Author: admin@hottinger.co.uk

by Tim Sharp

A strong finish to the earnings season particularly mega tech, and especially Nvidia and Meta Platforms whose reporting took on almost macro-economic event proportions, saw equity markets continue generally higher in February. Sticky inflation continued to vex investors as markets pared interest rate cut expectations back further to only three cuts in the US this year which has caused further adjustment in bond markets. Despite a slightly stronger dollar Emerging Markets rallied 4.6% outperforming the developed world as China bounced strongly following central bank easing of lending rates. Japan remained a dominant force up 5.7% on the back of a weak Yen that finished the month at 150 vs. the dollar. The laggard amongst the major markets was the UK where equities were flat on the month despite resilient data although unable to avoid a technical recession in the latter part of 2023, while Europe which continues to flatline saw equities boosted by China to finish up 3.4%.

Nvidia once more reported earnings that were ahead of expectations in the 4^th quarter with revenues up 265% to $22.1 billion vs. $20.4 billion expected guiding even higher for first quarter to rise to $24 billion vs. $22 billion consensus. The markets were unashamedly enthused pushing the shares up 16.4% the next day which was recorded as the largest change in market capitalisation of any stock, anywhere, ever, leaving the shares up 28.6% on the month, 59.7% year-to-date, while the wider S&P500 gained 5.2% in February. The CEO stated a surging global demand for accelerated computing and generative AI had hit a “tipping point” although there are some that believe that many Nvidia customers are over-stocking for fear of demand outstripping supply which may leave an inventory overhang later in the year. In any case the focus on the big 6 technology stocks continues to dominate returns with Meta Platforms also starting the month with bumper earnings. The performance of Meta Platforms following its results when it announced a 3% new dividend added $200bn to its market cap in one session, the equivalent of a gain in the total market cap of Cisco Systems – the darling of the 1999 technology stock boom.

Many active investment managers, including us, run strategies that include exposure to a diverse range of assets and asset classes quite often starting with an equally weighted positioning rather than concentrated in a small number of large positions. This kind of strategy would continue to lag headline indices while they are dominated by a small number of heavy weights even if we had exposure to these main stocks. This means that we must have a view on Alphabet, Amazon.com, Apple, Meta Platforms, Microsoft, and Nvidia, even if we do not intend to invest in them because of their ability to influence returns. There is a diverse range of forecasts for forward earnings for mega tech depending on the level of conviction which means that investors can view them as expensive, or fairy valued at today’s prices.

We have been adding to our software exposure this year viewing the mixture of innovation, cash flow generation, and low levels of debt as quality defensive in nature. Absolute Strategy Research (ASR) point out that Global Software has the best earnings momentum of any sector and a strong 4^th quarter earnings season. The sector has the highest delivered EBITDA margins, seeing a rise of 4% over the last 12 months, sales outgrowing costs, strong profitability, and fast growth on a valuation of 28x forward earnings[i]. Elsewhere, the emphasis on quality defensives sees us continuing to favour Industrials, Energy, and Consumer Staples.

In terms of fixed income, it was reassuring in some ways to see the negative correlation between bonds and equities return as bond markets priced out aggressive easing of rates particularly in the US where Fed Governor Powell ruled out a cut at the March meeting during the post FOMC press conference. During the month US Treasuries fell 1.4% and the speculation spread to Gilts (-1.3%) and European Government Bonds (-1.2%) where the likelihood of a summer cut is perceived more likely due to the current negative growth environment. Whilst Eurozone Services PMI’s were stronger than expected, manufacturing was weaker, and services continue to outperform manufacturing in the UK too. UK inflation remains higher than other developed countries where headline and core CPI were 4% and 5.1% although lower than anticipated, while US inflation surprised on the upside at 3.1% and 3.9%. Japan and China complete the picture with Japanese Q4 GDP reporting a 2^nd negative quarter to join the UK in technical recession while inflation continues to strengthen to 2%, and Chinese disinflation came in weaker than expected at -0.8% yoy[ii]. In summary, the resilience of the US economy is one of the reasons why global growth remains in positive territory presenting the Fed with a dilemma when it comes to the right time to ease monetary conditions.

Although the UK is in a technical recession i.e. back-to-back quarters of negative growth there are tentative signs of a pickup in activity as falling mortgage rates bring buyers back to the housing market pushing prices in January 1.3%, 2.5% yoy which is the strongest rate since 2022. The Business Activity Growth PMI rose to 54.3 vs. 53.4 in December in contrast to the manufacturing index which is affected by Red Sea traffic restrictions. Retail sales rebounded 3.4% in January after a record fall of 3.3% in December although volume of sales remains 1.3% below pre-pandemic levels of February 2020[iii]. Furthermore, the unemployment rate continues to fall, now showing 3.9% to November 2023. The BoE will be watching the path of inflation to try and balance growth and inflation with rate cuts. However, a flat stock market in contrast to the positivity in other developed markets is an indication of the hangover still being felt from Brexit trade restrictions, and the lack of growth stocks within the main indices leaving the UK unloved at present.

