Markets resist call of AI and steer through war, inflation and political volatility
The past quarter has seen a resumption of hostilities between the US and Iran and serious concerns about the vast amount of capital being poured into Artificial intelligence (AI) and related projects such as SpaceX. Russia’s war on Ukraine continues and the UK has its seventh PM in just over ten years.
And yet, financial markets continue to be resilient with stock markets including the FTSE-100 reaching new highs. Any of these events might have triggered a sharp fall, but instead markets have shown an Odysseus-like ability to steer between the hazards of war, inflation and a volatile political environment.
Trump’s weak spot
In our last report we noted how investors seem to be looking through the war in the Middle East by focussing on the pressures which would lead to an end to the conflict (see Spring update: Markets think the war is over, time to celebrate?). First and foremost of these is President Trump’s need for lower oil prices ahead of the mid-term elections for Congress in the US. Trump cannot ignore the fact that the cost of gasoline remains a key influence on political popularity in the States and is weighing on Republican prospects. Iran, of course, benefits from higher oil prices and does not face the pressures of democracy.
The market narrative held up well with the signing of a Memorandum of Understanding (MOU) between the US and Iran in mid-June, but was challenged on 7 July when hostilities resumed. The Strait of Hormuz briefly re-opened, but soon closed again, and it remains largely shut at the time of writing.
These swings are reflected in the oil price which fell significantly on the MOU before bouncing back above $100/barrel. Recent comments from the president have allowed prices to fall again with Brent crude currently at $84/ barrel. It is encouraging that oil prices have settled well below the levels seen earlier in the conflict, however energy prices will remain volatile as the “on-off” pattern of the conflict is likely to continue right up to the mid-term vote on 3rd November.
Inflation is still too high
The recent fall in oil prices will help lower inflation which has been improving lately. In the UK, CPI inflation was 2.6% in June, down one percentage point over the past 12 months. However, both this measure and the core rate (CPI ex. food and energy) continue to run above the Bank of England’s 2% target. Moreover, economists expect inflation in the UK to move higher in coming months as the energy price cap is lifted in October and the effects of past increases in energy and fuel costs filter into broader prices for goods and services.
The uncertain path of the oil price complicates the picture, but it is likely that CPI inflation will rise above 3% in coming months, with some expecting the rate to hit 4%.
Thereafter, there is scope for inflation to ease again as the high oil prices of earlier this year drop out, but the near term rise in the inflation rate will amplify concerns that we will see second round effects which will sustain above target inflation in 2027. Three members of the monetary policy committee voted to raise rates in July on this concern.
In my view, the labour market is key as wages are one of the main drivers of underlying inflation particularly in the people intensive service sector which accounts for just over half the CPI index. At this stage the evidence is encouraging as annual private sector wage growth has eased to around 3% on a range of measures. Economic activity and the demand for labour is not strong enough to drive faster wage costs at this point.
The impact of higher bond yields
Such data will give the doves at the BoE comfort and we expect the central bank to keep rates on hold in coming months. This view is reinforced by deflationary pressure from the tightening of UK and global financial conditions as a result of higher bond yields around the world. In the UK this is being felt through the higher cost of government borrowing and for households by the increase in the cost of fixed rate mortgage deals.
Such an environment is challenging for the new Prime Minister Andy Burnham who is seeing his room for fiscal manoeuvre narrowed by the rise in bond yields. The budget is not due until 28 October, but there is already speculation over higher taxes given the pressure to raise spending on defence and social care whilst meeting the fiscal rules. Given the Labour government’s manifesto commitments which limit tax options, there will inevitably be a focus on other measures such as capital gains tax (CGT).
Investors are questioning AI profitability and assessing higher bond rates
Meanwhile, to return to the markets, there has been an important shift in leadership over the past three months with the tech stocks experiencing turmoil as investors weigh up the impact of their high investment rates on future returns. According to the Financial Times the big four hyper scalers (Amazon, Google, Microsoft and Meta) have spent $1.1 trillion on capital investments since 2023.
Whilst this helps power US economic growth, it has given investors pause for thought on how profitable the industry will be in the future. Comparisons with the railway mania in Victorian Britain seem timely and there are plenty of examples in history where investors have been over optimistic about a new technology.
We do not know how the tech industry will shape up in the future, but a willingness to resist a possible siren call from AI might be welcome at this point. There are still opportunities in stocks, quality and value sectors are looking attractive, for example.
Our broader concern though is that the rise in bond yields has narrowed the premium which investors gain from taking risk. If markets believe that central banks will succeed in bringing inflation back to 2%, bonds are looking attractive again and will be more of a challenge for equities in portfolios. Investors will now be weighing this in their strategic asset allocation decisions.
Keith Wade
Former Chief Economist, Schroders
Adviser to the Mivida Investment Committee
