Global markets quarterly update

U.S.

A late-September pullback seemingly driven by fears that interest rates would remain “higher for longer” left stocks lower for the quarter. The declines were similar among large-cap growth and large-cap value stocks, but large-caps in general held up somewhat better than their small-cap counterparts. Sector returns within the S&P 500 Index diverged more broadly, with the small utilities and real estate sectors falling roughly 9% in total return terms (including dividends), while surging oil prices pushed energy stocks to a 12% gain. The much larger communication services and information technology sectors lagged as the mega-cap shares that dominate the indexes underperformed on an overall basis.

Fixed income investors also felt the impact of higher-for-longer interest rate expectations as the yield on the benchmark 10-year U.S. Treasury note increased to nearly 4.65%, its highest level in 16 years, before falling back a bit to end the quarter. (Bond prices and yields move in opposite directions.) High yield bonds managed a small gain, thanks to coupon returns that compensated for price declines and a generally contained default environment supported by resilient fundamentals.

Consumers prove resilient

The quarter’s economic signals generally surprised on the upside and arguably suggested that the economy might manage to skirt a recession in the coming months. The Commerce Department reported that the economy expanded at an annualized pace of 2.1% in the second quarter, marking only a modest slowdown since the start of the year. Several signs indicated that consumers continued to spend freely in July and August, especially on services.

Businesses remained more cautious, but evidence suggested that the pullback in capital spending earlier in the year was easing. Orders for capital goods excluding aircraft and defense, a widely accepted proxy for business investment, fell 0.4% in July but bounced back by 0.9% in August. The Institute for Supply Management’s (ISM’s) gauge of activity in the services sector remained in expansion territory in July and hit its highest level in six months in August, while the ISM’s manufacturing index moved to its highest level since November 2022, just below the threshold indicating expansion. 

Unions negotiate wage increases

Firms also continued to add workers, if at a less robust pace than earlier in the year. After hitting a post-pandemic low in June, monthly payroll gains picked up in July and August, and the unemployment rate remained near multi-decade lows, at 3.8%. While average hourly earnings gains moderated, growing demands from unions for higher wages and other concessions appeared to threaten profit margins and weigh on sentiment as the quarter came to an end. Most notably, the United Auto Workers announced limited strikes targeting all three of the major domestic automakers, and shipping giant UPS granted significant wage increases to avert a walkout by its roughly 300,000 Teamsters-organized workers.

Worries that the modest cooldown in the labor market would not satisfy Federal Reserve policymakers seemed to be a major factor in the equity market’s sharp decline in the last few weeks of the quarter. Fed policymakers kept official short-term rates unchanged at their September 19–20 meeting, as was widely expected, but revealed an increase in their rate expectations for 2024 and 2025, along with higher growth forecasts. Fed officials also anticipated raising rates one more time in 2023.

Europe

The STOXX Europe 600 Index posted its largest quarterly decline in a year. Major central banks indicated that a prolonged period of higher interest rates loomed, even as evidence mounted of an economic slowdown. Signs of a weakening economy in China—a major market for European exports—added to the downbeat mood. Major equity benchmarks in Germany, France, and Italy also fell sharply. The MSCI United Kingdom Index also finished lower in U.S. dollar terms.

As investors came to grips with rates potentially staying higher for longer, eurozone and UK government bond yields climbed to levels not seen in some time. Germany’s benchmark 10-year bond peaked close to 3%. Italian bond yields advanced to a high near 5% amid concerns that the government would need to increase debt issuance next year to finance a bigger deficit.

Eurozone growth revised lower; inflation drops to lowest level in two years

A string of economic data provided more signs that the eurozone economy continued to stagnate. Gross domestic product (GDP) in the bloc grew 0.1% in the second quarter, as a drop in exports contributed to Eurostat’s downward revision to its initial estimate of a 0.3% expansion. Purchasing managers’ surveys compiled by S&P Global indicated that private sector output remained in contractionary territory for a fourth consecutive month in September. Gauges of consumer and business confidence in Italy, France, and Germany also weakened considerably.

Meanwhile, annual inflation slowed to 4.3% in September—lower than forecast and the slowest pace in about two years—from the 5.2% registered in August. The data also showed that the core rate (which excludes food, energy, alcohol, and tobacco) declined to 4.5% from 5.3%.

ECB raises rates, hints peak has been reached

The European Central Bank (ECB) raised interest rates twice during the quarter and hinted that it could be nearing the end of its monetary tightening campaign. ECB President Christine Lagarde said a “solid majority” of policymakers had backed the quarter-point hike in September that took the key deposit rate to 4.0%, a record high. The ECB said that the move meant “interest rates have reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to the target.” 