Overall, our reasons for caution have not diminished, and the markets readjustment of future rate moves while welcome are still optimistic compared to feedback from the Fed. The possibility of a soft landing is still on the cards although unprecedented in recent market history. The US consumer should not be underestimated, however, there are signs in data and delinquencies that higher rates may be affecting areas of consumer credit notably auto loans and credit cards. US equities appear at a stretched valuation relative to the UK, Europe, and Emerging Markets, but the drive in technological innovation is likely to be reflected in US indices where weightings to growth sectors are higher than elsewhere meaning that US exposure may remain key to future returns.

 

 

 

 

 

 

 

 

[i] Nelson, Nick _ Absolute Strategy Research _ Equity Strategy _ Upgrade Software and Telecoms_ 29/02/2024

[ii] Ward-Murphy, Zara _ ASR Investment Committee Briefing _ 01/03/2024

[iii] Razi Salman _ Barclays Private Bank Daily Talking Points _ 16/02/2024

by Tim Sharp

 

Following a strong December “Santa Rally” in equities and a high level of positive correlation between asset classes, financial markets started the year priced for perfection in central banks execution of a perfect soft landing. Q4 earnings season is proving to be generally positive with disappointments harshly treated as the differing fortunes of the “Magnificent Seven” reporting again testifies to a market that needs to justify its current position. Japan was the best performing major market gaining 7.8% in Yen terms while China and Hong Kong were still deep in negative territory. A market perception of strength surrounding large global technology companies persists with the sector leading gains (3.0%), however, the main US indices, S&P500 (+1.6%) and the NASDAQ (+1.0%) performed inline with global equities (+1.2%) following comments from central bankers in the last days of the month. In the UK major equity indices fell 1.3% one of the weaker performances of major markets, as signs of inflation lingering, better flash composite PMI reading of 52.5 but a weaker consumer – retail sales fell 3.2% month-on-month, and no signs of an early rate cut weighed on sentiment. Incidentally, 2 members of the monetary policy committee still voted for another rate increase.

The month started strongly in the US with a robust December jobs report of 216,000 and a 4^th quarter GDP figure of 3.3% annualised that solidly beat expectations. This led quite nicely into an FOMC meeting in the last days of the month where Chair Powell confirmed that a March rate cut was unlikely followed closely by Bank of England Governor Bailey saying likewise in the UK. As we have been saying, we believed that there was a disconnect between the robustness of the US economy, strength in financial markets, and the market forecasts for the future path of interest rates which was laid bare during central bank press conferences. This clearly had effects on government bond markets (-1.8%) that began to price out early moves in rate cuts leaving US 10-year Treasury yields sitting at 3.9% while the dollars fortunes turned positive with the dollar index gaining 1.9%.

The ongoing concerns regarding the outlook for China affected its equity market (-6.3%) and that of Hong Kong (-9.2%) not helped by the news that 2^nd largest Chinese property developer Evergrande was ordered into liquidation following an 18-month Hong Kong court hearing where it failed to convince the court that it had a viable restructuring plan. Chinese 4^th quarter GDP came in at 5.2% year-on-year in line with expectations which is still low by historical comparisons, and Central Bank attempts to add stimulus were considered ineffective. This performance had a telling effect on Emerging Market indices (-4.6%) and the wider Asia Pacific region dominated by the size of the Chinese economy.

We started the year observing that the number of potential holes in the road from geo-political risks were high this year and reports in January have not decreased the potential for macroeconomic surprises. Despite the targeted strikes on Houthi bases in Yemen, the attacks on shipping continue driving a major proportion of Red Sea traffic around the horn of Africa causing supply delays and significant increase in shipping costs. Rising tensions between the US and Iran, and the US and Israel are also concerning escalations in the continuing Gaza conflict that might threaten the wider global economy.

The potential for a soft landing in the US and the positive impact of implied rate cuts in 2024 we feel has been fairly reflected in financial markets and as such we remain mildly defensive.  We believe that this would favour, amongst others, Industrials, Technology Software, and Consumer Staples and so it was notable that the worst performing sectors in January were Auto’s, Energy, Basic Resources and Real Estate. Although we remain slightly sceptical of valuations, and feel an element of caution creeping into markets, we continue to believe that attractive returns are available for long term investors through diversified, active management.

