Market Commentary September 2023
This year in financial markets has been all about potential “landings” for various economies. Will they be “soft” or “hard”, meaning either a shallow or deeper recession? Or might there be no landing at all, with growth remaining in positive territory? Eight months into the year, economists are still unable to reach a consensus, making for a choppier market in August as investors reacted to data releases.
Part of the problem in reaching an overarching conclusion is that different economies are moving at different speeds. Additionally, within those economies, the various subcomponents are unsynchronised. The most widely observed divergence is between the demand for goods and services. Broadly speaking, many goods producers were beneficiaries of the pandemic when consumers stocked up on more durable items as nests were feathered in response to lockdowns, while social activity was curtailed. Now, the reverse is happening, with “revenge spending” on holidays and experiences prevalent and households running down “excess savings” accumulated during lockdowns.
The lingering impact of supply chain disruption
The picture is further clouded by the lingering effects of supply chain disruptions and labour market shortages. In the case of the former, the rush to refill inventories has resulted in too much stock in some wholesale and retail channels. This can lead to discounted sales as well as a hiatus in demand at the manufacturing source. The stress is visible in global trade data. The shipping giant Maersk forecasts that container demand in 2023 will fall by between 1% and 4% relative to 2022. That might not sound like a lot, but it is the sort of shortfall that would leave Mr Micawber feeling distinctly unnerved. China’s monthly trade data is also revealing. In July, the value of its exports was down 14.5% from a year earlier, while its imports fell 12.4%.
The contrast in global economies
If we were to observe another pair of contrasting fortunes, it would be between the world’s two largest economies, those of the US and China. There will be more detail in the country sections to follow; suffice to say at this point that China is struggling to regain altitude owing to a combination of retrenchment in its overleveraged real estate sector and a lack of consumer confidence following the heavy-handed imposition of lockdowns that resulted from the country’s strict zero-Covid policy.
Meanwhile, the US economy is much stronger. The Atlanta Federal Reserve publishes a running estimate of GDP growth for the current quarter based upon the latest economic data. It calls this GDPNow. It is currently predicting growth for the current quarter to be running at an almost unbelievable 5.6% over the last quarter. Even if we allow for the fact that this is an annualised figure — and so actual growth of 1% would print at 4% — it is a long way from the recession that the vast majority was predicting at the start of the year. We have previously written about fiscal stimulus and a terming out of debt being two key factors in this resilience.
What are current interest rate expectations?
A consequence of this has been a recalibration of interest rate expectations over the last month or so, a factor that has determined recent market movements. So far this year we have seen peak interest rate expectations rise initially in response to resilient economic data before then collapsing in March following a slew of regional bank failures in the US. They then steadily regained their highs as it became apparent that the financial system was not mortally wounded. During August, this renewed confidence in the longevity of the economic cycle, accompanied by concerns that inflation might not decline as far and as fast as many had hoped, led to a rise in bond yields. Two-year sovereign bonds are the most sensitive to interest rate expectations. They bottomed out in March in the US and UK and 3.76% and 3.21% respectively, but hit new cycle highs of 5.07% and 5.5% in August.
Meanwhile, 10-year bonds, which are more important as the discount rate for financial assets, also rose sharply. In the US and UK again, these had fallen to lows of 3.30% and 3.28% during April, before hitting new highs of 4.33% and 4.74% in August. This created a valuation headwind for equities, which succumbed to profit-taking. Even so, the damage was limited, to some degree because corporate earnings reported for the second quarter remained resilient. There were areas of weakness, notably in the Resource sectors, where lower commodity prices reduced profits from 2022’s bonanza levels, but large consumer staples companies continued to display strong pricing power and the all-important (to sentiment) Technology sector displayed no signs of weakness.
Is generative Artificial Intelligence still having an impact on markets?
