This week in the markets: where now?

Investors are anxious. We’re two years into a bull market, tensions are high around the world and a pivotal US election is just around the corner. Where do markets go from here?

First the numbers

The current bull market began on 13th October 2022. It followed a savage bear market that year as interest rates started to rise. As is often the case, however, a sharp fall in markets has been succeeded by a dramatic rally.

The US S&P 500 is up 67% over two years, slightly behind the Nasdaq, which is 76% higher than at the low point. Other markets have followed suit. Europe is 61% up, Japan is 56% higher. Even emerging markets, dragged down by China for most of the period, have gained 42%. The FTSE 100 is the laggard, up just 29% as the oil price, a key driver of the index, has languished.

The surprise performer since 2022 has been gold, up 59% despite high interest rates throughout the period which have made the precious metal’s lack of income feel uncompetitive. Gold has surged on the back of central bank buying, its perceived safe haven status and the hedge it tends to provide against inflation.

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Where next?

The future path of equity markets will be determined by the outlook for earnings and the valuations that investors are prepared to pay for a share of those profits. Earnings look reasonable. Although the forecast growth in the third quarter stands at just 4% as results season kicks off, that number usually rises as the earnings round progresses.

High single digit growth will help reduce the valuation, which in the US at least is high by historical standards. The S&P 500 is on a 25-times multiple of trailing earnings, although the equal weighted index is a bit cheaper at 19 times. Elsewhere in the world valuations are much more reasonable, in the low teens and only about 12 here in the UK.

Watching the Fed

The other key driver of markets in recent years has been central bank policy. The good news is that interest rates have turned; less encouraging is the fact that the Fed’s success in averting recession while taming inflation means rates may not fall as far as investors had hoped.

The neutral level for US rates - not restrictive, not accommodative - looks to be between 3.5% and 4% so we should expect maybe only four or five quarter point cuts before rates level out. That’s started to be reflected in bond yields, with the 10-year US government bond now paying investors just over 4%.

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Does politics matter?

The interest rate cycle is really next year’s story. In the short term, the main focus will be the US Presidential election and, over here, Rachel Reeves’s first Budget.

How important the US election will be is open to debate. It feels consequential and it looks likely to be a close-run vote. In the short run, the best outcomes for investors tend to be a Republican sweep (White House and Congress) and a Democratic President with Republican Congress (divided government). As these are the two most likely outcomes, it is perhaps unsurprising that the market feels relaxed about the election.

Longer term, over the course of the whole four-year Presidential cycle, there is little to divide the various permutations in performance terms. That’s not altogether surprising - a $50trn US stock market is an oil tanker. Changing its direction is beyond even the President.

As for the Budget, everyone is on tenterhooks. What’s not in doubt is that taxes will rise in the Chancellor’s first big set-piece announcement. What’s less clear is where the axe will fall. She ruled out changes in the big revenue earners - income tax, employee national insurance and VAT. That leaves a small handful of taxes to raise a significant amount of money - Capital Gains Tax, Inheritance Tax and, most worrying for many, the tax treatment of pensions remain on the table.

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