The Chancellor delivered her first Budget on 30 October 2024, the first under the new Labour government.
Here is our summary of some of the key points.
Earlier this month, the US Federal Reserve delivered a long-awaited cut to its policy interest rate. Significantly, rather than stick to its typical quarter-point increments, the Fed felt able – or, more ominously, compelled – to reduce rates by half of one percent. The distinction is important. The benign interpretation is that the larger reduction was permitted by the slowing pace of inflation. At 2.2%, the Fed’s preferred inflation gauge has fallen a long way from its 2022 peak of 7.2% and is within touching distance of the 2.0% target. More worryingly, the move was made against the backdrop of slowing job creation, rising unemployment and faltering consumer confidence: might the outsized cut have been made in an attempt to forestall economic troubles ahead?
The market’s verdict is clear: the consensus is firmly behind the benign view – a soft landing for the economy, with inflation and interest rates falling without a meaningful rise in unemployment or slowdown in growth. In our view, adherents to this belief may well be confusing the current situation with the direction of travel. The US economy has proved remarkably resilient as interest rates were raised to, and then maintained at, multi-decade highs. We think investors should be asking ‘what next?’ We see evidence that the economy is weakening, and suspect the Fed has little power to arrest the decline.
How have financial markets responded to the rate cut?
Equity markets have, since late 2023, been fuelled by a growing consensus around a soft-landing narrative that demands interest rates fall rapidly while the economy and corporate profits remain resilient. From this perspective, it was perhaps inevitable that the jumbo rate cut was initially met with enthusiasm: US stock market indices climbed to all-time highs, while those tracking economically sensitive smaller companies were particularly buoyant. Interestingly, the initial gains were quickly rescinded, and subsequent advances have been more tentative.
History certainly suggests equity investors should be cautious when the Federal Reserve begins to cut interest rates. The reason is simple: as highlighted below (fig.1), reductions in interest rates are typically associated with recessions, and recessions are bad for corporate profits and therefore equity markets.
Equity investors, though, have tremendous reserves of optimism. Despite the tendency for falling interest rates to be accompanied by recession, the first rate cut in a cycle has all too often elicited a positive market response. For example, exactly 17 years to the day before this month’s move, the Federal Reserve also cut rates by ½%. Back then, the decision prompted the biggest one-day gain in four years with a certain investment bank, Lehman Brothers, rising nearly 10%. Needless to say, this enthusiasm proved hopelessly misplaced. The US stock market peaked just three weeks later while the economy had tipped into recession by January 2008. Importantly, some investors saw the writing on the wall, trusting to foresight and reducing equity allocations in advance of a stock market decline which measured 56% from peak to trough.
Despite engaging in an exercise that is inherently forward-looking, the investment industry has a remarkable propensity to find comfort in the status quo, and a will to believe in narratives – however fanciful – that might help it endure. We think this tendency explains how investors can, in aggregate, get it as demonstrably wrong as they did in 2007 and why we suspect they are making a similar mistake today.
Skate to where the puck is going
“Skate to where the puck is going, not where it has been.” So said the all-time leading goal scorer in ice hockey’s NHL, Wayne Gretzky. We consider this sound advice, particularly in the current economic environment. Yet we suspect that the vast majority of economists, investment strategists and investors who believe in the likelihood of a soft economic landing have their eyes firmly fixed on where the puck has been.
The US economy has proved remarkably resilient in the face of higher interest rates. Thirty months after the Fed first raised interest rates, its Chicago branch estimates GDP is growing at an annualised rate of 2.9% while the unemployment rate is just 4.2%. This, it is claimed, is far from a recessionary environment. We would counter that investors should focus not on where the economy is, but rather on where it is going.
Almost by definition, a recession involves a substantial increase in the unemployment rate. It stands to reason that a low current rate of unemployment does not prevent an increase from happening – if anything, it makes it more likely. Recent data have pointed to an unambiguous slowdown in the labour market and, though still low by historic standards, the unemployment rate has risen significantly from its post-pandemic lows. Indeed, this increase has been sufficient to trigger the so-called ‘Sahm rule’ which observes that a rise in the unemployment rate of this scale has historically – without fail – coincided with a recession (fig.2).
Meanwhile, business surveys point to a manufacturing sector in decline with little sign of recovery in sight and a service sector that, though currently strong, is increasingly worried about future demand and scaling back its hiring and investment plans accordingly. We note the proportion of household income being saved has fallen to historic lows, while delinquencies on consumer loans are rising. According to the Conference Board, individuals are increasingly worried about their job prospects and future economic conditions, posing a threat to consumer spending that has, alongside government expenditures, propelled the US economy through the many trials and tribulations of the past few years. Finally, the small companies that produce c45% of US economic output and employ c50% of the labour force continue to struggle under the burden of interest rates which – even after the Fed’s cut – remain penal, reporting sharp declines in earnings and concerns over future sales prospects.
Where some see a US economy that has to date proved remarkably resilient, we see one that is finally succumbing to the normalisation of post-pandemic distortions and the pressure of high interest rates. That it has taken so long for the Federal Reserve’s actions to bear down on the economy is instructive. Supported by historic precedence, it leads us to be extremely doubtful of the idea that reducing interest rates now will be sufficient to curtail or reverse the economic slowdown which is now underway.
If not the Fed?
If it is too late for lower interest rates to stave off a downturn, is there anything else on which equity investors might pin their hopes? We can identify two possible contenders, but neither is without its problems.
Firstly, growth could be supported by further government spending. At first necessitated by the shock of the pandemic and subsequently extended to pursue various political and strategic agendas, government expenditures have been a ferocious tailwind for US economic growth in recent years. With an election looming, neither Democrats nor Republicans are keen to discuss fiscal restraint. Whoever is elected, it is possible that a further wave of government stimulus could be forthcoming. While any such policy may support economic growth and asset prices, it would also likely be inflationary, necessitating higher interest rates. Additionally, with the budget deficit already at an historic peacetime high, it is distinctly possible that investors would demand a higher yield from US Treasuries, making it more challenging to service the deficit and tightening global financial conditions.
Alternatively, perhaps the wealth created by the phenomenal increase in asset prices in recent years could prove sufficient to cushion consumers from a standard cyclical economic downturn? The Federal Reserve estimates total US net household wealth stands at a staggering $163.8 trillion, a c40% increase from pre-pandemic levels. In theory, households could draw down this wealth to fund consumption, limiting the scope of any potential economic contraction. In practice, there is an inherent reflexivity to asset prices that we think undermines this scenario. Firstly, if these assets are sold en masse, the laws of supply and demand suggest their price should fall; households would find themselves less wealthy than they had presumed and potentially scale back their consumption, exacerbating the cyclical downturn rather than offsetting it. Perhaps consumption could instead be funded by further asset price gains? All else equal, higher asset prices mean lower future returns: at some point, the virtual spiral must grind to a halt. With US equity valuations at levels rarely ever surpassed, we suspect this point is close
Conclusion
When posed the question ‘what next?’, our honest assessment is that challenging times lie ahead. We are willing to stand out from the crowd when our analysis leads us to question the consensus – this is one of those times. We do not dispute the fact that US economic growth and stock market returns have been remarkably strong in recent years, even as interest rates have been raised to multi-decade highs. However, we think it is a mistake to confuse the current situation with the direction of travel. We see clear signs that the economy is weakening, and believe that cutting interest rates will do little to arrest the decline in the near term. Though we look forward to the day we can provide you with a more optimistic investment update, for now we continue to advocate caution.