 

References

Nokes, Zara _ JPMorgan Asset Management _ Review of markets over January 2024

Ward-Murphy, Zara _ Absolute Strategy Research _ Investment Committee Briefing

Market statistics verified on Refinitiv Workstation

by Tim Sharp, Research by Jack Williams

Following three consecutive months of declines, November caught investors by surprise, delivering a notable rally in excess of 9% within global equity markets. This has primarily driven by a belief that the path of interest rates will be lower rather than higher going forward.

Technology related stocks have continued to lead the market higher, with the sector gaining 14% as the impact of falling interest rates is discounted. Energy was the market laggard, tracking underlying weakness in the oil price and souring economic sentiment.

The US took pole position in this push higher in markets, outperforming the rest of world in USD terms, while the U.K was the region with weakest performance with a question mark hanging over themselves as investors look to assess the viability and health of its economy.

Further demonstrating the impact interest rate expectations are having on the market, correlations amongst asset classes remains broadly elevated, with global fixed income rising 2.8%. In terms of global yields, the US and European curves saw a bull flattener and in line with the risk on mentality, credit spreads tightened. A bull flattener occurs when longer term rates fall faster than shorter term rates.

Having underwhelmed this year, real assets saw a rally as a result of low valuations and being highly sensitive to interest rates. Copper led industrial metals higher as sentiment warms ever so slightly towards China. The most outsized returns came from the areas that have been most punished over the past year, with real estate being the notable standout as investors seek to capitalise on the deep discounts available within the space. The strongest performing indices of the period (Brazil, Spain, Korea, and the Dax) are all closely linked to Chinese Demand. This may be a signal of growing investor appetite at the margins.

Inflation was the main narrative of the month with developed markets showing a sustained fall in inflation, with both US core and headline CPI coming in below analysts’ expectations at 3.2% rather than the 4% predicted. In the Eurozone CPI fell to 3.6% and 2.4% respectively, UK CPI fell to 5.7% and 4.6%, which while still falling at a fair pace, is behind the inflation curve seen in the US and EU.

In the US, robust consumers saw Q3 GDP revised higher, while eurozone PMI’s remained in contraction territory at 43.8 on the manufacturing side and services of 48.2. U.K composites surprised investors by moving into expansion territory (albeit ever so slightly) surpassing contractionary expectations with a reading of 50.1 compared to 48.7 expected.

While the debate between soft landing and mild recessionary outcomes continues, policy makers have struck a less hawkish tone in recent weeks. Our core view remains that we are likely to see an earnings recession in the US during 2024, although given the surprising resilience exhibited over the past 12 months, have modest conviction.

Companies do seem to be holding up fairly well considering the sheer pace of these rate hikes with balance sheets still looking robust, especially so in the large cap space however we note that smaller capitalised firms relying more heavily on bank finance may be prone to higher levels of risk.

Europe has been skating around recession throughout this year as it has faced significant headwinds. Combating energy security risks, high inflation brought on by the Ukraine conflict along with weaker Chinese demand. Our research partners A.S.R (Absolute Strategy Research) point out that structural issues could persist within the Eurozone region for a longer period with no solution on the table for Europe’s fiscal framework, furthermore the number of cyclical headwinds being experienced by the region could flatten growth over the coming year which would further complicate their current situation.

As a historically more cyclical market, Europe has been impacted by the ongoing weakness in China. The country’s shift from real estate led investment, to growth in manufacturing has proven more difficult than originally envisioned. This will have a knock on in terms of infrastructure spend, with reduced investment in construction through 2024. This could have implications for China’s medium term growth outlook.

Other emerging market nations have shown fierce resiliency in the face of a strong dollar and heightened US interest rates. We are still confident our that emerging market thesis holds and complements our existing Asia positions. GDP growth in Brazil, India, Indonesia, South Africa, and Turkey has been around pre pandemic levels due to them being further within the cycle than developed market peers. Due to being later in the cycle, this allows these nations who moved to combat rising inflation first, the earliest opportunity to emerge out the other side of this tightening cycle whilst still maintaining good levels of financial health and stability. We saw the weak US dollar through the summer capture the interest of investors towards Emerging Market nations, a return to a weak dollar as markets look forward to rates moving lower may well provide some strength to the sector.

US fiscal policy had been receiving closer attention in recent months. Significant budget deficits at a time of low unemployment, along with the impact of the Federal reserve becoming a net seller through quantitative tightening had been cause for concern. However, there is surprisingly no historical relationship between yields and supply. Current net new issuance of $750bn is in line with historical averages and there is nothing to suggest that when facing recession, the level of quantitative tightening is not amended. It would seem the anxiety was short lived, as the recent potential for the Federal reserve to pivot has dominated fixed income markets.