As we have written about previously, generative Artificial Intelligence remains a powerful growth theme. Leading chip-designer Nvidia confirmed strong demand for its products with its results. As for the longer-term costs and benefits, it remains difficult to be precise. On the one hand, estimates of potential job losses run into the millions as computers take on more menial office tasks. On the other, Goldman Sachs projects that the median company in the Russell 1000 Index will eventually enjoy a 19% benefit to its earnings per share as a result of gains in labour productivity. Much as that might sound like a boon for investors, it also raises the spectre of increased social and wealth inequality, factors that have been at least partially to blame for the chaotic and divisive political scene that has developed in recent years. Politicians and regulators have a challenging few years ahead of them to ensure that the benefits of this new technology are equitably distributed.
What is the central bank outlook?
One big set piece in August was the annual gathering of central bankers at Jackson Hole, Wyoming. While this symposium is supposed to provide a platform for discussing long-term policy developments, the reality is that everyone tunes in for hints about current and future policy. The most important voice is that of the Chair of the US Federal Reserve, currently Jerome Powell. He provided fodder for both bulls and bears. On the one hand, he hinted that the Fed might now be willing to pause its rate increases again to consider the effects of policy tightening already undertaken; this encouraged hopes that the peak is in for interest rates. On the other, he reiterated the goal of returning inflation to 2%, which still seemed a long way off; this spoke to a “higher for longer” level of the fed funds rate. Similar sentiments were expressed by Christine Lagarde, President of the European Central Bank, although her tone seemed slightly more hawkish.
The conclusion was that central bankers feel that the bulk of their policy tightening is behind them and that they are now returning to a mode of “data dependency”. Bearing that in mind, towards the end of the month we did see some hints of a weaker US labour market, with job openings falling and employment growth coming in below expectations, as well as more muted wage gains. This sparked a bit of a rally in bond markets and dragged equities up from their lows.
The performance of key markets:
The resilience of US corporate profitability in the face of higher interest rates is a feature of the current cycle. We have written before about the tailwind of higher inflation and what that means for nominal growth. It has also made price increases more defensible. However, we remain concerned that this tailwind will subside. An unexpected source of profitability has been companies’ net interest bill, at least when looked at in aggregate. A paper from Société Générale investigated this phenomenon, and concluded that companies had taken advantage of historically low interest rates in 2021 and 2022 to issue debt and were now enjoying an effective “carry trade”, earning much higher interest on their cash than they are paying on their loans. However, in another example of inequality, and once again showing that averages can be misleading, it seems as though these advantages are being accrued mainly by bigger companies who had easier access to leverage on good terms. Further down the size scale, higher interest rates are biting, especially in the realm of private businesses. Bankruptcies are increasing, and, in the last two decades, have only surpassed current levels during the financial crisis and the pandemic. More evidence of the confusing two-speed economy that we referred to earlier.
Residential Housing is not an asset class that we invest in. However, we know that it is of great importance to our clients, for whom the primary residence is often their single most valuable asset. The value of residential housing in the UK amounts to around £9trillion, or close to four times the size of the economy measured in terms of Gross Domestic Product, and so has a big impact on how wealthy the population is feeling. It used to be higher. The latest figures from Nationwide suggest that the average house price has fallen by more than 5% over the last year and by a little more from the cycle’s peak. Given the experience of the early 1990s and the fallout from the financial crisis, concerns about another crash in house prices are ever-present. Recent analysis from Deutsche Bank and Longview Economics attempts to lay such fears to rest. Despite worries about rising mortgage rates, they see this having a much greater effect on those seeking to get on the housing ladder than on existing owners, given that just over half of current owner-occupiers are mortgage free. Of greater concern would be a large and rapid rise in unemployment, although neither sees that as being a probable outcome. Moreover, the government has made it clear that it expects banks to provide a degree of forbearance should defaults start to rise. Even so, don’t expect another boom, either. We have enjoyed a 40-year trend decline in funding costs that is unlikely to be repeated, and that coincided with an era of financial deregulation. Mortgage debt is around 70% of GDP today, compared with just 10% at the beginning of the 1980s and house price to income ratios remain elevated.