Our macroeconomic outlook is by now well-rehearsed: high interest rates tame inflation only by bearing down on economic activity. As the economy slows, corporate profitability declines, workers are laid off and unemployment rises. Given monetary policy operates with ‘long and variable lags’ in both directions, cuts to interest rates at this stage are invariably too little, too late, and the economy slides into recession. With unemployment already rising – both in the UK and the US – and GDP data pointing to a decline in US corporate profits in the first quarter of this year, we continue to see signs that the cycle is – albeit slowly – evolving as expected.
With yields on high quality short-dated bonds comfortably in excess of inflation, we see little to be gained in pinning our hopes on a positive economic surprise arriving just in time to validate very expensive equity markets. In this, however, we find ourselves in the minority. While many of the fund managers and investment strategists we speak with recognise the economy is slowing, belief in the Federal Reserve’s ability to manage an economic soft landing remains, for the most part, resolute. More worrying still, many market participants seem to think the stock market will prove immune to an economic slowdown. In our view, this belief is misguided, failing to recognise the range and interconnectedness of the risks stacked against it. We highlight four of the key risks below.
Economic cycles
The primary risk that investors are underestimating is a downturn in the economic cycle. Though high savings levels, fixed term mortgages and sound balance sheets have dampened the impact of rising interest rates, we have no doubt that, both in the UK and the US, an ever-increasing number of households and businesses are feeling the strain. The implications are becoming clear in the US labour market. The unemployment rate has risen from a low of 3.4% in April 2023 to 4.1% in June. If it rises only a little from here, the increase in joblessness will be sufficient to trigger the so-called ‘Sahm Rule’. Not a rule as such, this is rather an observation that, historically, whenever the unemployment rate has risen by half a percentage point within a year, it has marked the start of a recession, following which further job losses have been inevitable (Fig.1).
Of course, the Federal Reserve is well aware of this history, and stands ready to cut interest rates if necessary – and if permitted by further easing of inflationary pressures. Though the worst of the post-pandemic surge in prices is behind us, the Fed’s preferred inflation measure is making only slow progress towards its 2% target. Consequently, the Fed has signalled only one quarter-point cut in interest rates over the remainder of the year, despite the troubling signs in the labour market. In our view, a single rate cut will do next to nothing to support the real economy. Yet for the Fed to do more, the slowdown must be so pronounced that corporate profitability would surely be under marked pressure.
Irrational Exuberance and Stock Market Valuations
Counter to all economic rationale, it appears possible that rate cuts may, initially at least, stimulate further speculative gains in the stock market. We recently read a report from a US investment manager acknowledging the mounting risks to their base case of resilient economic growth. What struck us was the claim that the deteriorating growth outlook was encouraging them to increase their year-end targets for the US stock market.
From a purely mathematical perspective, falling interest rates can, in isolation, justify higher equity valuations. But rates will not fall in isolation: they will only head meaningfully lower in the context of a sharply slowing economy, and therefore sharply slowing corporate earnings growth. Interestingly, parts of the market appear to have taken this onboard: defensive sectors such as utilities and consumer staples have outperformed more economically sensitive sectors such as industrials and consumer discretionary. Yet, with the US stock market hitting a series of record highs in recent weeks, slower corporate profit growth is clearly not a widely held concern, giving rise to our second risk – that stock market valuations are unsupportable.
This brings us to artificial intelligence and the belief that some companies can grow their earnings irrespective of the economic cycle. With consistently strong profit growth in perpetuity, it is argued, there is almost no valuation too high for such companies. We are sceptical of such claims. Firstly, we stand firm in our belief that valuation is the difference between a good company and a good investment: even the very best company will prove a poor investment if it is bought at too high a price. Secondly, we have yet to find a company whose earnings are not, to some extent, influenced by the economic cycle – for example, Microsoft’s earnings per share dropped 13% in 2009 and Apple’s earnings fell 11% in 2016, even as the economy avoided recession.
At this point, we think it instructive to consider the history of Cisco, the US technology giant in the early part of this century. The company was identified as the leading provider of the ‘picks and shovels’ supporting the revolutionary potential of the internet. In five years, its share price rose 3,860% to a high of $80 in March 2000. In early July this year, Cisco’s share price was around $47, still 42% below its peak nearly a quarter of a century later. Importantly, this has occurred in spite of the company having grown its earnings by an average 14% a year over this period, meeting – or even exceeding – the expectations that were held to justify the eye-wateringly high share price all those years ago (Fig.2). Investors in Nvidia and the like would, we suggest, do well to reacquaint themselves with this history.
Financialisation
Such were the excesses of the tech bubble that its demise triggered a full-blown recession in the US. In response, the Federal Reserve slashed interest rates from 6½% to 1¾% in a little over a year. Regardless, unemployment rose from 3.9% at the end of 2000 to 5.9% by early 2002, and then – in spite of yet more rate cuts – to 6.3% by mid-2003. Cisco shares lost 90% of their value as, peak to trough, the US equity market halved.
Today, we hear all too often that a recession is impossible because household and corporate balance sheets are in good order, and there are ‘no clear imbalances’ in the economy.
This argument is used to justify relentless gains in the stock market, failing to recognise our third risk in the system: that the gains themselves are creating an economic Achilles’ heel. As a proportion of US GDP, wages have seldom been lower, while the size of the stock market has never been greater. Gallup calculates that 58% of American households have some exposure to equities, five percentage points higher than the previous peaks of ownership hit – ominously – in 2001 and 2007. The US economy has never been more exposed to the vagaries of the stock market. Mixed with stretched valuations and a deteriorating economic outlook, this strikes us as a heady and dangerous brew.
Politics: debt and elections
Our final risk in the system is easy to see but difficult to quantify. Here in the UK, with the scars from Liz Truss’ “mini budget” still raw, the challenges facing the new Labour government are self evident. Public services are in need of funding while growth could certainly benefit from a shot in the arm. Yet the tax burden is high and government debt as a proportion of GDP has never been higher in peace time. It seems likely that budgetary concerns must limit the Starmer government’s ambitions.
The US is flirting with a similar predicament. After huge unfunded expenditures through the pandemic, US government debt levels are also at record highs. The US government now pays more than $1trillion a year in interest, a fifth of its total revenues and a greater expense than its sizeable defence budget. Nonetheless, with November’s presidential election looming, neither candidate is keen to discuss the merits of – or need for – fiscal responsibility. The bond market, however, may not be so willing to ignore the issue. Though US sovereign debt remains the world’s ultimate safe haven asset, the government’s ability to issue ever greater quantities of it is not without bounds. Indeed, there are tentative signs that the infamous ‘bond vigilantes’ are beginning to probe the sustainability of the government deficit. At the very least, investors should question the extent to which fiscal policy can feasibly be relied upon to extend the current cycle, or to offset a future recession.
Risk Assessment
We have been surprised by the longevity of this economic cycle. The slow transmission of monetary policy, together with unparalleled fiscal expenditures, has allowed growth to endure far longer than we thought possible in a world of record debt and high interest rates. However, in doing so, we believe risk has been stacked upon risk. Investors’ refusal to countenance the likelihood of an economic slowdown and the consequences for corporate profitability – and to recognise that meaningful cuts to interest rates are only possible should growth weaken significantly – have propelled the stock market to precarious heights. Fearful of missing out, and emboldened by the mania surrounding artificial intelligence, more and more investors have eagerly climbed aboard, leaving the US economy more exposed to the risk of a correction than ever before. Meanwhile, there are signs that even the US government might be constrained in its ability to support future economic growth.