Gold has continued to perform well, despite a recent backdrop that would historically would have been unfavourable. Greater than anticipated declines in inflation have meant real rates – interest rates less the level of inflation – have been rising. One potential explanation is the uptick in central bank purchases of gold who are price insensitive. Additionally, heightened geopolitical tensions are likely to have driven a flight to safety. The positive trend could still yet continue for gold, if we see falling interest rates coupled with dollar weakness.

To the surprise of many – including us – the global economy has remained exceptionally resilient, despite the coordinated effort of central banks to cool inflation and temper demand. However, as the year draws to a close, our views on markets remain broadly unchanged. We continue to believe certain areas of the market are exhibiting exuberance and potentially vulnerable if the economic environment deteriorates materially.

In keeping with this, we continue to be positioned defensively, with a preference for higher quality companies, whose revenues, and earnings we believe to be far more resilient. Whilst we completely understand markets are forward looking, a significant positive impact from falling interest rates in 2024 has been reflected in the prices of both bonds and equities. A healthy dose of scepticism may be appropriate…!

Although our outlook remains cautious, we continue to believe attractive returns are available for long term investors through a disciplined and risk-controlled approach.

by Adam Jones, Researched by Alex Hulkhory

 

As a foreword to this month’s investment commentary, we wanted to acknowledge the ongoing crisis in Israel and Gaza. Whilst we would never want to downplay the immeasurable social and humanitarian costs of the hugely tragic events over the past month, this is not our area of expertise. In our role as custodians of our clients’ assets, our focus is always through the lens of how any events are likely to impact global asset markets.

Much of last month’s blog centred around inflation, and the ongoing risks this presents to asset prices. Although this remains an important issue, as with markets, our attention this month is focused on the ongoing strength of the US economy. In our view, consumers globally have faced increasing headwinds as extreme inflation and rising interest rates have – in theory – reduced their spending ability.

Unstoppable force, meet immovable object.

Post the Global Financial Crisis in the era of ultra-loose monetary policy and quantitative easing, the old edict “don’t fight the fed” became almost gospel to many market participants. In short, the path of monetary policy drives the overall performance of risk assets. Indeed, against a backdrop of significant tightening in 2022 this adage rang especially true. Asset prices – not just equities – suffered significantly.

Investment markets are forward looking and beyond the impact of changing discount rates, we saw the idea of an impending recession in 2023 creeping into the minds of investors. In our view, this was one of the most widely anticipated recessions in modern history. [i]Bloomberg economics had predicted a 100% percent probability of a US recession by October 2023. Comparing this to the latest figures released by the [ii]Bureau of Economic Analysis, which showed US GDP accelerated to an annual rate of 4.9% in the third quarter of 2023, something doesn’t quite add up…

The investment truism “never bet against the American consumer” has returned to the fore with a bang. We can certainly include ourselves in the list of market participants that have been surprised by the ongoing resilience of US consumer spending. In our view, this strength has been the backbone that has propelled equity markets and US GDP this year. One potential explanation has been the level of COVID savings that were accrued whilst we were all in lockdown. However, we feel this is finite and there are clear signs the US consumer is beginning to feel the pinch. The personal savings rate  [iii]  continued to decline through September, falling to a rate of 3.4%. Whilst we are inclined to side with the Fed, only time will tell who will win out in this battle.

What’s been happening in markets?

October heralded Q3 earnings season, an eagerly anticipated look into many of the big tech names that have propelled markets. Touching on the colloquially named ‘Magnificent 7 (The tech-focused, seven largest constituents of the S&P500), we felt that broadly their earnings were impressive. However, it was perhaps an insight into just how high expectations – and valuations – have become!

Alphabet, the parent company of Google, was an excellent example of this. Despite delivering a meaningful [iv]beat on both earnings and revenue, the stock was punished with a bruising 9.5% fall on the day of results. This was also evident for the companies delivering exceptional results with, at best, anaemic upward movements.

This weakness was also reflected in the broader markets with the [v]S&P500 joining the Nasdaq in official correction territory from the highs reached earlier this year. October was a difficult month for markets generally, with most asset classes delivering negative returns. One particular standout was [vi]gold, up 7.4% over October. As a safe-haven asset this reflects recent increases in geo-political tension.

Looking slightly closer to home it was difficult month for the UK market, which was down more than 3% over October. This may in part be driven by sector composition. Energy is not an insignificant component of the UK market and the sector fell by 8.7% over the month. The economic back drop also remains challenging with [vii]ASR’s Nowcast showing continued deceleration along with PMI’s firmly below 50. In our view, one saving grace is that equity valuations here in the UK remain among the most compelling in the global equity universe.

