Rate Hike Recess

Here are some of the biggest stories from last week:

• The OECD raised its growth outlook for this year but lowered it for 2024.
• Britain’s inflation rate unexpectedly fell in August to its lowest level in 18 months.
• The Bank of England kept interest rates unchanged for the first time in almost two years.
• The Fed also held interest rates steady, but it hinted at a hike later this year.
• Joining the two, the Bank of Japan also left its monetary policy unchanged.
• EM small-caps are set for their second-best relative return over large-caps in 14 years.

Dig deeper into these stories in this week’s review.

Macro

After a stronger-than-expected start to 2023, buoyed by lower energy prices and China’s reopening, global growth is expected to slow down as rate hikes weigh on economic activity and China’s rebound disappoints. That’s according to the OECD, which upgraded its growth forecast for the world economy this year but lowered its outlook for 2024. Global growth will ease to 2.7% in 2024 after an already “sub-par” expansion of 3% this year, according to the latest OECD forecasts out last week. With the exception of 2020, when the pandemic struck, that would mark the weakest annual expansion since the global financial crisis. What’s more, the organization warned that risks to its forecast are tilted to the downside due to potential stronger effects from past rate hikes, persistent inflation, and China’s ongoing challenges.

Delving into the regional and country outlooks, the OECD reduced its growth forecasts for the euro area for both this year and next. That's largely due to Germany, which is anticipated to experience a 0.2% contraction in its economy this year, placing it alongside Argentina as the only G20 nations expected to face downturns. China's downgrades were also particularly bad, with growth next year falling further below the government’s official target of “about 5%” due to weak domestic demand and lingering problems in the property sector. That’s not good news for the world economy, with the OECD warning of significant global repercussions should China's slowdown accelerate further.

Over in the UK, the country’s inflation rate unexpectedly fell in August to the lowest level in 18 months. Consumer prices in Britain rose by 6.7% in August from a year ago, contrary to economists' expectations, who had forecasted inflation to rise from 6.8% in July to 7% last month. Adding to the good news, core inflation, which excludes food, energy, alcohol, and tobacco prices, fell sharply to 6.2% in August from 6.9% the month before (economists had expected no change in the figure). Services inflation also eased to 6.8% from 7.4%, potentially alleviating the upward wage pressure that has particularly worried the Bank of England.

The report came as a massive relief for the UK, which for months has had the worst inflation problem out of the G7 countries. But some economists cautioned that it’s too early to celebrate. After all, Britain’s inflation rate is still more than three times higher than the BoE’s 2% target. What’s more, with oil prices surging in September, the decline in headline inflation could decelerate or even reverse.

Still, the bigger-than-expected drop gave the nation’s central bank the confidence to keep interest rates steady last week. The BoE held its key rate at 5.25%, marking the first pause after 14 consecutive rate hikes since December 2021, when rates stood at just 0.1%. But the decision was far from a unanimous one, with five officials voting to leave rates unchanged and four wanting to raise them to 5.5%. In any case, the BoE made it very clear that this was just a pause, and that it would respond with more rate hikes if inflation doesn’t fall as expected.

Across the pond, the Fed also left interest rates unchanged last week, but it signaled that borrowing costs will likely stay higher for longer after one more rate hike this year. The US central bank left its target range for the federal funds rate unchanged at a 22-year high of 5.25-5.5%, while its latest "dot plot" showed that 12 out of 19 officials supported an additional rate hike in 2023 to rein in inflation once and for all. The plot also revealed that most officials see a much slower path of rate cuts in 2024 and 2025. They now anticipate the federal funds rate to drop to 5.1% by the end of 2024, up from 4.6% when projections were last updated in June. They expect further declines to 3.9% and 2.9% by the end of 2025 and 2026 respectively.

Fed officials also released a new set of economic projections forecasting stronger growth and a more benign inflation outlook this year compared with previous estimates released in June. They reduced their core inflation forecast for 2023 to 3.7%, down from the previously predicted 3.9%. For 2024, they maintained their forecasts at 2.6%, while projecting that inflation would only return to the Fed’s 2% target by 2026. Officials' economic growth estimate for this year rose sharply to 2.1% from 1%, and was further adjusted up by 0.4 percentage points for 2024 to 1.5%. In other words, a "soft landing" for the US economy, which seemed elusive just three months ago, now appears attainable – surely a cause for celebration for investors.

Finally, in a move widely expected by economists, the Bank of Japan kept its monetary policy unchanged last Friday, maintaining its short-term interest rate at minus 0.1% and making no adjustments to its yield curve control program. The latter allows the yield on 10-year Japanese government bonds to move within a tight band of plus or minus one percentage point around a target of 0%. The BoJ’s stance comes despite the fact that inflation has exceeded its 2% target for 17 straight months, prompting some economists to believe that the central bank will have to eventually abandon its ultra-loose monetary policies.

Stocks

Emerging market small-cap stocks have been trouncing their large-cap counterparts since the end of the Covid-induced market selloff in 2020. So far this year, the MSCI EM Small Cap Index has registered a gain of approximately 12 percentage points higher than the large-cap index, setting it on track for its second-best relative return advantage in 14 years.

Several factors are contributing to this trend. First, the small-cap index has a notably lower weight in China at 7.4%, compared to the large-cap index, which attributes its largest weight to the country at 29.5%. This lower exposure has helped the small-cap index since 2020 given that China implemented some of the strictest pandemic restrictions and kept them in place for the longest, adversely affecting its economic activity and stock market. And even though the country abandoned these restrictions about 10 months ago, its subsequent economic recovery has been very underwhelming.

Second, China's economic struggles have a more pronounced effect on non-Chinese stocks in the large-cap EM index than on those in the small-cap index. This is primarily because larger companies often have supply chains, investments, and operations in China, making them more susceptible to the nation’s economic shifts. Smaller firms, in contrast, are typically more influenced by their local economies than by international factors. What’s more, the small-cap EM index's biggest country weight is India (at 25.7%), which has been a notable growth success story recently, positively impacting the small-cap firms operating within its borders.

Last but not least, EM small caps have been benefiting from the investing craze in young AI and EV companies. For example, the tech-centric markets of Taiwan and South Korea, the second- and third-biggest country weights in the small-cap index at 21.3% and 14.4% respectively, are seeing their semiconductor companies benefit from the booming demand for all things AI.

This week

• Monday: German Ifo survey (a closely watched business climate index that acts as an early indicator of morale in German industry).
• Tuesday: US consumer confidence (September), US new home sales (August) Earnings: Costco.
• Wednesday: US durable goods orders (August). Earnings: Micron Technology.
• Thursday: Eurozone economic sentiment (September). Earnings: Accenture.
• Friday: Japan unemployment rate (August) and retail sales (August), eurozone inflation (September).