These risks are interlinked: we believe any one of them has the potential to topple the whole edifice. For these reasons, we remain cautious.
The US stock market has recently recorded a series of all-time highs driven by the prospect of imminent interest rate cuts which have added fuel to a market increasingly enraptured by the potential of artificial intelligence (AI). Huge share price gains have come alongside breathless forecasts of the scale of opportunity and the profits that will follow. Understandably, some on the sidelines are wondering what they are missing and questioning whether they ought not to delay their participation any longer for fear of forgoing potential profits. We are wary of getting caught up in the exuberance especially as, in our view, the macroeconomic outlook remains challenging.
In this update we discuss the narrow subset of stocks that have driven markets higher, such as those at the centre of the AI story, which appear to promise strong growth regardless of the economic backdrop. We follow this by taking a look at Nvidia, the flagship of the AI hysteria, to highlight the risk that such growth may not be as enduring as current valuations demand. We begin, however, with a brief update on economic developments.
Economic Developments
Our understanding – that high interest rates suppress inflation by bearing down on economic activity – is entirely orthodox and causes us to attach a low probability to the fabled ‘soft economic landing’ scenario where inflation returns obediently to target while growth trundles on. In our previous investment update, Walking a Narrow Path, we highlighted the challenge that central bankers face in returning inflation to target while the economy remains resilient and near full capacity. Indeed, recent data has confirmed that short-term annualised measures of US inflation have been trending higher. At the same time, however, leading indicators of the labour market, such as a survey of US small companies’ hiring intentions, have deteriorated and are pointing to potential weakness ahead.
This presents a double-pronged challenge to investors; on the one hand, a resurgence in inflation would jeopardise the rate cuts that markets are expecting – likely undermining the ‘soft landing’ outcome baked into equity market valuations. While on the other hand, a deterioration in the labour market would likely put paid to inflation, but at the expense of a marked economic slowdown. We don’t believe markets are appropriately discounting either of these risks.
At this point, we turn to the Magnificent Seven – the group of stocks that have propelled markets higher – and the latest investment phenomenon: artificial intelligence.
How Magnificent?
As has been widely reported, seven US technology names have become enormously influential in global stock markets. Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla. Together they make up close to 30% of the US stock market and almost 20% of the Fidelity Index World fund that we recommend within portfolios. Collectively, these seven stocks are worth more than five times the hundred largest companies listed on the London stock exchange. Indeed, two of them – Microsoft and Apple – are each individually worth more than those one hundred “large” UK companies.
It is worthwhile reflecting on the development of the Magnificent Seven. Initially, investor interest was focused on the FANGs – Facebook, Amazon, Netflix and Google. Apple was subsequently added to make the FAANGs, before Microsoft’s introduction at the expense of Netflix laid that acronym to rest. The Magnificent Seven were then identified following some spectacular share price gains from late 2022 onwards. Our point is that such groupings are artificial and short lived. It therefore comes as no surprise that the Magnificent Seven has recently started to splinter. Tesla is facing stiff competition from Chinese manufacturers and is no longer among the ten largest US stocks. Meanwhile, Apple shares are c9% lower over the year-to-date, even as the wider US market is up c10%, thanks to a significant regulatory threat to the income it derives from forcing transactions to take place within its App Store.
Inevitably, another trend has come to the fore: the artificial intelligence goldrush, with Nvidia as its posterchild enjoying a near 700% gain in its share price over the past 18 months. We believe Nvidia presents a good example of the risks currently embedded in global equity markets.
A Bubble in Earnings?
In contrast to the tech bubble of the 1990s (which otherwise bears strong comparison), investor exuberance is not obviously apparent in high valuations. Following a 586% jump in earnings per share over its last financial year, and with a further 114% increase expected over 2024, Nvidia ‘only’ trades at 36x this year’s expected earnings. Factor in forecasts of 25% annual earnings growth over the following three years, and Nvidia’s valuation arguably appears palatable at close to twice the US market’s valuation.
Investors should instead be questioning whether the earnings forecasts that underpin these valuations are themselves reasonable. In our view, they appear to incorporate some heroic assumptions.
Nvidia, which designs high powered, market leading microchips, operates in a highly cyclical industry – one in which the earnings of its peers have historically been highly volatile. Yet consensus expectations appear to extrapolate recent earnings growth into a long-term structural trend with no cyclical downturns. Given the excitement over AI, perhaps it is reasonable to expect an ever-increasing demand for the powerful processors necessary for building and training large language models? We doubt it, but even if this were the case, is it reasonable to expect Nvidia to maintain its c80% market share? Nvidia’s customer base is concentrated, and heavily incentivised to unpick Nvidia’s near monopoly. Several of its biggest customers, including Apple, Meta and Amazon are developing rival chips designed specifically for their needs and therefore expected to be significantly more efficient than the general processors supplied by Nvidia. Meanwhile, Microsoft is working closely with AMD – one of Nvidia’s key competitors. And if it faces stiffer competition, can Nvidia really be expected to not only maintain its profit margin (which has grown from 59% to a staggering 74% over the past year alone) but to expand it further still, as demanded by the earnings forecasts? We wonder whether TSMC – the Taiwanese company that manufactures all of Nvidia’s chips and is itself the dominant player in its part of the industry – might, at some point, question how fair it is that Nvidia gets to keep such a large share of the profits.
We are open to the idea that AI may well exert a profound influence on the global economy and the corporate landscape. Nonetheless, we are staggered by the assumptions and extrapolations that are fuelling the stock market, with the shares of many of Nvidia’s competitors (Broadcom +114%, AMD +78%) and other AI-themed stocks (SoundHound AI +63%, ServiceNow +68%, Super Micro Computer +771%) rocketing over the past year. The recent earnings growth of Nvidia and its ilk is undeniable. However, in our view, it is also unsustainable. We believe investors buying into these stocks now are quite possibly being sucked into a bubble in earnings. Unsurprisingly, we believe this bubble presents a clear risk to investors, particularly when the economic backdrop remains precarious.
Though market pricing indicates investors are confident that the global economy can stay on the narrow path to a soft landing, the threats of recession on one side and stubborn inflation on the other have not been entirely put to bed. Investor enthusiasm for companies capable of growing earnings even in an economic downturn, and of raising prices to protect against inflation is therefore understandable. However, we think cyclical growth has in many cases been mistaken for structural growth. In these cases, investors risk finding themselves on the receiving end of a sharp one-two as earnings disappoint, simultaneously undermining the premium valuations awarded to these stocks in expectation of long, strong, uninterrupted growth.
Greed and the Fear of Missing Out
We strongly caution against the temptation to yield to the fear of missing out. The feeling that we are standing on the sidelines while riches are being amassed lends an interesting twist to Warren Buffet’s wise counsel to “be fearful when others are greedy, and greedy when others are fearful”. It is not missing out that we should be fearful of, but rather the risks building in markets as investors pile assumptions on top of extrapolations in an attempt to justify expectations of further stock market gains.
Interestingly, even the most optimistic Wall Street forecasts we have seen put the US stock market only 4-5% higher from current levels by the end of the year. Given the risk that the economic outlook proves less benign than currently assumed, or that stubborn inflation might curtail hopes of lower interest rates, or that disappointing earnings pull the rug from beneath the feet of the AI trend, we find these prospective returns unappetising. Encouragingly, we do not need to give in to greed to find more appealing fare elsewhere. High quality short-dated corporate bonds currently offer yields around 6% – enough to deliver a positive real return even after accounting for a possible resurgence in inflation, while presenting little risk of permanent capital impairment. In our view, this is a much more compelling balance of risk and return.
