Welcome to our ‘November 2023 Insights’ report where we provide you with the means to keep informed of the latest economic and investment market conditions. In this report we set out our views on the current environment and the challenges and opportunities that lie ahead for investors over the next twelve months. Our aim is to keep you updated on such matters leading to better investment decisions and by extension more acceptable returns on employed capital.

Soft landing ahead?

The United States economy, the world’s growth engine and by extension the leading indicator for global growth, remains on course for a soft landing. Because of its size and interconnectedness, developments in the US economy are bound to have important effects around the world. The US has the world’s single largest economy, accounting for almost a quarter of global GDP, one-fifth of global FDI, and more than a third of stock market capitalisation. It is the most important export destination for one-fifth of countries around the world. The US dollar is the most widely used currency in global trade and financial transactions, and changes in US monetary policy and investor sentiment play a major role in driving global financing conditions.

There has been lots of change over the past few months. A warm, windy, and wet start to winter has averted the energy crisis in Europe, while in the US the consumer has brushed off bad news and continued spending its ‘Covid piggybank’. Governments have helped avert the energy crisis in Europe and ended lockdowns in China. While falling energy costs will cut headline inflation back from record levels, underlying inflation is still 4.90% in the EU and 3.70% in the US, whilst the 2% rate for central banks is still the target. The head of the IMF Kristalina Georgieva, in October, has said the “remarkable resilience” of the global economy this year has cut the chances of a painful recession in the coming quarters, even as she warned of weak growth over the next five years.

Global  fiscal policy and particularly the US has been the primary growth driver and has been incredibly supportive in recent years to households and businesses in response to the pandemic. Its effects continue to reverberate both domestically and internationally. Whilst Global price inflation has declined, we know that monetary policy operates with long and variable lags. So, it won’t be until next year until we find out whether Central Banks raised interest rates enough. Indeed, in recent days, the US Federal Reserve has commented on the uncertainty of future Interest Rate increases and the potential for more.

Ultimately, many Managers believe the Federal Reserve will keep rates higher for longer until there is verifiable evidence that inflation is back under control (or unless something breaks in the meantime), and U.S. consumer spending trends have moderated. A successful outcome will depend on energy price volatility and on the outcome of the unfolding crisis in the Middle East. So far, energy markets have looked through the geopolitical chaos.

However, it would be folly to underestimate the risk of recession over the next twelve to eighteen months, as certain challenges continue to percolate below the surface.

Outside the United States, growth trends are a little less encouraging. In the Eurozone, many of the economic indicators  suggest the region is flirting with recession, particularly in the manufacturing sector. Inflation rates also remain elevated. While the view exists that the ECB has finished raising interest rates, similar to the U.S., a reversal of course is not on the horizon. Turning to China, policymakers had been following a conservative fiscal policy, despite growth momentum slowing sharply in recent months. This policy changed in October and the Chinese government has become more willing to use its balance sheet to support its slowing economy. China’s National People’s Congress recently approved the issuance of an additional RMB 1 trillion of treasury bonds in 2023. This will increase China’s budget deficit for the year from 3% to closer to 4% of GDP. The proceeds will support growth by increasing infrastructure investment across the country. While this will be welcomed by local governments, it will not move the growth needle in a meaningful way. China continues to deal with the ramifications of a property bubble that is deflating, which will take years to run its course.

How will markets adjust to slowing GDP growth and falling inflation?

The combination of positive but declining economic growth and inflation in 2024, quarter-on-quarter will be a challenging environment for equities to navigate. The heavy lifting will have to be done by corporate earnings next year for a broad return from equities. Multiple expansion will be difficult with interest rates remaining higher for longer. Jerome Powell may land the plane in 2024, but not without some turbulence along the way.

For the remaining months of 2023, we have witnessed, and many expect a continuation of a ‘Santa Claus’ rally to look forward to as active fund managers and individual investors, underweight the stock market for much of the year, chase equities higher into year end. Performance anxiety will likely become a dominant theme. Take a look at the AAII Investor Sentiment survey for example. The latest reading shows bears outnumbering bulls by a factor of two to one. Only 24.3% of those surveyed had a bullish outlook for equities over the next six months, while 50.3% held a bearish view. The difference is reported in the chart below. Investor sentiment is usually quite a useful contrarian tool when analysing market trends.

Despite a negative performance in October where stock markets fell over -2% on average, year-to-date, global equities remains on a solid footing. November is also off to a strong start. Meanwhile, Eurozone government bonds continue to struggle as yield curves steepen across development markets. Cash is becoming an attractive alternative for conservative investors with ECB deposit rates now at 4%pa. Let’s turn our attention next to equities to discuss what may lie ahead next year for this important asset class.

 

Equities

Annualised performance data in euros at 31st October 2023

We know that equities are valued by assessing a stream of future earnings, discounting those cash flows by an interest rate, and then adding a risk premium. Over the last decade, interest rates fell to historic lows and liquidity was abundant, thanks to your local central bank. Good times led to strong corporate earnings growth and P/E multiple expansion, excellent news for equity investors. Alas, times change, and those good times may now have passed. Today, interest rates are high(er), and liquidity is being drained from the system to the tune of $80 billion per month in the US. So far, corporate earnings have remained resilient and P/E multiples have remained elevated.

