Reasons to be optimistic in Q4

As we embark on the final quarter of the year, the markets are dreary. Sentiment was depressed in Q3, and positioning indicators were stretched to the downside. There was a near financial crisis in the UK, stocks recorded their third straight quarterly loss in the US and interest rates across the Western world have surged. There have been very few bullish talking points for financial markets in recent months, but it’s usually darkest before the dawn, so is it time to look for a brighter future? We love a contrarian point of view where it is reasonable, and below we list our reasons for thinking that things can only get better, if you are a bull, of course.

1, The sport light is off the UK, for now  

After the catastrophic market reception of the “fiscal event”, on Monday the government scrapped the abolition of the top rate of income tax, which will remain at 45%. This U-turn from the Government is humiliating, however, they still get to freeze the rate of corporation tax and ending the cap on bankers’ bonuses stays, so Trussenomics is bruised but not flattened. Since scrapping the top rate of income tax was unpopular on both sides of the political aisle and would only have cost £2bn to the Treasury, this seems like small cheese to roll back on. However, the pound has bounced back above $1.12, UK 30-year Gilt yields have stabilised around the 3.8% mark, and you can now get a 5-year fixed mortgage with an LTV of 70% for 5.44% with HSBC. This is cheaper than the 7.06% rate charged by US banks, however, that is for a 30-year fixed mortgage, which plenty of us would prefer here in the UK.

On Monday, UK gilt yields were climbing as market jitters increased ahead of the Chancellor’s speech at the Conservative Party Conference. However, we think that Kwarteng will tread a very careful path with this speech. Instead of committing to major policy changes, he may focus on simplifying regulation, and the messaging is likely to be a much more low-key compared to what he delivered on 23rdSeptember.

Added to this, the government U-turn does not change the economic outlook for the UK, given that scrapping the 45% tax rate would have only cost Treasury £2bn. Given that the UK government is planning to borrow £600bn in the next 5 years, this is a mere drop in the ocean. Instead, this move is more political than economical. The fact that the FX market reacted well to this news is a sign that 1, the government’s policy of publicly ditching the economic orthodoxy promoted by the likes of the IMF leaves a credibility deficit. In the short term, this is good news for stabilising financial markets, it is also good news for the Bank of England, who have only spent approx. £4bn of the £65bn special purchases fund that was introduced last week to tame market volatility. It shows that the BOE can still calm markets and has lost none of its credibility, that is good in the current environment where the UK government is suffering from a major credibility deficit.

However, this will cause Truss problems in the long term, how can the current government be taken seriously when it comes to cutting public spending and eventually bringing the UK’s public debt back under control? It will likely also usher in an era of Labour governments as the capitulation of support for the Tories - according to the latest polling numbers - will be hard to climb back from.

One final point on the UK, last week the UK was targeted by markets who didn’t like unfunded tax cuts alongside vague plans for growth. However, rising rates and surging mortgage rates is a global story, not just a UK story. In the US, mortgage rates are above 7%, which is just below the 8% level of high yield or junk bonds. Thus, while the UK is an outlier politically compared to Europe and the US, the problem exposed by the UK’s mini budget is universal: the end of cheap credit is hurting financial markets. If everyone is in the same boat, it could help the UK to go unnoticed for a while, which is what the BOE will certainly be hoping for.

2, The US: when elevated recession risk is a good thing  

The most important thing for global financial markets right now is that inflation comes down. This is the new “winning signal” for the world economies. An economy that can bring its inflation down quickly and see its economy cool will do well in the long term at avoiding a deep and long recession because they will need a shorter rate-hiking cycle. Right now, the US appears to be in the lead according to these economic metrics. Its inflation rate is below rates for the UK and the Eurozone, and The Conference Board’s Leading Economic Index fell for a sixth consecutive month in August, which indicates recession. Only initial jobless claims and the yield spread were positive; however, the yield spread has narrowed significantly. Added to this, there are signs that the US labour market will moderate in the months ahead, as the average work week in manufacturing has contracted in four of the last six months, which tends to happen before companies cut their workforce. Thus, if the labour market, which has been a key driver of higher interest rates in recent months, is about to go into reverse, then we could see a less aggressive Federal Reserve hiking cycle than is currently priced in. As a reminder, the Fed’s latest dot plot expects a median 4.6% interest rate in 2023. Of course, weaker employment will not immediately lead to lower inflation, however, if we see NFPs for September drop below 250k per month, then it could give markets some hope that US inflation has peaked, leading to a rally in stocks and risky assets.

3, Earnings and seasonalit 

US and European stocks started Q4 with a broad-based rally at the start of this week. It is worth noting that October is historically a strong month for US stock returns, in comparison to September. Added to this, stocks tend to perform well in Q4 overall. FactSet analysis has found that EPS estimates from analysts for Q3 have received their largest downward revision since 2020, the peak of the pandemic. During Q3 analysts reduced their Q3 EPS estimates by a larger margin than average of 6.6%, compared with the average of the past five years, which is 2.3%. Analysts have also started lowering their forecasts, on aggregate, for Q4. Thus, the bar is low for US corporate earnings in the coming months, and if earnings start to beat expectations, then it could trigger a decent rally in risky assets.