There will come a time to be greedy. This, we are sure, is not it.
With the inflationary threat widely thought to have been defeated, stock markets have enjoyed a broad-based rally fuelled by hopes that central banks will soon cut interest rates. This reflects investors’ increasing optimism in the likelihood of a soft economic landing, in which economic output continues to grow apace while inflation subsides. This is an historically rare pairing; the two normally move in the same direction. Furthermore, periods of falling inflation have historically gone hand-in-hand with thinner corporate profit margins and slower earnings growth. This presents a challenge to market expectations which require earnings growth to accelerate from near zero to a healthy double-digit pace – even as inflation eases back to target.
These considerations, in our view, leave the US equity market in a vulnerable position. Earnings forecasts appear ambitious, and valuations are heady – even if the soft landing comes to pass. Though we continue to have concerns over the macroeconomic outlook, this set-up leads us to believe that a recession is not a prerequisite for equity market returns to disappoint, particularly relative to the 5% yields currently available from high quality bonds. We therefore continue to recommend caution, even – or perhaps especially – as equity markets continue to rise.
The Macroeconomic Outlook
We have for some time expected one of the most aggressive monetary hiking cycles on record to tip developed market economies into recession. While acknowledging ‘long and variable lags’, we have been surprised by the resilience of the global economy, and that of the US in particular. A strong labour market and excess savings have supported households through the cost of living crisis and, with wages now rising more quickly than prices, a resumption in normal service from the all-powerful US consumer is expected. Markets are presuming that this will be sufficient to stave off the threat of recession, but moderate enough not to stoke inflationary flames, leaving central banks free to cut interest rates.
We continue to doubt this narrative. As we have previously argued, soft landings are historically rare – and for good reason: without either fiscal or monetary policy constraining economic growth, there are few viable ways to force inflation to fall back to target. Economic growth implies rising demand – and when, as now, the economy is already operating at full capacity, additional demand is inflationary. Higher interest rates bear down on inflation only by bearing down on demand, and hence growth. This coarseness of monetary policy is ill-equipped to achieve the delicate balance between growth and inflation required of a soft landing.
Thus far, high interest rates appear to have made little impression on growth. That is because they are yet to fully work their way into the economy – but this is now changing. The first three weeks of 2024 saw a record $153bn of investment grade debt issuance as companies rushed to take advantage of the sharp decline in yields over the last two months of 2023. Reacting to the same stimulus, issuance has also been high in government, high yield and emerging bond markets – there have even been nascent signs of life in the frozen US housing market. Yet yields are only back to where they were a year ago, at which point the Federal Reserve had already implemented an eye-watering 4¼% of rate hikes (that is, four-fifths of the trough-to-peak total). The borrowers rushing to issue debt might have avoided the very worst of the interest rate pain, but they must now accommodate meaningfully higher interest costs nonetheless.
Meanwhile, outstanding credit card debt has surpassed $1tr – up more than 14% over the past year – while the use of ‘buy now pay later’ facilities expanded 40% year-on-year to late 2023. Worryingly, delinquency rates (which measure the proportion of consumers falling behind on their debt payments) are already back to pre-pandemic levels and continue to rise. In the corporate sector, some 40% of the Russell 2000 index of US smaller companies is unprofitable. These are sobering statistics in the context of an economy operating at full employment, enjoying above-trend growth and which is still only part-way through the process of absorbing higher interest rates. We believe they are a legacy of the cheap and plentiful credit of the post-financial crisis period, which encouraged the proliferation of consumer borrowing and business models that cannot stand up to the rigours of positive real interest rates. The longer real rates stay above zero, the more likely the moment of reckoning.
The path to a soft landing is extremely narrow. While it is possible – through skill or by luck – that the Federal Reserve could lead the US economy safely along it, we think it more likely that the delicate balance can only be maintained temporarily. Lean a little too far one way and interest rates bear down too heavily on growth, tip a fraction in the other direction and robust demand opens the door to a second round of inflation and rate hikes.
The Market Outlook
Following the ‘everything rally’ in the last two months of 2023, equities – especially in the US – are priced in expectation of a pain-free resolution to the soft landing paradox that demands strong growth alongside low inflation and falling interest rates. While a recession would certainly settle this dilemma decisively, we do not believe it is required for equity markets to disappoint this year.
While an economist’s definition of a soft landing has economic growth holding firm while inflation subsides, investors tend to focus on the growth of corporate earnings. Intuitively, economic growth and company earnings are closely linked, but there are some nuances to the relationship that are perhaps less obvious. The connection between inflation, profit margins and earnings is of particular interest at this juncture.
As the last couple of years have made clear, inflation can make life uncomfortable for consumers: when prices are rising, each pound of expenditure buys fewer goods. In this environment, we might expect companies to reduce profit margins in the hope that prices a little lower than they might otherwise have been will help support demand. In practice, however, companies typically use the cover of inflation to increase profit margins, using price rises to offset any shortfall in demand and thereby delivering positive earnings growth. Conversely, periods of disinflation (in which inflation falls without turning negative) have historically gone hand-in-hand with thinner profit margins and slower earnings growth.
This experience has once again played out over the post-pandemic cycle. As inflation rose, profit margins were expanded, and earnings growth was strong. Subsequently, as inflation has eased, margins have fallen and earnings growth has disappeared.
Remember, the soft landing consensus requires economic growth to continue, allowing companies to grow profits even while inflation fades. Indeed, consensus forecasts for the S&P 500 currently point to 12% earnings growth in 2024 and 13% growth in 2025 – ambitious targets at almost any point in the cycle. However, as the chart below shows, earnings growth seldom picks up when inflation is falling, never mind accelerates to 12% from a standing start.
In short, we struggle to envisage a scenario in which corporate earnings can grow by 25% in the next two years while inflationary pressures are sufficiently muted to allow the Fed to cut rates by 1½% in the space of nine months – all of which the consensus demands.
Arguably, a disappointment on earnings can be withstood if valuations are reasonable. However, a range of measures indicate that this is not the case. While valuations appear most extreme among the largest US companies, particularly the so-called “Magnificent Seven” of Amazon, Apple, Alphabet, Meta, Microsoft, Nvidia and Tesla, the issue is not confined to these names, nor to the technology sector as a whole: eight of the ten sectors in both the MSCI World and S&P 500 indices are trading above their long-term average valuations. Following the sharp rally over the past couple of months, the forward price earnings multiple for the US stock market (based on expected 2024 earnings) is 19.9x. This is expensive: indeed, it has only been higher 11% of the time since 1985. A halving of 2024 growth forecasts would drive the multiple up to 21.4x, a value only surpassed at the height of the tech bubble and, briefly, in the immediate post-pandemic euphoria.
Conclusion
Hopes of imminent rate cuts have largely banished fears of recession from the financial headlines and the mood music in markets has been decidedly upbeat. Unfortunately, we think the optimism is misplaced. The combination of wishful earnings forecasts and lofty valuations is similar – if perhaps less extreme – to the conditions that preceded the 2022 market weakness. This leads us to believe that, while we remain wary of the macroeconomic outlook, it need not take a full-blooded recession for equity returns to disappoint.
While the resilience of the US labour market or renewed fiscal stimulus could forestall the growth slowdown we have long expected, neither resolves the paradox at the heart of the soft landing consensus. Inflation and interest rates may fall, or corporate profits may surpass already ambitious expectation, but the combination of the two is, at best, improbable. We therefore continue to recommend caution, even as the siren song of rising equity markets plays on.
