By David Coombs

IT’S been quite the turnaround for financial markets over the last few months. The gloom in evidence in the late autumn has been followed by this year’s record-strewn first quarter for most big equity markets. Probably the biggest shift has been the extent to which investors have reined in their bets on how much the US Federal Reserve (Fed) is going to cut interest rates this year.

For much of 2023, investor confidence tracked central bank-speak slavishly. Stocks sold off in early autumn when investors expected the Fed to keep rates higher for longer in in its ongoing fight against inflation and then surged towards year-end when the central bank seemed to be getting more confident about getting inflation down to its 2% target.

Back then, investors were confidently forecasting six or seven Fed cuts this year. They’ve since reined those bets in big time. Investors currently think the Fed will deliver about three 0.25% cuts, perhaps starting in the early summer.

Why have stock markets hardly blinked this year as rate cut bets have been pared back so aggressively? It seems that as 2023’s higher-rate-driven US bank failures fade from their collective memories, investors have got a lot more comfortable about higher-for-longer rates. Who needs cuts when America’s economy keeps defying recession forecasts and is booming instead?

We think American rates will fall in time, but inflation and economic growth will need to moderate first, and exactly when that will happen is anyone’s guess. Ours, for what it’s worth, is sometime in the second half of this year.

Government bonds are the asset class most sensitive to rate expectations so it’s hardly surprising that their yields (which run in the opposite direction to their prices) have been rising significantly. But we haven’t lost our appetite for US Treasuries or UK gilts.

Yes, US inflation has been running a bit hotter than expected over the last few months, but we don’t see much that suggests a nasty resurgence in inflation that might force the Fed to start hiking rates again.

As a result, we’ve been adding to our government bonds. Because we think rates and yields will drop at some point this year, we think 10-year yields north of 4% give our portfolios a nice buffer if stock markets do suddenly drop markedly. Specifically, we’ve been buying the UK Treasury 1.5% 2053 and 1.75% 2037.

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Given slightly hotter US inflation of late, it’s encouraging that the latest personal consumption expenditures (PCE) index – the inflation measure the Fed watches most closely – is now retreating towards 2%. That said, it’s still not falling at a pace that inspires a huge amount of confidence that we’ll get Fed cuts quite as soon as markets expect.

Of course, things are very different this side of the pond. Here, the Bank of England (BoE) seems positively itching to cut rates now we know the UK fell into a technical recession in the second half of 2023 and inflation is falling sharply. BoE Governor Andrew Bailey has confidently signalled that UK rate cuts are “on the way”. Investors are fully pricing in a 0.25% cut in August – followed by two more this year.

All this hasn’t helped UK stocks much – they ended the first quarter more or less where they began it. By contrast, US and European equity markets have kept powering ahead. Coming in to this year, we felt that some earnings forecasts might have got a bit lofty but overall company earnings have proved pretty solid so far.

Providing company profits prove sustainable, stocks can probably keep rallying for a while longer. Stronger profitability would tend to imply a better economy and, therefore, less pressing need for those ever-elusive rate cuts. Stock-market bulls also argue that gains are getting broader, and less alarmingly concentrated, even if it’s still the huge US tech groups that tend to dominate the headlines.

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Speaking of which, the run-up to a single company’s earnings results rarely generates the kind of palpable tension evident ahead of AI chipmaker Nvidia’s big reveal in late February. The US chip designer has become something of a bellwether for the health of markets so there was a collective sharp intake of breath ahead of its results announcement.

Happily, Nvidia delivered the goods and more, with another blowout set of results that highlight the increasing importance of its chips as the vital lifeblood of technology companies, data centres and everyone else scrambling to keep up with the AI revolution.

As Nvidia’s shares have kept rallying, we’ve trimmed back our holdings a bit. We don’t want to sell outperforming businesses completely (lots of people want to own them for a reason). But, equally, why take the risk of getting hit by any short-term downdraughts?

David Coombs is multi-asset fund manager, Rathbones Asset Management