Market Musings 180125: Europe, UK stocks surprisingly hit new highs

Market Musings 180125: Europe, UK stocks surprisingly hit new highs

Surprise surprise! European and UK stock markets hit a new all-time high this week...

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Reversing Trump Trades: Higher long-term US interest rates, stronger US dollar

From late September last year, until a week ago, one of the clear Trump trade winners has been the strength of the US dollar, reinforced by the rise in long term interest rates, ie US Treasury bond yields. The 10 year benchmark.Treasury bond yield had risen from 3.6% at the low in September to touch 4.8% at the beginning of this year, more than 1% higher. We saw a similar reaction in Europe, particularly in the UK, with a similarly sharp rise in the 10 year gilt yield, ie, the UK government bond yield.

So we had a twin movement here, which was driven principally by

1. the strength of the US economy,
   
2. the expectations that the arrival of Donald Trump in the White House will reinforce this growth, and
   
3. the potential inflationary impact of Donald Trump's policies, which in turn, have driven interest rates higher.
   

We should recognize that this is an unusual series of events at a time when the US central bank, the Federal Reserve, has been cutting its benchmark Fed funds rate to 4.5% from a peak at well over 5%.

Usually when the US central bank cuts interest rates, long term interest rates, ie, bond yields, typically fall. However, in this case, the reverse has happened. While the Fed funds rate has been cut, certainly over the last few months, long term interest rates have actually risen.

This is important in the US because it has a number of impacts on certain sectors, most typical, most particularly on the housing sector, where the key source of financing is set according to the 30-year fixed mortgage rate. Typically housing activity is stimulated when this fixed mortgage rate falls below 6.5% but at the moment, given the rise in long term bond yields, the fixed mortgage rate is actually at 7%, which is clearly keeping a cap on US housing activity for now.

The question is, how inflationary will Donald Trump's policies really be?

We know that he is focusing on four pillars in terms of policy, namely:

1. lower taxes.
   
2.  higher tariffs on imported goods.
   
3. deregulation of certain industries such as finance and energy, and
   
4.  trying to cap immigration, and in particular illegal immigration.

Clearly, the market consensus is that higher tariffs and a potential cap on immigration will both stoke inflation, firstly, via higher the higher cost of imported goods for US consumers, and secondly, via potential tightening of the labor market, which could result in higher wage growth and thus higher inflation, particularly in service sectors.

But we won't know the extent of the incoming Trump administration's policies for a few days, at which point we will be able to better assess any potential impact on both growth and inflation. 

Interestingly, the US inflation data released last week was actually somewhat benign as far as financial markets go. Both producer prices and the consumer price index, ie CPI, came in below or at the very worst, in line with economists' expectations, and show that the the continued drift lower in US inflation rates is not yet over.

US core inflation % year-on-year still falling

US core inflation eased on a monthly basis in December to 0.2%

Source: tradingeconomics.com

This has, in turn, provoked a little bit of a turnaround in the trend higher in both the US bond yield and the US dollar. The US 10-year benchmark yield has now pulled back to 4.6% from a higher 4.8% and
the US dollar has also pulled back from its recent strength with the euro/US dollar exchange rate stabilising at around $1.03.

The rise in the dollar is important for a couple of reasons, firstly, because the higher the dollar goes, particularly when interest rates go higher, the tighter financial conditions become. This in turn slows the economy and also  tends to impact upon financial markets such as the stock market. Secondly, the slowing of economic growth is lagged, but should happen because US goods and services become less competitive versus overseas.

However, thus far there is little evidence of the strong US dollar hitting US growth, with the timely Atlanta Fed GDPnow indicator of growth for Q4 2024 still running at a strong annualised 3% rate.

Source: Atlanta Federal Reserve

Interestingly, there is also an earnings translation impact for the largest US companies, because their overseas earnings, let's say in euros, yen or other currencies, are suddenly worth less in dollars because of the strength of the dollar versus those currencies. This at least optically should result in a slowing of earnings growth rates, particularly in sectors most exposed to overseas earnings, which of course, does include the very highly rated technology sector.

But again, for now there is little evidence that the stronger US dollar is hurting the share prices of US large-cap technology stocks, judging by the relative reslience of the Nasdaq 100 index.

That said, despite the pessmism surrounding the Eurozone economy and most notably Germany and France, the weaker euro does seem to have been a factor in the strong rally to new highs in the benchmark Euro STOXX 50 index. This has been boosted in the last week by surprisingly strong earnings results from Swiss luxury goods company Richemont, which has boosted sentiment around French branded and luxury goods companies (e.g. LVMH, L'Oreal, EssilorLuxottica, Hermes) which are a siezeable share of the Euro STOXX 50.

Remember that, just as the stronger US dollar should slow US growth over time, so the weaker euro should conversely help European growth over time too, given the relatively open nature of the European economy.

Note too the strength of the German benchmark DAX index, which also rallied to new all-time highs this last week on top of a 19% return delivered over 2024, and a cumulative 72% return including dividends since the start of this current bull market in October 2022. This has occurred in spite of the ongoing gloom surrounding German carmakers who are suffering from the twin threats of high energy prices and intense Asian competition.

Looking to the UK, note that the weakness of the pound sterling (from $1.34 in September to under $1.22 today) has also sent the UK FTSE 100 index to a new high. Recall that the FTSE 100 is largely composed of globally-exposed companies in the Oil & Gas, Mining, Healthcare and Banking sectors. So a weaker sterling should boost the contribution of their overseas earnings when translated back into pounds.

One clear beneficiary of lower long term interest rates, particularly in the US, is the infrastructure sector, because infrastructure tends to rely on long term debt financing to put big projects such as road, rail, air and even bridge construction into place.

This tends to be a good sector for long term, steady returns, particularly for investors looking for income combined with income growth, so that they can protect themselves against  inflation over the long term.

In particular, I like US infrastructure development which particularly focused on two areas: electricity demand through building of new generation and upgrading of transmission networks, and also oil and gas networks via Master Limited Partnerships (MLPs) that control the oil and gas pipelines and other oil and gas infrastructure related, for instance, to the transport and delivery of Liquefied Natural Gas (LNG) abroad (e.g. to Europe).

One final sector to focus on which has been one of the key drivers of this European stock market breakout to new all-time highs is the Banks sector. I continue to like this sector as lending volumes are improving and should continue to improve as central banks cut their interest rates further, while valuations are cheap and returns fo shareholders via dividends and share buybacks remain elevated.

Including reinvested dividends, the STOXX Europe Banks sector has delivered a cumulative return of 113% since October 2022, including 33% over calendar 2024. It also offers a dividend yield of 5.5% which remains generous.

Have a great week ahead

Edmund

Note: source for charts tradingview.com unless otherwise stated.