There are some uncomfortable parallels between the state of economies and markets today and previous challenging periods in recent financial market history. These have provided material for eye-catching newspaper articles in recent weeks including The Telegraph’s ‘Why Britain is on the verge of a cataclysmic financial crisis’. In this note we examine the validity of such parallels, offer our views on the outlook for developed economies and investment markets, and outline the resulting portfolio positioning. Our view is that, given the rapid pace of interest rate increases in developed economies and the resulting bond market turmoil, equity markets are skating on thin ice.
We begin with a brief economics refresher.
The Theory
Central banks are raising interest rates to bring inflation to heel. Higher interest rates mean higher financing costs which act as a brake on economic activity, thereby reducing inflationary pressures. The brake operates through companies and households: both are forced to think twice before borrowing at higher interest rates to fund investment or consumption. Meanwhile, those with existing borrowings pay more in higher interest costs and so their spending elsewhere is squeezed. Even in the public sector, higher borrowing costs mean government spending comes under pressure as a larger portion of revenue goes to make interest payments on debt. Thus, economies slow, inflationary pressures ease and price stability is regained.
That, at least, is the theory. The challenge is that interest rates are an extremely blunt tool. While it ought to be possible to use them to bring inflation back to target without denting economic growth too much, history offers very few successful examples of this fabled ‘soft landing’.
The Uncomfortable Parallels
We now move on to consider briefly the parallels mentioned in our introduction. Comparisons have been drawn between the current economic backdrop and that in 1987, just prior to the Black Monday stock market crash. In both periods interest rates and bond yields were rising to cool economic growth and thereby bear down on inflation. Also, in both periods, the stock market continued to show resilience, seemingly oblivious to the growing burden that higher and higher interest rates put on consumers and companies. In 1987, this continued until the fateful day, 19th October, when equities suffered their worst daily fall since 1929: the US stock market plummeted by an astonishing 20% in one day, on its way to a peak-to-trough decline of 33%.
At that time a recession in the UK was staved off for a couple of years, thanks in no small part to interest rate cuts in response to the stock market crash itself. However, a downturn was only delayed, not averted: the UK went into a deep recession in 1990. Extending the comparison to other time periods, the chart below shows, for the US, that interest rate hiking cycles are almost always followed by recessions. This is because the ‘medicine’ administered to deal with inflation has the unwelcome but unsurprising side-effect of triggering an economic downturn.
Recent Experience
A final glance at the chart above reveals not just the significant scale of the recent rate hikes, but also the extraordinary low interest rate environment that preceded them. We have transitioned from a world of almost ‘free’ money to the highest rates in over 20-years, and it has happened at an eye-watering pace.
There are two interconnected points here. Firstly, the long period of ultra-low interest rates encouraged borrowers, including governments, to load up on debt. According to the Institute of International Finance, global debt has grown by $100tn in the past decade to a record $307tn by the second quarter of this year. Arguably, this was not an issue when interest rates were close to zero – but huge debt levels and high interest rates are a potent and combustible mix.
Secondly, the pace at which rates have been raised has been remarkable. The second chart below highlights the break-neck speed at which the Federal Reserve has raised interest rates over the last 19 months in an attempt to bring runaway postcovid inflation back to the 2% target. By way of comparison, rates were increased by 4¼% over two years in the run up to the financial crisis: by Autumn this year they had risen 5¼% in three-quarters of that time.
The pace of increase in interest rates is a concern as it means the full weight of higher borrowing costs has yet to be felt by consumers and companies. This is why central banks are now pausing their hiking cycles.
Together, the pace of rate hikes and the fact they come after such a prolonged period of very cheap money suggest further cause for caution. Given how seldom central banks have achieved a soft landing in the past, to do so having foisted hugely rapid rate hikes onto economies burgeoning with debt seems a very, very tall order.
Nevertheless, optimism that this aggressive medicine is working – that economies can slow gently, and inflation can return to target – has prompted a resurgence in equity markets. By contrast, bond prices have continued to fall. Bond yields (the inverse of bond prices) appear to be rising for two reasons.
Firstly, investors are beginning to believe that higher yields are justified by resilient economic growth – that economies can withstand higher interest rates and bond yields. Secondly, huge auctions of new government bonds, together with the reversal of quantitative easing, suggest that higher yields may be necessary to persuade investors to soak up the expanding supply.
To summarise, equity markets have remained resilient because economic growth has remained robust. Bonds have fared less well for the same reason; robust economies mean higher interest rates appear justified. But this is a paradox: the further long-term bond yields rise, the more likely it is that economic growth will suffer.
Outlook and Positioning
In our view, the chances of a happy ending to central bank campaigns to cure inflation are increasingly slim, and equity investors’ optimism increasingly misplaced. As higher interest rates and long-term bond yields make their mark, we expect equity markets will come under pressure as the economic backdrop deteriorates sharply. Briefly considering the US equity market, with valuations around 20x this year’s estimated earnings, this looks priced for perfection not peril. Moreover, the consensus of analysts’ expectations is for earnings growth of 12% next year – an aggressive pace of recovery, when we have as yet seen little by way of a slowdown. As the stock market gains this year are not being underpinned by earnings growth, we are unsurprisingly cautious on the outlook for equities and are positioned accordingly.
By contrast, we believe that now is a very good time to be a fixed income investor. For the first time in 15 years, the yields on high quality bonds look appealing. While the capital values of bonds have taken the pain of interest rates that have risen higher and faster than anticipated, ongoing holders are compensated by the attractive income now being paid. Additionally, bonds now also offer potential for capital gains should interest rates – and so bond yields – eventually retreat from current, elevated levels. This would occur in an economic slowdown or recession. It would also occur should financial accidents happen (as they did exactly 36 years ago, and as they did in US regional banks earlier this year), and also should financial markets become more concerned about intensifying geopolitical instability.
Given the dead weight of high interest rates on our hugely indebted and politically unstable world, we consider this to be a matter of ‘when’ not ‘if’. With bonds set to deliver meaningful positive returns, portfolios are positioned for such an outcome.
When we last wrote, in May, we suggested markets were travelling much too hopefully, ignoring the likely consequences of an historically aggressive series of interest rate hikes. Since then, the US stock market has continued its upward surge, driven not by stronger company earnings, but by investors’ willingness to pay a higher price for those earnings. Having risen 27% from its October lows, the S&P 500 is trading at a multiple of more than 20x this year’s earnings, well ahead of the ten-year average multiple of 17x. These extraordinary gains have been fuelled by optimism that, having raised interest rates forcefully in the face of high inflation, the US Federal Reserve may now be on course to engineer a much hoped for ‘soft landing’.
In the soft landing scenario, fading inflation allows the Fed to start cutting interest rates before they inflict significant damage on the economy; growth slows and perhaps some jobs are lost, but crucially recession is avoided. The implications for investors are lower bond yields – and hence positive capital returns from fixed income allocations – and equity markets that are underpinned by solid, if unspectacular, earnings growth.
The appeal of the soft landing scenario is clear. But is it credible?
After a torrid 2021 and 2022, the year to date has been much more encouraging on the inflation front. The rate of growth in US consumer prices peaked at 8.9% year-on-year in June last year, but has since drifted down to 3.1%. Admittedly, core inflation (which strips food and fuel from the calculations, two areas where prices can be volatile and driven by factors beyond the central bank’s control) has proved more stubborn, but the trend has nonetheless been downward. Furthermore, signs of normalisation in housing rents and used car prices – major contributors to the inflationary surge – suggest there is good news still to come. At the same time, unemployment remains near record lows. Wages have been rising (in nominal terms, at least) at the same time that inflation has been easing. Surely this augurs well for a soft economic landing?