Return of the bond vigilantes…

Another interesting development has been taking shape in bond markets over the past month. Longer dated bond yields have continued to climb, with US 10-year treasuries almost touching 5% on the October 19^th. Despite the implied equity risk premium – the extra return investors demand for holding risk assets relative to government bonds – being at near [viii]historic lows of only 30bps, markets have been unwilling to purchase treasuries en masse. This has no doubt been exacerbated by the current Fiscal position in the US where significant deficits exist alongside exceptionally low levels of unemployment, which we believe to be an unsustainable aberration over the long term.

Given significant levels of indebtedness, large fiscal deficits and an apparent desire to reduce the scale of public sector balance sheets an important question is being asked by markets. Who, ultimately, is going to buy the bonds that DM governments so clearly need to issue? With the need for issuance to cover significant government spending over the coming years, in our view there have been growing fears that yields may have to move meaningfully higher for demand to meet supply. This could partly explain why investors’ appetite for bonds has been lacklustre despite their apparent attractiveness relative to riskier assets such as equities.

Whilst we have seen yields come down at the margin, we expect investors to be more sensitive to changes in fiscal policy and the resulting issuance as we move forward. The “Bond vigilantes” – a term famously coined by Economist Ed Yardeni to describe fiscal hawkishness by markets – are back!

How have central banks responded?

In a break from the new normal, central banks broadly left rates unchanged this month. Much of this is wanting to assess the impact of the rises we have seen over the past two years. However, the previously highlighted [ix]rise in bond yields will also have a meaningful impact in tightening financial conditions, doing a lot of work on behalf of the major central banks.

In what was largely seen as a sleepy month for policy makers, the Bank of Japan provided a point of interest. With the Japanese Yen trading below ¥150 to the dollar – the historic level at which the BoJ has intervened – many had speculated that we could see a shift in policy. [x]Given its influence on global bond markets this could have especially meaningful consequences, particularly if this drew significant levels of liquidity out of bond markets!

 

 

 

 

References:

[i] https://www.bloomberg.com/news/articles/2022-10-17/forecast-for-us-recession-within-year-hits-100-in-blow-to-biden?leadSource=uverify%20wall

[ii] https://www.bea.gov/news/2023/gross-domestic-product-third-quarter-2023-advance-estimate

[iii] https://www.bea.gov/data/income-saving/personal-saving-rate

[iv]  https://www.barrons.com/articles/alphabet-google-earnings-stock-price-4890483f?mod=md_stockoverview_news

 

[v] https://www.ft.com/content/839d42e1-53ce-4f24-8b22-342ab761c0e4

 

[vi] Absolute Strategy Research Investment Committee Briefing – October 2023

[vii]  Absolute Strategy Research Investment Committee Briefing – October 2023

 

[viii]   https://www.reuters.com/markets/rates-bonds/soaring-treasury-yields-threaten-long-term-performance-us-stocks-2023-10-26/

 

[ix]  https://www.reuters.com/markets/us/fed-poised-hold-rates-steady-despite-economys-bullish-tone-2023-11-01/

 

[x] John Authers – points of return 31/10/2023

by Tim Sharp,

As the summer months draw to a close, and the cooler temperatures begin to set in, September saw the Fed pause, signalling that the sustained period of interest rate rises may also be approaching an end. Indeed, officials are hoping that policy is now ideally positioned to cool the sweltering inflation we have seen over the past 18 months, without strangling the economy.

Following the rapid rises in interest rates over the past two years, that has seen the FOMC hike 11 times and an incredible 14 consecutive rate increases from the Bank of England, this month potentially indicated a shift in central bank policy.

Looking at the Cleveland Fed’s inflation nowcast (an estimate of current inflation) suggests that core CPI in the US is running at 4.17% YoY[i]. Whilst this is certainly too high for comfort, it does represent a marked decrease from the highs of 9.1% reached in 2022. UK inflation remains a relative outlier in developed markets, with the latest CPI print at 6.3%.

If inflation is still a problem, why pause?

Whilst central banks have taken their foot off the gas…for now at least! We see the messaging as clear; the fight against inflation is far from over. Interest rate increases have a lagged effect, and it does take time to filter through to the broader economy. In our view, this along with greater uncertainty has convinced policy makers that pausing to assess the impact on the economy is the best course of action.

We feel that although rates are unlikely to rise much further from here, the overall tone of policymakers was hawkish. This was in large part due to greater emphasis that rates aren’t going to be coming down anytime soon. Given the continued resilience of the consumer – to the disbelief of many – and the ongoing inflationary risks, we think that central banks have been trying to persuade markets that rates will remain elevated for the foreseeable.

What does all this mean?

With regards to the current higher for longer narrative, we’re not entirely convinced. This will largely hinge on the ongoing strength of the economy. A central assumption being that economic growth will remain robust enough to justify the current rate environment. In our view central banks trying to regain their credibility after the rampant price increases of last year and aiming at all costs to stop higher inflation expectations becoming embedded.