BoE likely to keep borrowing costs higher for much longer

The Bank of England (BoE) raised its key interest rate by a quarter of a percentage point to a 15-year high of 5.25% in August and then held it steady at that level in September—the first pause since December 2021. The central bank said in August the Monetary Policy Committee will ensure that Bank Rate is “sufficiently restrictive for sufficiently long to return inflation to the 2% target.”

Japan

Equities in Japan outperformed most developed market peers in the third quarter of 2023, with the MSCI Japan Index returning 1.75% in local currency terms to continue its strong run year‑to‑date. Yen weakness, benefiting Japan’s exporters, remained a tailwind. However, sentiment was dampened by the U.S. Federal Reserve signaling that it planned to keep interest rates higher for longer to combat persistent inflation. In contrast, the Bank of Japan (BoJ) retained its dovish stance but surprised investors by tweaking its monetary policy to add flexibility to its conduct of yield curve control (YCC).

Against this backdrop, the yen weakened to its lowest level in over 11 months to around JPY 149.8 against the USD, from about 144.3 at the end of June. This added to speculation that Japanese authorities could intervene in the foreign exchange market to prop up the yen, having repeatedly stated that they would respond appropriately to rapid currency moves. However, Finance Minister Shunichi Suzuki denied that the authorities have in mind a specific level for the USD-JPY that would trigger intervention.

BoJ retains dovish stance, adds flexibility to yield curve policy

The BoJ kept its key short-term interest rate unchanged at -0.1% and that of 10‑year Japanese government bond (JGB) yields around 0%. However, the central bank announced in July that it would conduct YCC with greater flexibility to enhance the sustainability of monetary easing under the current framework.

While it will continue to allow 10-year JGB yields to fluctuate in a range of around plus or minus 0.5% from the 0% target level, greater flexibility means that it will regard the upper and lower bounds of the range as references, not as rigid limits, in its market operations. The BoJ will also offer to buy 10-year JGBs at 1.0% (changed from 0.5%) every business day through fixed rate purchase operations. The yield on the 10-year JGB rose to 0.76% over the quarter, from 0.39% at the end of June, reaching its highest level in over a decade.

Core inflation anticipated to slow

Japan’s core consumer price index (CPI) rose 3.1% year on year in August, slightly ahead of consensus expectations. Core inflation has continued to slow, however, mainly because of the government measures pushing down energy prices. The BoJ anticipates that the year-on‑year rate of increase in the CPI is likely to decelerate, before it is projected to accelerate again moderately, as the output gap (which measures the difference between an economy’s actual and potential output) improves and as medium‑ to long-term inflation expectations and wage growth rise.

Downward revision to second‑quarter economic growth weighs on sentiment

Some sluggish economic data releases suggested that Japan’s economy was not doing as well as previously thought, with a downward revision to second-quarter economic growth weighing on sentiment. Japan’s second-quarter GDP expanded 4.8% quarter on quarter on an annualized basis, weaker than preliminary estimates of 6.0% growth. Capital spending, private consumption, and public investment were all softer than anticipated.

China

Chinese equities retreated amid concerns about the country’s crisis-hit property sector and slowing economy, despite some signs that the economy may have bottomed. The MSCI China Index declined 1.83% while the China A Onshore Index fell 4.54%, both in U.S. dollar terms.

Inflation data showed that consumer prices returned to growth during the quarter after falling into contraction in July. The CPI rose 0.1% in August from a year earlier, up from July’s 0.3% decline. The producer price index fell 3% from a year ago but eased from July’s 4.4% drop. 

Economy appears to stabilize

Other readings showed that the economy was stabilizing in China, where activity began to flag starting in April after a brief post-lockdown rebound. Industrial production and retail sales grew more than forecast in August from a year ago, while unemployment unexpectedly fell from July. However, fixed asset investment growth missed forecasts due to a steeper decline in real estate investment.

The crisis facing China’s cash-strapped property developers showed no signs of abating. Country Garden, one of the country’s largest developers, reportedly began talks with financial advisers about an offshore debt restructuring plan after the company narrowly avoided defaulting on two U.S. dollar bonds. China’s property sector has been in a slump since 2021 after Beijing announced a series of debt metrics to curb leverage among property companies and reduce the risk of a real estate bubble.

Government offers targeted stimulus

In response to deteriorating growth signals, Beijing issued a flurry of stimulus measures over the summer targeting real estate and other sectors. However, the measures stopped short of offering direct stimulus to consumers to stimulate spending, a move that some economists have called for to boost the economy.

In monetary policy news, the People’s Bank of China cut its reserve ratio requirement by 25 basis points in September for the second time this year to inject more liquidity into the financial system. The central bank also rolled out RMB 591 billion into the banking system versus RMB 400 billion in maturing loans. In August, the central bank unexpectedly cut its medium-term lending facility rate by 15 basis points to 2.5%, its largest reduction since 2020.