Unfortunately – and perhaps predictably – we are sceptical. While we acknowledge a soft landing is possible, we think it improbable. As many, including us, have repeatedly pointed out, monetary policy works with long and variable lags: the current state of the economy says more about interest rates as they were twelve or eighteen months ago than it does about the appropriateness of today’s policy stance.
Twelve months ago, US interest rates were 2.50%. Eighteen months ago they were just 0.25%. Today they stand at 5.50% with a further quarter-point hike possible before the Fed calls it a day. The Fed’s task is far from easy. Historically, soft landings are vanishingly rare. Given the violence of the post-pandemic economic cycle, the ferocious pace of the policy tightening and the Fed’s “data dependent” (i.e. backward looking) approach under Jerome Powell, the chances of success – either by luck or by judgement – appear slight.
We admit that we have been surprised by the resilience of the economy in the face of one of the most aggressive hiking cycles on record. In retrospect, we underestimated the endurance of the fiscal largesse enacted during the pandemic, the degree to which long-term mortgage deals would shield homeowners from the effects of rising interest rates and the extent to which inflation would support company earnings even as sales volumes deteriorated. However, we believe the inevitable has merely been delayed.
By most estimates, the stimulus cheques handed out by the US government during the pandemic enabled households to add around $1.5tr to their accumulated savings, equal to about 6% of annual economic output. These excess savings subsequently allowed many – though by no means all – households to weather the onslaught of inflation, ensuring consumption has remained a powerful engine of economic growth. However, data suggest this war chest is now close to empty, and signs of financial frailty among portions of the population are emerging. For instance, delinquencies on car and credit card loans are edging up, particularly among younger borrowers.
Unsurprisingly, banks are taking notice of the strain imposed by higher interest rates. A striking feature of this quarter’s earnings updates has been the news that US banks are already being forced to take higher write-downs on bad loans, and to set aside higher sums to cover future impairments. To try to limit the damage, they are tightening lending standards: more than one in five loan applications were denied in June, the highest rate of rejection in five years.
Meanwhile, the corporate sector is also coming under pressure. Though credit spreads (a measure of the additional yield demanded by bond investors to lend to riskier borrowers) have remained curiously subdued, the interest that companies must pay on debt has nonetheless risen sharply thanks to the Fed’s rate hikes. Consequently, companies are drawing in their horns: issuance of new high yield bonds over the first six months of the year is the lowest it has been since 2009. As debt is fuel for spending and thereby growth, its withdrawal is likely to weigh on the economic outlook.
More pointedly, increasing numbers of businesses are simply not able to bear the burden of higher interest rates. Bloomberg calculates that, globally, some $590bn of debt is either in default or distress and that bankruptcies are happening at a pace that, outside the early days of the pandemic, has not been seen since the depths of the financial crisis. We expect bankruptcy and default rates to climb steadily as, one-by-one, debts become due.
It is not particularly original to quote Hemingway at this point:
“How did you go bankrupt?”
“Two ways. Gradually and then suddenly.”
However, we think the lines that follow – and that are often left out – are also pertinent:
“What brought it on?”
“Friends. I had a lot of friends… Then I had a lot of creditors, too.”
As higher interest rates and tighter lending standards turn friends into creditors, we expect the resilience of the labour market to crumble. Unfortunately, job losses are inevitable as business models that, unwittingly or otherwise, were dependent on the availability of abundant and cheap financing are identified and exposed. Rising unemployment creates its own economic downdrafts, and so a recession begins.
The depth and severity of the recession depends in part on how long this process takes to play out. The longer interest rates remain high, the more dominoes are likely to fall – and the more spectacularly they are likely to do so. Seen in this light, ambivalent economic data which foster hopes of a soft landing seem much less benign.
We have for some time advised caution, reducing equity allocations on four occasions and skewing fixed income holdings towards high quality bonds which we expect to deliver meaningful positive returns in a recession. This is often the most challenging part of the cycle. In order to protect against the fall-out from the market’s excessive optimism, we have to be willing to position against it. Nonetheless our caution has at times been uncomfortable as equities and bond yields have marched higher. This discomfort is, we think, nonetheless worth enduring as we wait for the burden of high interest rates to finally make itself felt in the real economy – it is a price worth paying to make sure portfolios are well positioned when friends become creditors and the gradual becomes sudden.
Equity markets have regained their poise after March’s mini banking crisis; UK equities have gained c4% through the first four months of the year while US equities are now c15% higher than the lows reached in October of last year. In our view, however, investors are travelling much too hopefully – not least in ignoring the growing impact of the highly aggressive and ongoing interest rate increases imposed by central banks over the last year to tackle sticky inflation. In this context, the tightening of credit availability, a consequence of serial second-tier bank failures in the US, is likely to prove a further turn of the screw – bearing down on lending, economic activity, and thereby corporate earnings. In this note we review recent developments and present the evidence for continued caution.
US Regional Banks
At a press conference following the meeting of his interest rate setting committee on 3rd May, Fed chair Jerome Powell sought to reassure financial markets that the failure of three US regional banks was a discrete and contained series of events that was now safely in the past.
“There were three large banks, really, from the very beginning that were at the heart of the stress that we saw in early March, the severe period of stress. Those have now all been resolved, and all the depositors have been protected. I think that the resolution and sale of First Republic kind of draws a line under that period.”
Chair Powell’s Press Conference 3 May 2023
As he was speaking, however, Powell must have had a keen sense that his words were rooted more in hope than reality. The share price of another regional bank, PacWest Bancorp, was plunging at that very moment, losing more than 50%. It wasn’t the only one – shares in other second tier lenders were also plummeting.
US regional banks might be considered a dusty corner of financial markets, but they are far from insignificant for the US economy. According to the FT, US banks with less than $250bn in assets (that is all banks beyond the 12 largest) provide 80% of all commercial property loans, 60% of residential real estate loans and half of the commercial and industrial loans in the US. Unsurprisingly, given the storm they find themselves in, their willingness to lend is declining rapidly. The chart below shows two readings from the latest Fed’s Senior Loan Officer Opinion Survey, together with recession bands for the US economy. It shows that banks are rapidly tightening lending standards for commercial and industrial (C&I) loans – and also that demand for such loans is declining. As can be seen, with data going back to 1990, current readings are at or close to those seen in past recessions.
*The surveys ask senior loan officers a series of questions. Shown above are (LHS) Net percentage of Domestic Banks Tightening Standards for Commercial and Industrial Loans to Large and Middle Market Firms and (RHS) Net percentage of Domestic Banks Reporting Stronger Demand for Commercial and Industrial Loans from Large and Middle Market Firms. The scale is from +100% (all respondents replying in the positive) to -100% (all respondents replying in the negative).
Looking ahead, given that US businesses are now labouring under the yoke of interest rates at their highest level since 2007 – and regional banks are continuing to suffer deposit outflows while enduring losses on their bond investments – it appears highly likely that the situation will deteriorate further.