We see signs that longer term expectations are shifting with longer dated government bond yields climbing and the yield curve beginning to steepen. The performance of treasuries over the month was a good example of this, with yields on the 10Y up 10% compared to only 4.1% for the 2Y. This in turn should further raise borrowing costs, tighten financial conditions, and ultimately help cool the burgeoning demand that has driven prices higher in our view.

This can also be seen in currency markets with the dollar continuing to strengthen. The Japanese yen notably continuing its weakness – down 2.35% over the month and 13.49% YTD – as the BoJ pursues a “golden opportunity to dispel the deflationary mindset”.[ii]

So, prices should start to come down?

A significant amount of progress has been made in bringing inflation back towards the two percent target, set by most central banks. However, we see two big ongoing risks that that will keep policy makers awake at night. Wages and energy costs! Meaningful inflation that persists over long periods – as was seen in the 70’s – has historically been driven by elevated wage growth, evolving into a vicious wage-price spiral.  The latest data show’s UK wage growth at 8.5%[iii], a figure that we expect will certainly concern the BoE.

Adding fuel to the fire, the ongoing efforts of OPEC to avoid a capitulation in the oil price have been taking effect. Over the past three months WTI crude oil prices are up over 30%. Where falling energy prices had been a detractor for much of the year, they are now a meaningful contributor.

Whilst a win in the battle against inflation, the most recent PMI figures will provide little consolation. September services PMI data for the UK came in at 47.2[iv] – a figure below 50 representing contraction – with similar figures seen around the Euro area. The US marginally managed to buck this trend, with the PMI’s coming in at 50.2, showing continued expansion.

How does this affect markets?

Looking more closely at markets, September has been a challenging month. Except for the UK, all major equity markets are down over the period. History tells us that rising rates are usually bad news for asset prices. As was seen in 2022, if markets are digesting higher rates over the longer term, then the future profits companies can return to us as shareholders, have a lower value when discounted back to the present.

This is notable when looking at the dispersion of returns over the month. The fast growing, tech heavy Nasdaq has been the worst performer in September – down 4.97% at the time of writing – this makes sense, given much of the value these companies will be able to return to shareholders is likely to be captured far in the future.

The painful performance has not solely been confined to technology with many other broader equity indices and geographies suffering. The S&P 500, DAX and Nikkei delivered -5.22%, -4.33% and -0.93% respectively.

In addition to this, as the return offered by lower risk assets becomes more attractive, investors may be incentivised to de-risk their portfolio’s, we believe this could provide a headwind to risk assets going forward.

This all sounds quite gloomy?

Storm clouds have been gathering on the horizon for some time now and given investors plenty of reason to be cautious. Our positioning has reflected this. However, we see much of the strong performance of markets this year having been driven by the enduring resilience of the economy. Indeed, the Fed more than doubled their 2023 GDP projections from 1% to 2.1%[v]. This is a stark contrast to the 100% percent probability of a US recession by October 2023 forecast by Bloomberg economics last year.[vi]

Markets are forward looking, and although sentiment has been improving, a lot of good news is reflected in prices. US valuations are high by historical standards. The CAPE Shiller PE – a cyclically adjusted ratio for the price multiple on earnings – currently stands at 29.5 for the S&P 500, compared to a historic average of 17.1[vii].

Conversely, in the UK where investor sentiment is particularly negative, we believe valuations are far more reasonable. Whilst the backdrop remains challenging globally, there continue to be companies that offer value. We are confident that attractive returns are available to long term investors through a disciplined and diversified approach.

 

References, research by Alex Hulkhory:

[i] https://www.ons.gov.uk/economy/inflationandpriceindices

[ii] https://www.boj.or.jp/en/mopo/mpmsche_minu/opinion_2023/opi230728.pdf

[iii] https://tradingeconomics.com/country-list/wage-growth?continent=g20

[iv] https://tradingeconomics.com/forecast/services-pmi

[v] https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20230920.pdf

[vi] https://www.bloomberg.com/news/articles/2022-10-17/forecast-for-us-recession-within-year-hits-100-in-blow-to-biden?leadSource=uverify%20wall

[vii] https://www.multpl.com/shiller-pe

Author: Tim Sharp

Researcher: Jack Williams

Published: September 22, 2023

 

Another month has passed in the markets, bringing a reversal of sorts with technology leading indices lower, mixed bags of data and an oil price pushing towards $100.

Inflation surprised to the downside, although any optimism was quickly sapped by Jerome Powell’s hawkish rhetoric at the Jackson Hole symposium increasing the odds of future rate hikes from the Fed despite the deflationary data incoming.

