The second quarter of the year continued in much the same vain as the first, with central banks increasing interest rates in an attempt to curb stubbornly high inflation. However, stronger than expected economic activity in both the UK and the US has impacted on the central banks’ task of taming inflation. For the UK in particular, inflation is falling back to target much slower than initially hoped encouraging the bank of England to accelerate its tightening by raising interest rates.

Interest rates and inflation characterized the quarter. Alongside this, other key points from the past three months include:

  • UK inflation fell less then expected, forcing the Bank of England to raise interest rates by a cumulative 1% over the quarter to 5%.
  • Global equity markets were up over Q2, but UK equities posted a negative return.
  • Corporate bonds (i.e. debt issued by companies) outperformed Government debt, which fell in value after interest rate expectations increased on the back of strong inflation data. Alternative bonds with more of a global focus, like High Yield and Emerging Market Bonds, proved more resilient.

Light at the end of the interest rate tunnel?

There is increasing speculation that the painful interest rate cycle may be nearing its end. Given two opportunities during Q2 to change interest rates, the Federal Reserve skipped one, and hiked by just a quarter of a percentage point in the other. Like most central banks, it is reported that the Federal Reserve will now scrutinize incoming data for indications that the interest rate rises have gone far enough and that the economy may falter if continued.

Further evidence that interest rates are near their peak concerns the rate of inflation. Many of the issues that contributed to the rise in inflation during 2022 are now resolved and commodity prices, which are usually the most impactful drivers of inflation, have generally been dropping. Recent figures have shown that UK inflation has dropped to its lowest in a year to 7.9% for the 12 months to June. This will put pressure on the Bank of England not to increase interest rates further. However, this won’t be welcome news for those with cash funds as it may limit returns available.

Investors have now aggressively reassessed their view on the extent to which the Bank of England will raise interest rates to tackle inflation. Investors now expect rates to peak at around 6.5% in March 2024. This figure was around 4% just a couple of months ago. This has led to a fall in bond prices over recent months, meaning short-dated Government bonds now yield over 5%.

Equities and Bond Yields

Despite the high interest rate rises, global equities pushed higher. Market gains were largely driven by mega-cap tech stocks in the US. However, the UK lagged, following a stronger pound and weaker oil and commodity prices hurt the energy and mining sectors.

Expectations of higher interest rates also drove up bond yields and hurt bond prices, especially in the sterling market. However, this yield is now making fixed interest look more attractive than it has done for a very long time, with investors now being paid for their money. Bonds markets with a more global exposure, like high-yield and emerging market bonds, held up better.

Markets have continued to rise despite the concerns over increasing interest rates. The US equity market has recovered well, returning almost 17% this year, but the recovery has not been as even as it first appears. These gains are largely driven by the very largest US companies in the tech sector such as Microsoft, Amazon, and Meta/Facebook. Any mention of Artificial Intelligence (AI) in company reporting has attracted investors. This has led the tech heavy Nasdaq to its strongest first half of a year for over 40 years.