In a pro-capital world, companies hold the pricing power. During boom times, as productivity rates rise, companies prosper, their share prices appreciate, and economies tend to operate at close to full employment. During downturns, as corporate margins contract and capacity utilisation rates decline, unemployment rates tend to rise. Today we are living in an ageing society where retirees are starting to outnumber those in the workforce. There are fewer employees available to work. It is possible we are transitioning to a pro-labour world where unemployment rates remain structurally low and pricing power transitions from the board room to the factory floor. It is too early yet to tell, but there are signs that employee power is on the rise. If true, this will mean pressure on corporate earnings and margins, and another headwind for equity investors to navigate.

Today’s stock market is dominated by a handful of tech giants. Companies like Apple, Microsoft, Amazon, Google, and Meta are quasi-monopolies that continue to operate in a pro-capital world. The recent sharp rise in interest rates has had limited impact on the share prices of these tech titans. They still command pricing power in the sectors in which they operate. They continue to dominate their competition. Their share prices also benefit from the relentless demand for passive indexation strategies that have dominated the investment industry in recent years. The larger the market capitalisation of a stock, the more money is allocated to the name, irrespective of valuation; a flawed strategy but one that still persists.

Outside of this narrow tech-dominated field, an increasingly pro-labour world comes into view where small and medium sized companies operate in a more challenging and competitive environment. Wage pressures are rising. This is impacting corporate margins and is reflected in the recent share price performance of the Russell 2000 Index (small and medium market cap companies) relative to the S&P 500, which is dominated by the mega-cap stocks. Since peaking in late 2021, the Russell 2000 has fallen -29%. Meanwhile, the S&P 500 is just -8% off its late 2021 highs.

If inflation rates remain sticky in 2024 or fall to a new floor above the Federal Reserve (and ECB) target levels of 2%pa, we can expect a lot more investment analysis and research next year explaining why corporate margins are being negatively impacted and potentially why stock markets are having a more difficult time.

Bonds

Annualised performance data in euros at 31st October 2023

In our September investment update, we discussed how long duration government bonds remained unattractively priced. The US yield curve at the time was inverted by 70 basis points with 2-year yields at 4.9% and 10-year yields at 4.2%. Since then, long duration US government bonds have continued to fall in price. 10-year yields have risen 40 basis points to 4.6% while 2-year yields have held at 4.9%. The curve has flattened but remains inverted by 30 basis points. Unless we are headed for recession in 2024, a view many Managers do not subscribe to, long-term bonds should offer a premium to shorter-dated fixed income securities to compensate for the longer duration of the investment. The yield curve should not be inverted. Looking back over more than forty years of data, 10-year yields have at times exceeded 2-year yields by over 200 basis points. There is still plenty of room for long duration bond yields to rise and values to decline.

Drivers behind the sudden rise in long-term yields include the recent surge in issuance this year in the US to fund their exploding deficit; quantitative tightening by the Federal Reserve as Jerome Powell looks to reduce the Fed balance sheet by selling some of the bonds they own; investor concern about growing US deficits and debts during non-recessionary times; and more simply, the impact of the Fed’s repeated message of keeping rates higher for longer. It is most likely a mix of all of these factors that continues to weigh on government bond prices.

Alternatives

Annualised performance data in euros at 31st October 2023

Most traditional assets appear to be pricing in an expectation of near-flawless central bank policy decision making, anticipating that central banks can deftly tame inflation without prompting a subsequent meaningful recession. Listed alternatives, on the other hand, appear to be pricing in a far more pessimistic outlook. Alternatives can be a powerful force in portfolios beyond diversification. For example, infrastructure and real assets can offer protection if inflation lingers (or, in a worst case, reaccelerates). Private credit can benefit in an environment with higher interest rates and tighter financial conditions, and experienced managers can capitalise on stress in commercial real estate. In all, Managers see opportunity in a world in transition despite the recent track record of this sector.

Sector in Focus  –  Safe as houses?

This month, we turn our attention to the property market as we examine the recent challenging performance of the real estate investment  sector in Europe. We consider whether the worst is now over for this alternative asset class. There is no sugar-coating it, European Property Vehicles have been a terrible investment in recent times having lost -10.5% per annum over the last three years and -8.0% per annum over the last five years. Earnings expectations for the sector have cratered by -25% since January 2020. The pandemic clearly hit the office and retail sectors very badly, while industrial and residential delivered a more resilient performance during that period. However, the recent surge in interest rates has hit REIT investors particularly badly.

After years of underperformance, EU REITs are starting to reflect value. However, as with most assets, we will only know if such potential is delivered, when we are looking back. Whilst appetite is very limited for Property as an investment, since March of this year, many companies  within the sector have turned a corner and have started to trend higher.

Is the worst over for the EU REIT market? Possibly not. Ultimately, global macroeconomic factors will dictate the extent of future price performance for the EU REIT market. Real estate prices and rents tend to be most affected by changes in interest rate and inflation expectations. When rates and inflation are high but falling, REITs have delivered positive returns historically. However, REITs are also positively correlated with the business cycle. So, if recession risks begin to rise, this would be a negative development. A number of headwinds still remain. Once we see recession stories on the front pages of the newspapers, this should mark the turning point for the sector.