inflation remains well behaved, however the impact of higher borrowing costs is yet to be felt by the majority of households and businesses.
Rising short term interest rates could in many ways prove just as important for asset allocation. Suddenly, for US investors at least, cash is back as an asset class! For a decade policymakers have made depositing money in the bank so utterly unappealing to investors that almost anything else looked better. Now US based savers can generate a similar yield to the domestic equity market while taking almost zero investment risk. The bar has been raised for investors to move up the risk curve and US equities will have to maintain an impressive rate of earnings growth to continue to attract domestic investment dollars. The emergence of cash as a credible, low risk asset class is still in its infancy, but could have a powerful impact on asset allocation and portfolio flows.
What does this mean for UK-based investors? The case for a similar path to normalisation in the UK is complicated by deteriorating economic data and a Brexit-shaped elephant in the room. Indeed, the Bank of England is starting to look a bit silly having gone to great lengths to prepare the market for a series of rate hikes starting in May, only for Governor Carney to walk back from this guidance through some leaked comments made on the side lines of a conference in Washington in April. The Bank is starting to risk losing credibility and could arguably be undermining rather than underpinning financial stability with this constant flip-flopping and micro-managing of interest rate expectations. Businesses in the UK, now more than ever, need certainty in order to plan and invest and unnecessary volatility in interest rates and currencies helps no one. Unfortunately cash as an attractive low-risk investment capable of generating a reasonable return is likely to remain the preserve of US investors for the time being.