In Europe and the U.K inflation data has been more stubborn while both flash PMI’s and retail sales came in much weaker than expected. US manufacturing and services PMI’s also fell into contractionary territory, and we think this will inevitably have some impact on risk assets.

Substantial monetary tightening measures in developed nations may now be taking a toll on economic activity. So far, the key pillar supporting the notion of a robust consumer has been the accumulation of surplus savings resulting from the pandemic, stimulus measures, and reduced opportunities to spend discretionary income during quarantine. However recent data suggests these excess savings could be very close to being depleted.

Our cautious investment strategy has resulted in our abstention from participating in the AI driven rally that swept through the markets during the first half of the year. Nonetheless, we remain optimistic about the potential vindication of our quality-driven, defensive stock selection approach in the latter half of the year. This optimism is underpinned by the fact that valuations continue to remain elevated when compared to long-term historical averages. Moreover, there are ample reasons to maintain a cautious and sceptical stance as an investor in the current market environment.

The US has seen the use of fiscal policy, boosting onshoring through the CHIPS act and seeing an uptick in construction due to the IRA (Inflation Reduction Act), that may have underpinned growth in the shorter term while unemployment remains low, although recent moves in Treasury yields suggest there could be a turning of tides on the horizon.

With bond yields on the rise, this has provided a headwind for equities made worse by the deteriorating landscape in China for investors which earlier in the year was being looked to as the tide that could lift all boats.

Consumer confidence within China remains weak, the countries dismal reopening following extremely tight Covid policies, currently being further amplified by slowing economic momentum.

Many are of the view that policymakers will have to inject some form of stimulus into the economy to avoid a complete collapse in confidence as the nation toils with a spiralling property market, a reversal in globalisation and erosion of geopolitical relations.

We continue to keep a close eye on the deterioration of US/China relations, noting the recent push to increase the number of countries associated with the BRICS (Brazil, Russia, India, China and South Africa) trade group, along with the notable empty chair of the Chinese Premier at the G20 summit as it appears to be distancing itself from western developed nations.

As US influence wanes and developing nations continue to align themselves to alternative regimes and trade groups, the possibility of a dual centred global economy rises. We believe this would be a significant headwind for future global growth through the inefficient use of resources while also increasing uncertainty with regards to security and the obvious increase in geopolitical risks.

We believe the rally seen to date this year within equity markers has been supportive of our earnings trough thesis, with gains in this rally driven near completely by PE expansion rather than growth in earnings.

The question of whether bond yields have returned to mean or will fall in line with inflation and interest rate expectations may determine sector rotation amongst equity allocators. Recent rises in bond yields saw cyclicals come under pressure as risk appetite reduced, however should this reverse and yields back off from their 16-year highs sectors such as Technology, Healthcare and Food Retailers could enjoy a move to the forefront of investors attention.

Guidance from US companies has weakened notably, with margins falling back to non-recession lows and quality of cash flows deteriorating to a point where some are now reducing the size of their buybacks schemes with the worst affected sectors being Technology and Industrials. A recovery in buybacks will probably require an increase in profits growth which looks unlikely to us at present. Financing costs have soared, especially for small and medium sized companies, and debt levels across markets have risen, providing increased headwinds for a market that is priced for perfection. Interestingly buybacks in Japan continue to increase providing a tailwind to equity markets there and underlines our positive stance towards Japanese equities.

Andrew Bailey, Governor of the bank of England revealed rates in the U.K are probably near the top because a “marked” drop in inflation was likely as we move through the year. The surprise drop in August inflation data led to the Monetary Policy Committee voting to leave rates unchanged at its September meeting against market expectations.  The front end of the yield curve reacted positively bringing 2-year Gilt yields lower although the longer end remains cautious due to a rise in oil prices along with resilient earnings.

On a relative basis Gilts appear cheap compared to Bunds and US Treasuries, ASR (Absolute Strategy Research) note in an environment where growth slows, and inflation declines Gilts seem fairly priced given U.K fundamentals.

In our overarching investment strategy, we maintain a favourable stance toward a defensive asset allocation framework. This approach underscores our emphasis on high-quality defensive equities while adhering to a relatively conservative equity allocation in comparison to alternative assets and fixed income instruments. This strategy reflects our commitment to prudent risk management and capital preservation, aligning with our long-term investment objectives.

 

References

Absolute Strategy Research Investment Committee Briefing – August 2023

by Haith Nori

 

August was a rather volatile month this year for global markets. The Bank of England continued to increase interest rates. US Federal Reserve Chair Jerome Powell made his speech at the annual Jackson Hole Symposium, reiterating his approach to fighting inflation and the need to endure on the path of increasing interest rates until the 2% inflation target is reached. US debt has been downgraded by Fitch Ratings from AAA to AA+. The Bank of Japan has signalled an end to negative interest rates at the start of next year. Nvidia Corp continues to increase in share price and CEO Jensen Huang comments on the latest partnership with Google. Economists are continuing to downgrade their views on growth projections for China, worsening the outlook for China.