Europe is also having to deal with a two (or more) speed economy. Countries including France and Spain are enjoying a recovery led by a combination of increased exports and strong tourism. However, the largest economy in Europe, Germany, is in recession. Its dominant automotive industry is struggling with the transition from internal combustion to electric power, and the export of capital goods to China is constrained by that country’s lacklustre performance. It’s cost of energy remains much higher than that of, say, the United States, which is a major manufacturing export competitor. Meanwhile the latest inflation data came in slightly hotter than expected, leaving the European Central Bank little scope for easing monetary policy. The dependence of Europe on imports of natural gas was highlighted again in August as potential strikes that would curtail Liquified Natural Gas exports from Australia to Europe caused a spike in gas prices. Economists will once more have to become meteorologists as winter approaches. Last winter turned out to be milder than average, meaning that greatly feared energy shortages never materialised. This year we are facing a strengthening El Niño weather event. Although this natural phenomenon has its roots in the currents of the Pacific Ocean, its effects are felt much further afield. A study from Leeds University concludes that “cold winters in northern Europe” are one of the consequences. Despite the fact that gas storage is at peak levels, look out for the possibility of more volatility in energy prices over the winter months.
We return to China. Economic data continues to disappoint. Any lingering hopes for a swift “re-opening” trade have been firmly quashed. Industrial Profits in July were running 6.7% below the level of a year earlier and -15.5% if calculated on a cumulative year-to-date year-on year basis. The once-booming housing market has ground to a halt and the outstanding balance of mortgage debt is falling for the first time in more than a decade. In the Real Estate sector, Evergrande filed for Chapter 15 bankruptcy in the US and Country Garden is at risk of default. A high-profile “Wealth Management” entity, Zhongzhi, also experienced a liquidity crisis and potential restructuring. Hopes now lie in the expectation of an aggressive policy response, but so far it has been piecemeal at best. Interest rates have been cut, but only marginally; required downpayments on home purchases have been reduced; Stamp Duty on share purchases was cut in half in an attempt to buoy the stock market, but all seemingly to little avail. Global investors sold record amounts of Chinese equities in August, with their concerns exacerbated by fears of increasing geopolitical tensions. What the country still needs is greater structural reforms, especially stronger social safety nets that might encourage households to increase consumption. By some estimates we have seen, the price/earnings ratio of Chinese equities could be as low as 7x, which, if taken at face value, would be extraordinarily cheap. However, while this might provide a good reason not to bet against the Chinese market, taking a more proactively positive approach remains difficult against the political background.
The Bloomberg Global Aggregate Dollar Index of investment grade bonds gave up the majority of its gains for the year so far during August. We continue to note that three consecutive years of negative total returns in a calendar year would be unprecedented and believe that the recent fall in prices provides an opportunity for balanced portfolio investors to take advantage of more attractive yields. We would also re-emphasise the fact that selected short-dated Gilts offer risk-free yields of more than 5% with tax benefits even when not held within tax-exempt wrappers such as SIPPs or ISAs. Low coupons mean that the taxable income is negligible. But the “pull to par” on maturity delivers a tax-free capital gain. They remain an attractive home for surplus cash savings.
UK Gilts have delivered a total return of -0.1% over the last three months and -9.5% over the last year. Index-Linked Gilts returned +1.3% and -19.9% over the same respective periods. Emerging Market sovereign bonds produced a total return of +0.4% in sterling over the three months to end August (-3.1% over 12m). Global High Yield bonds delivered +1.8% (+0.4% over 12m) in sterling.
Conclusion and Outlook
We continue to experience some frustration with markets. Our long-held opinion that the sharp rise in interest rates over the last year or so will lead to a broader economic slowdown is taking longer to be borne out than we (and many others) expected. We have witnessed a degree of capitulation amongst some in the industry as they have shifted from being bearish to more bullish. Whether this turns out to be a justified volte face or an ill-judged folding of the cards remains to be seen. Our analysis of the economic cycle still holds us back from becoming more relaxed about the outcome.
Even so, we continue to emphasise that neither is this a time for “tin hats”. It is becoming clear that we are very close to the peak of the current interest rate cycle. Much of the valuation damage resulting from a higher discount rate has been done; we just need to gain more conviction as to where the corporate earnings cycle might land. We have maintained for a while that we expect to be projecting a more optimistic view at some point during 2023 (or early 2024), and that remains the case.
Learn more at www.melvynmangion.com