Economic Data and the Recession Narrative
At such times we believe it pays to watch the economic data very, very carefully. The numbers are panning out broadly as one might expect as the dead-weight of higher and still rising interest rates progressively bears down on economic activity. Readings that have historically given early indications, most notably the outlook surveys and housing market data, have long been signalling weakness ahead. Elsewhere, inflation itself has been slow to fall back while in the labour market the picture remains, inexplicably, resilient. However, in our view the direction is set and we attribute the contradictions between leading and lagging indicators to timing. The maxim that monetary policy works with long and variable timelags, although too often quoted, remains apt; we do not believe there is much more than the remotest chance that a marked economic downturn is avoided. While there are few commentators yet prepared to say that the downturn could be very painful, to our mind this is more about not wanting to be accused of talking the economy down, rather than any genuine belief that further weakness will be avoided.
Consideration of just one economic series is sufficient, to our minds, to demonstrate this point. The chart below plots theUS Conference Board Leading Economic Index (LEI) series since the late 1960s. Once again, we include recessions as shaded areas. The LEI is constructed from ten components such as manufacturing new orders and building permits. The direction and magnitude of monthly changes in the underlying components are standardised to give the index itself. As can be seen, the index has proven a reliable indicator of recessions. The current level of the LEI is consistent with US recession. The commentary accompanying the latest data release (20th April) included the statement:
‘The Conference Board forecasts that economic weakness will intensify and spread more widely throughout the US economy over the coming months, leading to a recession starting in mid 2023.’
Since 1970, whenever the LEI has reached the level denoted by the dotted line, a recession has followed.
Equity Markets – earnings and valuations
One of the ten components of the Conference Board’s Leading Economic Index discussed above is the stock market, as measured by the S&P 500 Index. Notably, it was one of just two of the ten that has contributed positively over the past six months. There is a striking irony here; if the stock market wasn’t holding up far better than circumstances justify, the LEI would be deeper in negative territory. To put numbers around our contention that equity markets are doing rather better than warranted, we highlight the current P/E ratio on the S&P 500 Index. It currently stands at 18.6x – almost exactly in line with the 10-year average of 18.5x. With earnings already suffering downgrades as higher interest rates start to bite into economic activity this, in our view, is too generous – especially as investors should be demanding a margin of safety at this point of the cycle, given the very real possibility that earnings could fall a long way should the economy tip into a recession.
Conclusion
Higher interest rates, tightening bank lending conditions and current valuations all suggest that investors should proceed with caution. We have not touched on the impact of the ongoing conflict in Ukraine, political risks around US-China relations or indeed the impending debt ceiling wrangle fast approaching in the US: all add to the argument that a defensive stance is warranted.
Given the above, it will come as no surprise that recommended portfolios are light on equities – with a preference for highquality companies that exhibit strong cash generation, robust balance sheets and earnings resilience – and heavily weighted to high quality bonds. We expect the latter to provide a degree of protection in the event of further equity market weakness and expect to recycle bonds into equities in due course as opportunities present themselves.
Stock markets have enjoyed a strong rally over the past four months amid optimism that inflation could fall back to target without a painful economic adjustment, despite the sharp interest rate increases implemented over the past 12 months. In this note we look behind the equity market strength to developments in some of the economic data and consider the likelihood of inflationary pressures dissipating without a significant economic slowdown. Our conclusion is that we are not yet ‘out of the woods’, and we continue to recommend caution.
The ‘Happy’ Roadmap for 2023
After last year’s precipitous ascent in interest rates in developed world economies, 2023 was expected to be all about a moderation of inflation and a resulting turn lower in interest rates. In recent months, inflation in the all-important US economy seems to have followed this script. Having surprised to the upside time and again through the first three-quarters of 2022, inflation appeared to peak and begin to fall back in October. Readings since then have mostly surprised to the downside, igniting hope amongst investors that victory was in sight in the battle to re-establish price stability so that interest rates could begin to fall, and economic growth could be allowed to safely re-accelerate once more – ushering in a new expansion phase.
Such sentiment saw equity markets consolidate and begin to move higher once more. From its October lows, the S&P500 Index of the largest US companies recovered by 16% to mid-February – halving the losses suffered by investors since share prices began their descent at the start of 2022. Bond markets were similarly cheered, with the yield on the US 10-year government bond moving down from 4.25% in late October to 3.37% by mid-January. The ‘soft landing’ scenario – where inflation drains away without impacting economic growth too much or taking unemployment meaningfully higher – seemed to be the central scenario being priced into financial assets. Hopes for a soft-landing were bolstered by an improvement in some indicators of the health of the US economy, suggesting that interest rate hikes have not sapped economic growth. Data here includes resoundingly strong new job creation, extremely low unemployment and resilient retail sales.
A Dose of Reality
We remain doubtful that such a rosy outcome is likely. While the idea of the economy remaining strong as inflationary pressures disappear of their own accord is hugely appealing to policymakers and investors alike, it doesn’t appear plausible. To believe that inflation can return to the 2% target while US unemployment is at a 50-year low, and wages are growing far in excess of a level that is consistent with this target, is simply too optimistic.
In support of this view, the latest twist in the data has seen the soft-landing narrative begin to morph into something much less cheery: a ‘no landing’ scenario. Here growth does not slow – and inflation does not fall back to target. To us, ‘no landing’ simply indicates that inflation isn’t responding to the policy measures taken to date – that the medicine of serial interest rate hikes has not been strong enough, or applied for sufficient time, to return US inflation to target. It is not a happy outcome; further interest rate increases would follow, increasing the pain inflicted on those sectors of the economy that are very sensitive to higher interest rates, such as housing. It also seems likely that higher interest rates for a longer period would increase the likelihood that when the economic slowdown does arrive, it will be of the hard variety. This, of course, will provide further challenges for investors.
In recent days this message has begun to get through to financial markets. Government bond yields have started to climb once more, with the 5-year US government bond yield rising from 3.64% to 4.19% through February (see chart). This indicates that bond investors now believe that interest rates may need to rise further – and have to stay at elevated levels for longer to force inflation back towards target. Such developments have halted the stock market rally, at least for now, with US equities peaking at the end of January.
Last Friday, new data confirmed that optimism that inflation might ease while economies remain strong might well prove misplaced. The Personal Consumption Expenditure (PCE) measure of US inflation ticked higher once more with an annual core measure (which excludes food and energy) of 4.7% for the year to January, up from 4.6% in December. For completeness, the headline number was reported at 5.4%, again higher than expectations and higher than the December reading of 5.3% (see chart). Of course, these numbers might be a one-off, but taken together with coincident indicators of economic resilience elsewhere, investors would do well to take heed of the mounting evidence before them.
Portfolio Positioning
We have been surprised that the scale and speed of the interest rate increases across the developed world has not, thus far, had greater impact on economies and in particular, labour markets. This may be down to the much-discussed time lags in the transmission of tighter monetary policy to the real economy or possibly to changes in the structure of markets, such as that for labour, which alter the sensitivity to higher interest rates. Either way, it now seems more likely than not that the path back to 2% inflation will be prolonged and uneven – and may well involve a recession.
From a portfolio perspective, flexibility remains our watch word. We continue to look favourably on the now higher levels of income available from high quality bonds and indeed are recommending additions here, given that yields have ticked higher again in recent weeks. Aside from the yield on offer, bonds should provide a degree of protection as and when economies eventually slow under the weight of successive interest rate rises. While there is, of course, some risk that yields rise further still (bond prices fall), in our view this is becoming an increasingly asymmetrical bet – with interest rates and yields unlikely to be sustainable at higher levels in the medium term.
Turning to equity allocations, these have been much reduced from the recommended positioning twelve months ago. Within equities we continue to believe that earnings visibility and quality should fare better than the market more broadly, but we are taking advantage of recent strength in markets to reduce portfolio sensitivity to a prolonged period of elevated interest rates – as we judge the risk of such an outcome has now increased.
