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
Our investment strategy committee, which consists of seasoned strategists and investment managers, meets regularly to review asset allocation, geographical spread, sector preferences and key global market drivers and our economist produces research and views on global economies which complement this process.
Our quarterly report presents our views on the world economic outlook and equity, fixed income and foreign exchange markets. Please click the link to download.