On 2^nd August, Fitch Ratings, one of the three big American credit rating agencies, made the decision to downgrade the US debt rating ’from the highest AAA rating to AA+, citing “steady deterioration in standards of governance.”’ [i] The downgrade was a result of US lawmakers taking their time and negotiating continuously until the final deadline with the issue of the debt ceiling, having placed them on a ratings watch since the start of May when governance worries began. The rating change highlights a slightly higher expectation of default risk from the lowest possible level, albeit still implying a very remote probability.

Following the rate hikes in July by both the US Federal Reserve and the European Central Bank, the Bank of England started off the month (3^rd August) by hiking interest rates in the UK by 0.25% to 5.25%. This was their 14^th hike in a row and leaves interest rates at 15 year highs, with the Bank of England stating that ‘high inflation meant it was unlikely to stop rates any time soon’[ii]. Sterling continued to depreciate after the release of the news, remaining at a lower level for the rest of August. Like Sterling, UK equities also took a negative fall after the release of the news and continued to fall before regaining some of the lost value in the last week of August. Between April to June this year basic wages in the UK rose at their fastest rate of 7.8% which, whilst promising for the general public, also boosts the chances of the Bank of England continuing to increase interest rates. The next meeting for the European Central Bank, US Federal Reserve and the Bank of England will be in mid-September.

On 10^th August US CPI data was released for the 12 months ending in July of 3.2% slightly higher than the June data of 3.0%. Whilst this is a slight disappointment US data is still the closest to the 2% inflation target. On Wednesday 16^th August UK CPI data was released for the 12 months ending in July of 6.8%, down from 7.9% in June, exactly as predicted by analysts. In the Eurozone CPI figures were 5.3% for the 12 months ending in July, down from 5.5% in June. Whilst these figures have been promising all round, Central Banks have stressed the need for interest rates to remain high until inflation is under control. This was the key takeaway to come from Jackson Hole, which took place between 24-26^th August. US Federal Reserve Chair Jerome Powell ‘once again reinforced the “higher for longer” mantra’[iii] in terms of his approach to interest rates and stressed that the committee remain determined to reach the 2% inflation target and are unwilling to stop until the job is done.

The Bank of Japan’s board member Naoki Tamura stated in a speech to Japan’s business leaders, that Japan’s inflation is in clear view of their target and has been ‘signalling the chance of an end to negative interest rates early next year.’ [iv] The comments have been the most compelling as an indication that the Bank of Japan will take action to phase out its unique approach to ultra-low interest rates. Along with the other developed market central banks, the Bank of Japan has a 2% inflation target. Tamura suggests that timing will be important and any such change will be dependent on the conditions of the economy falling into place.

Nvidia Corp, the best performing stock in the S&P 500, currently up 234% since the start of the year, on 31^st August was blocked from selling its A100 and H100 chips to certain areas in the Middle East. This follows an announcement from US President Joe Biden expanding the initial restrictions that were placed on selling to China. Clarification on which specific countries in the Middle East the restrictions have been extended to has not yet been announced. Nvidia stock has continued to increase in share price over the month and the chipmaker has announced (29^th August) a partnership with Google to increase the distribution of its artificial intelligence (AI) technology. This will allow google customers access to the technology that is created by the H100 GPUs. Nvidia CEO Jensen Huang stated “Our expanded collaboration with Google Cloud will help developers accelerate their work with infrastructure, software and services that supercharge energy efficiency and reduce costs”. [v]

Overall, August has been volatile in terms of performance within asset classes. Brent Crude, after the gains made during July remained relatively flat during August. The UK 2-year, 10year Gilt yields and US 10 year Treasury yield have all returned to levels seen at the start of the month following initial increases in yields during August. Sterling continued to depreciate against the US Dollar and Gold also returned to a similar level at the start of the month.

[i] https://edition.cnn.com/2023/08/01/business/fitch-downgrade-us-debt/index.html

[ii] https://www.reuters.com/world/uk/view-bank-england-raises-rates-14th-time-2023-08-03/

[iii] https://www.reuters.com/markets/us/global-markets-view-usa-pix-2023-08-28/

[iv] https://www.reuters.com/markets/asia/boj-policymaker-signals-chance-policy-tweak-early-next-year-2023-08-30/

[v] https://www.cnbc.com/2023/08/29/nvidias-stock-closes-at-record-after-google-ai-partnership.html