Finally, with regard to overall portfolio positioning, we believe that re-risking via additions to equities in due course will prove profitable and are carrying out research to identify the appropriate funds. At present, however, given the uncertainty surrounding the path of growth and inflation, and therefore interest rates, this seems premature.
Very few investors will rue the passing of 2022. The Financial Times headlined its final issue of the year with ‘Markets lose more than $30tn in worst year since financial crisis’. In stark contrast to the crisis of 2008 however, 2022 offered investors almost nowhere to hide, with high quality bonds suffering significant losses alongside equities, thanks to the cascade of interest rate increases imposed on economies in response to an inflation shock that built progressively over the year. With the key central bank, the US Federal Reserve, still talking tough on further rate hikes and concerns that the impact of a possible recession is not yet fully discounted in share prices, the traditional, rose-tinted outlook that greets most New Years is notably absent. In this note, we revisit a key lesson from last year, try to put some context around the derating of equities with help from Wall Street legend Peter Lynch and consider what this implies for investment markets and portfolios as 2023 begins to take shape.
The Fed
If there is one lesson we might usefully re-learn from 2022 it is that forecasting macroeconomic variables such as inflation, unemployment and interest rates is very difficult. Believing that Fed. chairman Jerome Powell had any special insight when he repeatedly stated that inflation was transitory and that interest rates would not need to increase in 2022 was a pit into which many stumbled. Despite the innumerable economists working for the Federal Reserve, Powell’s assertion proved no more than misplaced optimism. Looking ahead, this might lead us to question the degree to which we should believe his latest pronouncement – that interest rates will now need to rise further and stay higher for longer. They may or they may not, depending on the path of unemployment and inflation data from here. Powell and the Fed are ‘data dependent’, they will respond to the evidence as it evolves – especially with regard to the labour market and wage growth. We should keep this in the front of our minds as we contemplate the consensus view – that investment markets will continue to struggle. The chart below shows the extent to which equities and bonds fell last year. After such marked weakness we need to be mindful to avoid the trap of allowing past performance to colour our judgement about the future. Asset prices are now meaningfully cheaper, and we should factor that into our investment decisions moving forward.
Fidelity’s legendary manager
Our Christmas-break reading included revisiting one of the great books on investing, One Up on Wall Street by Peter Lynch. Lynch was the celebrated manager of Fidelity’s Magellan fund in the 1970s and 80s. He achieved returns of close to 30% p.a. over 14 years until his retirement in 1990. We were struck by his humour and clarity of thought, particularly about what he could and couldn’t do as an investor. With regard to equity markets, his straightforward but very helpful insight was that, while he had no idea at all whether the next 1,000 point move in the stock market would be up or down, he knew with some certainty that the next 6,000 points would be up. His logic is simply that the short-term volatility of the economy quickly becomes irrelevant, while corporate earnings grow over time – and share prices move higher to reflect this fact. This is useful not only when putting last year’s weakness into context, as discussed above, but also when digging into individual stocks:
‘I don’t think people understand there’s 100% correlation with what happens to a company’s earnings over several years and what happens to the stock’.
It forms part of One Up on Wall Street’s repeated focus on the obvious, but seemingly often ignored fact that behind every stock there is a company, and an investor must know what they own. This brings us to our next section – on the sorts of stocks we prefer at this time of great uncertainty.
Ferrari
We were struck by a CNBC article late last year reporting, in a surprised tone, that despite surging fuel prices, rising ESG concerns and the hype surrounding electric vehicles, the best performing car manufacturer in 2022, in share price terms, was Ferrari.
Truth be told, the hurdle was not high. Ferrari shares declined by c15%, compared to most of the start-up electric vehicle manufacturers losing c75% of their market value, and volume car makers such as GM and Ford losing c40%. In fact, one might have hoped for better from the shares of the Italian sportscar maker. The chart below illustrates perfectly the Peter Lynch quote – the Ferrari share price has closely followed the company’s earnings growth since its flotation as a standalone company seven years ago. At least it did so until late in 2021. Since then, earnings have continued to grow but Ferrari shares have fallen back.
Is the recent divergence of the company’s share price from its earnings noteworthy? What is the correlation breakdown telling us? In our view, nothing at all. The fall has been part of a general de-rating of equity markets as higher bond yields began to offer investors attractive levels of income for the first time in 15 years – and analysts used higher interest rates when calculating target share prices for equities. The latter simply resulted in lower ‘theoretical’ share prices for all companies – but particularly those faster growing companies trading on higher PE multiples. How do we know that the share price is not signalling declining earnings ahead? Of course, we cannot be certain, but we do know that as recently as November Ferrari raised its profit guidance for 2022 and stated that it foresaw no problem with demand in 2023, regardless of the economic conditions. In our view, Lynch’s 100% correlation will reassert itself in due course.
Moving from the specific to the general, charts for many of the largest holdings in our recommended portfolios look similar; at this juncture we prefer to own high quality companies that possess a history of delivering consistent earnings growth through the economic cycle. Below we share just one more example, LVMH, the French luxury goods company. It too has suffered a derating despite continued earnings growth. Sooner or later, as long as the business model remains intact and management continue to execute, the share price should catch up – and track higher along with continued profit progression. The key point is that the strong underlying business economics of such companies mean that they are largely insulated from the short-term ups and downs of economies and interest rates. The appendix displays the impressive 5-year annualised total return and earnings per share growth for the 10 largest underlying equity holdings in our recommended portfolios.
Portfolio characteristics
As 2023 gets underway, the range of possible outcomes for investment markets appears extraordinarily wide. A positive year for equities and bonds is entirely possible should inflationary pressures ease more quickly than currently assumed. At the other end of the spectrum, inflation and wage growth could remain stronger for longer – leaving the Fed with little choice but to continue hiking interest rates. This would most likely result in another year in which markets struggle. Other factors will also, no doubt, come into play, not least the Russia-Ukraine war and its continued impact on energy prices but also, for example, the path of China’s reopening and possible changes to Japanese monetary policy. Clearly, there is plenty to concern investors, however, as noted above, equity markets have endured a reset and valuations are now much more attractive. This is also the case in bond markets, where yields are now more attractive than they have been for over a decade.
As a result of this heightened uncertainty, recommended portfolios are positioned for flexibility. Allocations to cash and short-dated bonds are included to provide yield and defensive characteristics while the equity allocations, much reduced through 2022, are skewed towards the types of companies discussed above – those with strong business models which should prove resilient to short term volatility while also having the potential to participate in the upside when the macroeconomic picture brightens. Should the likelihood of the latter increase, holdings of defensive assets give us the flexibility to rebuild risk asset positions to capitalise on an economic upturn.
Appendix
The ten largest equity holdings within Heronsgate Capital Model portfolios:
| Stocks | Annualised Return, 5 Year (%) | Annualised EPS Growth, 5 Year (%) |
|---|---|---|
| Microsoft | 24.2 | 24.1 |
| Mastercard | 18.4 | 12.6 |
| ASML | 30.3 | 27.7 |
| LVMH | 24.2 | 18.2 |
| Novo Nordisk | 25.4 | 10.1 |
| TSMC | 18.2 | 24.8 |
| Lonza Group | 12.2 | 2.0 |
| Alphabet | 11.1 | 28.5 |
| Ferrari | 15.8 | 9.6 |
| Cadence Design Systems | 30.9 | 24.4 |
