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Market Outlook: Fed’s interest rate forecast surprises financial markets

Last week was a bit gloomier in many stock markets. In the United States the broad S&P 500 Index fell by 1.9% from June 11 to June 18, and Sweden’s OMX All-Share Index (OMXSPI) closed 1.7% lower. There was also some movement in fixed income markets, with 10-year US Treasury yields spiking briefly at 1.57% mid-week before reverting to less than 1.5%. Both US exchanges and the OMX Stockholm were trading higher on June 21-22.

Fed may hike its key interest rate earlier than previously expected

Last week’s main event in terms of macroeconomic data was the announcement following the Federal Reserve’s June policy meeting. The US central bank left its key interest rate unchanged, but the quarterly “dot plot” showing individual policymakers’ projections of where interest rates might be headed now points towards two rate hikes during 2023. Meanwhile the Fed has begun to discuss a “tapering” or gradual phase-out of its stimulative bond purchases. Compared to the Fed’s statements following its previous meeting, this implies that rate hikes will begin earlier. The Fed expects US inflation to slow by this coming autumn.

Biden and Putin meet in Geneva

Last Wednesday’s summit between Russian President Vladimir Putin and US President Joe Biden was the first time they have met since Biden was elected. The meeting did not change relations between their countries, but it led to limited progress. The two agreed to work towards new arms control agreements and to return their ambassadors to Washington and Moscow, respectively.

Parliamentary no-confidence vote ousts Swedish government

After the failure of weekend negotiations, a historic no-confidence vote in Sweden’s Parliament toppled the centre-left minority government of Stefan Löfven on June 21. A majority of MPs voted Yes to a no-confidence motion against the prime minister, triggered by disagreements on the possible future abolition of rent restrictions on newly built residential properties. The rules give Löfven one week to decide the next step in the process: either to resign and let the speaker of Parliament explore possible new governing constellations or to call a snap election for this autumn, just a year before the regular September 2022 election. Sweden’s stock market reacted calmly to the no-confidence vote.

 

Our market view

Temporary stock market turbulence due to worries about key rate hikes

Signals from the US Federal Reserve that it may hike its key interest rate earlier than previously expected led to a few shaky trading days on stock exchanges. Investor worries are understandable, since higher interest rates and yields would undoubtedly hurt share prices – especially if yields rise to levels that make bonds an attractive alternative to equities. But it will take a while to get there. And what happens instead when investors become worried about the stock market outlook and move money into bonds is that this triggers a decline in yields (= bond prices rise). Ten-year US Treasury yields have now fallen from the 1.6-1.7% range to well below 1.5%. In Sweden and elsewhere in Europe, government bond yields remain at extremely low levels.

As the economic recovery accelerates during the next few quarters, it will be reasonable if bond yields climb. Major central banks are unlikely to raise their key interest rates before 2023 at the earliest. We believe that 10-year US Treasury yields may climb above 2% during 2022, a development that is widely expected. This will probably also be acceptable to investors − without causing major stock market reactions − since the upturn in yields will not be large or alarmingly rapid.

A sharper upturn in yields than we are forecasting might be triggered by persistently high inflation. Right now we are experiencing higher inflation than for a long time, but there are many indications that this surge is temporary and that inflation will again fall to the vicinity of central bank targets.

Inflation worries are offset by other, powerful forces that favour stronger stock market performance. Listed companies have made it through a few tough quarters with earnings that surpassed market expectations. Now that economic growth is taking off in earnest, corporate earnings should do the same. Consensus forecasts point to nearly 40% higher earnings for global listed companies this year. This will provide solid support to share prices.

In the past week or so, growth stocks have regained their pace-setting role – benefiting from low interest rates and yields, which boost the present value of their future earnings. We also expect that many of the trends that favour this type of companies, especially digitisation and automation, will continue to generate good potential for expansion. Large and increasing spending on sustainability, especially in the environmental field, also indicates that this type of investments will not only be good for the planet but also for portfolio performance, at least in the long run.

Shaky stock markets after rapid upturns are fairly typical. Renewed worries about inflation, bond yields and interest rates – or ominous new signals related to the pandemic and COVID mutations − are among factors that may trigger such market turbulence. But good fundamentals, including strong economic growth and continued low interest rates and yields, should help maintain dynamic stock markets. Because of somewhat stretched valuations, however, future upturns do not have the same potential as those of the past year.