In an era of global interest rate hikes and global uncertainties, the surprising resilience of markets despite the growing appeal of a 5% risk-free return has many confused.
2023 has been a year of relentless challenges and unwavering resilience - rising global yields, geopolitical tensions, and advancing technology. Uncertainty for the global financial environment has reached new heights and the following year may see it worsen as the expected global recession may finally come. The need for insightful direction has never been greater. David Barrett, CEO of EBC Financial Group (UK) Ltd, a leading player in the global financial services space, provides his valuable perspective on some of the pivotal issues.
Interest rate hikes, unexpected regional wars
We have seen a consistent rise in Treasury yields in the second half, which is weighing on investor sentiment. Will they continue to head higher? Would the interest rate hike affect the assets classes, and how?
It might seem that rates have only been on the move this year but it’s important to realise this has been going on since March 2022, when the Fed first started to hike. Eleven hikes later we have seen the Fed target rate range move from 0.25/0.50% to 5.25/5.50%, by any standards this is a massive move in such a short period of time. I suspect many people miss the point that rates are not high, by historical standards, they are simply higher than the market has been used to in the recent past.
Comments from the Fed indicate that near term hikes are likely done until they see more of the lagging effects of the previous hikes on the economy, I would tend to agree. But I do see a ‘higher for longer than the market might like’ type scenario playing out and I do not dismiss another round of inflationary pressure; especially given the abundant global risks we have now.
Considering what we have seen of late - rates, geopolitical tensions, inflation to name a few - you would be forgiven for thinking risk in general has held up better than many expected. We have just started to see a few cracks in stocks, credit, and housing but as the longer-term effects of the hikes play through the economy I am firmly in the ‘it’s not fully priced in yet camp’. Being able to earn 5% risk free in cash as we see the geopolitical tensions unfold doesn’t seem like the worse trade in the world.
We see the unexpected Israel-Hamas warfare amid the continuing Russo-Ukrainian war. The risk of regional instability is at another new height, how does it affect the the individual/institutional investor's choice of investment and the asset allocation?
As touched on above having a risk-free rate of 5% will make individual and institutional investors think twice about being exposed to price and news risk to the extent they have been in the recent past. I would consider a lower risk exposure and a higher cash allocation to be prudent at least into year end.
I suspect those asset groups that have massively over performed this year, the ‘Magnificent Seven’ stocks would be a great example, will see some profit taking. The risk with these being that they are so heavily owned that any repricing could become very volatile.
Has inflation come to an end…or not?
Some analysts think oil prices could hit $100 by the end of 2023. Do you think that it could happen? Would it accelerate investment in replacements i.e. green energy tech and its relevant industries like battery, solar panel and raw materials like lithium and cobalt?
Even before the present global tensions OPEC’s supply cuts have squeezed oil prices higher. I suspect the real answer to the question is almost totally dependent on the way the situation in the Middle East unfolds. For now, the market is remarkably resilient to the news cycle as it appears to be waiting to see if the conflict widens to other actors – Iran in particular. Should that happen I worry that price discovery for that additional risk could be very harsh indeed.
Higher fossil fuel prices always have a knock-on effect to renewables and the component prices. For me the short-term pricing is very much a speculative event – no renewable project be it solar, EV, Hydrogen or any other sector has a short term pay off. These are all huge long term investment projects and investors should be involved only if they have the stamina to stay the course.
Green Tech investment allocation is being driven by government subsidies and higher rates. Massive US subsidies have attracted a lot of the investment, that had been centred in other regions, into their economy. Given my view on needing to take a longer-term view, projects in those countries that can write the cheques will keep the institutional investors’ attention. As with many markets in a more stressed environment, large well-funded balance sheets will be a draw for investor flows.
Inflation continues to cool gradually across major economies but central banks remain cautious. Would that factor still be our primary consideration in investment decision heading into 2024?
For me global interest rates will remain the main driver in most markets for at least the first half of 2024. The market is pricing in cuts to start mid-year as the effects of the past rate hikes have the desired effect on the economic data. Any sustained dip in inflation that encourages this thought will make risk assets attractive again.
For me there are far too many variables out there now to make that call. Core inflation remains a lot more suborn than many would like, the Middle East and Ukrainian tensions could easily spark an energy price spike and broader trade tensions between the West and China rumble on. It is also easy to forget that we have a US election coming up in 12 months and the prospect of a change of administration in the White House could spark higher tensions as we have seen previously.
Global Market Outlook 2024
It is predicted the tech stocks would underperform in 2023. Are they now fairly valued after a pullback over the last two months? Is it time to buy the dip?
The ‘Magnificent Seven’ stocks have made index watching a little skewed this year, their rally in the first half was nothing short of astonishing. My call, in Q2, for tech to underperform was clearly too early in terms of the QQQ index but globally Asian Tech, Cyber Tech, Fin Tech and Software Services have not kept up.