Other Key Markets

Türkiye (Turkey)

Turkish stocks, as measured by MSCI, returned 32.78% in the third quarter versus -2.79% for the MSCI Emerging Markets Index. 

Stocks jump on central bank’s more orthodox policy

During the quarter, the Turkish central bank raised its key policy rate three times, lifting the one-week repo auction rate to 30.0%. However, year-over-year inflation has been around 60%, so real (inflation-adjusted) interest rates were still deeply negative.

According to the central bank’s most recent post-meeting statement, policymakers are continuing to raise rates “in order to establish the disinflation course as soon as possible, to anchor inflation expectations, and to control the deterioration in pricing behavior.” They also noted that rising oil prices and other factors are adding to inflation risks. In addition, central bank officials affirmed their intention to continue raising rates “as much as needed in a timely and gradual manner until a significant improvement in the inflation outlook is achieved.”

The central bank also announced various measures throughout the quarter to discourage and reverse the unsustainable accumulation of, and costs associated with, bank deposits protected from losses stemming from foreign exchange (FX) fluctuations. Such FX-protected deposits now exceed 3 trillion Turkish lira (USD 125 billion) and have cost the government more than 550 billion lira (USD 20 billion). Most recently, the central bank raised the reserve requirement ratio (RRR) for FX-protected deposits with maturities up to six months to 25% from 15%, and it reduced the RRR with maturities over six months to 5%. For perspective, more than 80% of Türkiye’s FX-protected deposits have maturities of less than six months.

T. Rowe Price sovereign analyst Peter Botoucharov notes that there are still extensive macro-prudential regulations in place that are not allowing more normal functioning of the local interest rate markets and the FX market. In addition, there is still the risk that President Recep  Erdogan’s unorthodox policy views—for example, he has openly opined in the past that high interest rates cause high inflation—could resurface.

Hungarian stocks outperform broad emerging markets

Stocks in Hungary, as measured by MSCI, returned 0.51% in the third quarter and outperformed the MSCI Emerging Markets Index.

Over the last few months, the National Bank of Hungary (NBH) has been reducing certain interest rates in an attempt to normalize what policymakers considered an “extraordinary” interest rate environment that has been in place since October 2022. At that time, policymakers were confronted with financial market turbulence and a weakening forint currency that exacerbated already-high inflation and forced them to raise certain interest rates sharply.

While the central bank’s base rate has remained at 13.0%, the NBH has reduced the overnight collateralized lending rate—the upper limit of an interest rate “corridor” for the base rate—in several steps, from a peak of 25.0% in late 2022 and early 2023 to 14.0% in late September. In addition, the central bank has been reducing its depo rate—the interest rate paid on optional reserves—from 14.0% to 13.0%, completing its convergence with the base rate.

Monetary policy entering “new phase”

According to the NBH’s post‑meeting statement on September 26, policymakers have “concluded” the normalization of the extraordinary interest rate environment, with monetary policy entering “a new phase” in which the base rate “will become the effective central bank interest rate” and the interest rate corridor will be symmetrical. Policymakers, however, did not signal a continuation of interest rate reductions.

T. Rowe Price sovereign analyst Ivan Morozov believes that the central bank may continue cutting rates, though the size of additional interest rate reductions would likely be smaller. He also believes that policymakers will be watching the forint closely and could decide to pause rate cuts if the currency weakens materially.

What we’re watching next

Investors are confronting a new market regime, although its exact outlines remain to be seen. The “New Normal” regime of accommodative central bank policy, which lasted from roughly 2008 to 2019, has come to an end. In the New Normal, the economy got stuck in neutral, making for an era of low growth, low interest rates, and low inflation. At least the latter two conditions no longer hold.

I don’t think it’s likely that we’re returning to the postwar boom years of 1955 to 1969, either—an era of fast growth alongside low inflation, thanks to increasing automation, a broadening of the labor force, and other factors that drove significant productivity gains.

Nor do I expect that we’re returning to the stagflation years of 1970 to 1981. This was an era when two major oil supply shocks resulted in years of slow growth and high, and often unanchored, inflation, resulting in the poorest stock returns of the postwar period.

Our analysis suggests that the regime we’re entering might be closest to the “Old Normal” years of 1982 to 1987. After Fed Chair Paul Volcker slayed the inflation dragon in the early 1980s, this was a period characterized by “normal” levels of growth of inflation of about 3% each.

This is one reason why I don’t think it pays to be too bearish in the current environment, despite the recent rise in interest rates. While rates are high relative to the New Normal, they are not high relative to the longer history of capital markets. The federal funds rate has exceeded 5% for decades, and stocks markets have still performed well. Any coming market sell‑off might pose a buying opportunity for long‑term investors.

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