At the time of writing, we are seeing the results season show that not all the leading Big Tech firms have a strong outlook for 2024 and their prices have been slipping. I expect nothing will move in a straight line for the rest of 2023 and into 2024 but I remain wary of technology as a sector. I think there is more value to be had elsewhere.
Technology is a sector that gets more things wrong than it get right as it innovates and looks for new products. The last two decades have allowed the sector to boom on free money – the cost of getting it wrong has been small enough that they just kept going – this has changed and the risk appetite to take on a much higher cost to find innovation will stall the sector.
I suspect the ‘Magnificent Seven’ have been the main beneficiaries in the sector exactly because they have those very strong balance sheets that can weather the rising cost of using them better than the small more innovative firms.
The Japanese yen eyes 150 per dollar, putting traders on alert for forex intervention. Why have not Japanese officials stepped in? Does JPY lose its haven status?
I suspect the authorities have been involved in DlrYen, smoothing the price action when they deem it to be to one way. The anonymity that single and multi-bank platforms give these days means they can do this with less fanfare than they might have before.
The reality for the market, the Japanese Government and the Central Bank is that Yen has always been heavily driven by yield differentials. The Bank of Japan Yield Curve Control policy means that the USD yield moves have created a very attractive carry trade. It is perfectly logical for the market to have been buying the Dlr and in particular DlrYen up to these levels. 150 has no real significance as a number it is more phycological than material.
There is no point conducting huge intervention to ‘protect a level’ – they have learned that lesson over many years. Intervention can hurt speculative flows in the short term but it will not change the main driver of the Dlr buying – yield differentials. If they want to change that they will need to revise their YCC policy. This may well be coming as local data is showing growing signs of inflation but the authorities do not seem to be in a hurry to untie the complicated knot they have made for themselves.
The risk reward of being short Yen at these levels is definitely less than it has been but I think that is more about the chances of a policy move coming than it being at 150.
The Yens safe haven is a strange one for me, previously I might have been convinced but now I am not sure it really qualifies. The FX rate is more volatile, it causes pressures in the economy and its reliance on importing energy keeps it vulnerable. The fact that the Yen is this weak given the global risks that exist says a lot about the safe haven status it might have.
We see the outbreak of generative AI and the massive adaption of AI technology on every trade in 2023. Algorithm trading is also a growing trend, too. Is it a good trend or disaster if more traders turn to or increase their reliance on algorithm trading?
At the moment I would suggest the majority of Retail clients trade using algorithms, be that copy trading or using Expert Advisors. As a broker that sees this kind of flow via our clients it is clear it creates herding instincts in many trades. We see many clients with the same / similar trades and the timing of entry and exit can be very similar – especially in moving markets.
Institutional clients use them mainly as execution tools – trying to avoid adverse market moves while they execute large flow into the market.
If you look at how the main ‘real’ liquidity providers manage their risk these days I can see this building up to become a real issue as we get higher realised volatility in markets. Real market makers are now trying to warehouse as much short-term risk as they can. The basic principle being that they see enough two-way flow to allow them to trade out of risk each side of the price, thus reducing hedging friction costs and capturing spread income.
They tend to hold risk for given windows of time, they have the capability to analyse each client’s ‘quality’ of flow and the profile of what happens to the price from the moment the client executes a trade. This is why many have become very sensitive to difficult flow – they want the decay of the price to remain stable for as long as possible, post execution, so that other clients are able to take them out of the risk and create spread income.
This works well in stable markets but anything that reduces that window of time (news, large flow or tricky client flow) means they have to hedge out of the position they hold sooner than they would like. The more market makers that adopt this risk management the more sensitive the price is to them being forced to hedge.
In many ways this means they are all running short volatility by default – great in a low volatility environment, but not great as volatility rises as we are seeing now. We have seen real volatility in bond markets for sure, stock and commodity markets have their moments and FX has been very quiet in comparison. Risk managers have the jeopardy of becoming too systematic in the way they manage exposure when all is going well, the real test comes when real volatility hits all sectors of the market.
About David Barrett
David Barrett is the CEO of EBC Financial Group (UK) Ltd, his career in financial markets spans 35 years, during which time he has found several consultancy business. With a background in foreign exchange, fixed income, commodities and derivatives, Barrett has held sales and trading roles for financial institutions including AIG, NatWest, ABN Amro and Nomura.
About EBC Financial Group
EBC Financial Group has cemented its role as a leading entity in the financial industry. Its teams are comprised of interdisciplinary and multilingual experts, specializing in the global financial technology field. The group's core team members possess over three decades of industry experience, and they have worked for large securities firms, investment banks, exchanges, etc. It is committed to offering a trustworthy and foolproof online trading service to its diversified clients across the globe.
Learn more about EBC in https://www.ebc.com
