Summer should be a time for positive moods to flow. The evenings are light, the central heating goes off as the temperature outside goes up, the beaches fill with eager sunworshippers and conversations about summer holidays abound. Glastonbury, the Euros, the Olympics are all still mostly ahead of us…
Instead, market sentiment can be best described as anxious at best. Financial markets have spent much of 2024 being scared of their own shadow. Fearful of recession, inflation, US/China trade wars, tariffs, right-wing populist politicians, elections, Gareth Southgate and the experiment with Trent in midfield and probably a few other things I’ve forgotten in between.
All paths lead to Rome
The Romans were a smart bunch, conquering all the best Mediterranean summer holiday destinations within their empire with the vision and foresight that would have made it a world beater tourist hotspot had it only lasted another 2000 years. Alas, you can’t time the market. Suffice to say, the history books say they ‘only’ ruled over c2 million square miles and about 1/5th of the world’s population at its peak until it collapsed under the weight of its own expansion. Simple ideas, like straight roads, helped make for efficient expansion.
The desperate search for clarity and visibility has driven ‘the market’ to a single, simple path of expansion too. Whatever the chief concern at the time, be it interest rates up or interest rates down, growth up or growth down, all paths lead to a small number of US mega-cap tech companies.
Performance of the US equity index, the S&P 500, remains dominated by several large US tech companies with high valuations. The valuation of the top ten stocks is currently 30 times forward earnings, which is tracking about 50% higher than the average for the last 30 years (ish). Separately, an index of US technology stocks separately trades with a price to sales ratio well ahead of any point in the last 30 years too. Sticking with the thirties theme – the number of times the S&P 500 has hit an all-time high this calendar year? 33.
Putting aside the techie ‘stock valuation’ point. Investors today are paying a high amount for the continuation of a trend that has been in place since the global financial crisis – namely the continued domination of US equities. That may well indeed be true, but as valuations rise, if the laws of investment still ring true, the likelihood of future investment returns fall too.
But for now, a simple solution for an ever more complex and challenging world, continues to be the path of least resistance.
You pays your money, you takes your choice.
“There is nothing more deceptive than an obvious fact.” Sherlock Holmes
Through the first half of the year, we have seen fixed income markets return to their sobriety, after a period late last year, where they accidentally got carried away thinking interest rates were going to get cut much more quickly than turned out to be the case.
In recent weeks, we have seen the first interest rate cut from a G7 nation with the Central Bank of Canada cutting rates by 0.25% during early June, which was swiftly followed by the ECB, which made its well-flagged cut at its last meeting. It was so well flagged in fact, that if the ECB were basing their decision only on the data set they were being presented with, they may not have been compelled to make the same decision. Either way, the rate cutting cycle is upon us and whilst there’s significant doubt on the exact timings and how far major central banks will go in this cycle, the direction of travel is clear. Lower, it is.
The most famous resident of 221b Baker Street would be looking across Regents Park towards Threadneedle Street and wondering what was prompting the inaction at the “Old Lady”. The obvious facts, Sherlock Holmes would no doubt ponder, is inflation is on target having fallen a whole 9% points in under 2 years, unemployment is low, growth is weak and yet we have the highest interest rates we’ve had since early 2008. Sherlock could reasonably be expected to conclude that something is indeed amiss. Yes, there are caveats to incorporate. Services inflation is higher than the Bank expected, airline fares (the Euros dash?) as well as package holiday prices have risen, accommodation costs (such as hotels) have also kept this part of the inflation calculation elevated, presumably supported by the recent rise in the national living wage.
Source: Consumer price inflation from the Office for National Statistics
We wrote in the previous quarterly the real interest rate (the interest rate after adjusting for inflation), has been steadily rising. The more inflation falls and the longer interest rates now remain at their peaks, the longer the period of pain being inflicted on households and the more unnecessary damage is heaped on an already weak economy. But as Sherlock also pondered, “It is easy to be wise after the event.”
The Euros have kicked off – avoiding own goals
Despite the header, this is nothing to do with football. The elections for the European Parliament triggered a kneejerk reaction in Paris where President Macron called for a snap election. In a year full of elections, yet another and this time unexpected one, helped create uncertainty and prompted weakness in several European bourses, particularly in France and within French banks. French bond yields spiked too – the yield gap between 10-year French and German bonds widened to levels not seen since the dark days of the European debt crisis. With the French running a heavy fiscal deficit and debt/GDP at elevated levels, all of a sudden, the Southern European countries are looking at their northern cousins with some justified concern. The ‘southerners’, who took the European project close to the wall early in the last decade, know a thing or two about living fiscally foot loose and fancy free. However, they are now growing their economies faster than the north, bolstered by a less-damaging energy crisis and benefitting from a more favourable economic backdrop as inflation falls and debt burdens lessen. Spanish households, have for example, been fastidious in reducing their debt burdens following the excesses that had been built up in the early part of the millennium.
Source: J.P.Morgan Asset Management, Guide to the Markets-UK. Data as of 13 June 2024
This all makes for interesting politics as likely winners from the election are promising increased public spending at a time when the European Commission is proposing to place France (amongst others) into Excessive Deficit Procedures (aka ‘the naughty step’). This does raise the prospect of increased instability within the institutions of the EU and increased wariness on the part of investors to invest in the region. The previous decade saw Europe stumble from one crisis to another and cause major market disruption and dislocation, that kind of chaos needs to be kept in the history books.
Inflation – A bit like Play your Cards Right?
For anyone under the age of 25, ie before the internet became a ‘thing’ for entertainment people used to either go out or watch TV. Sometimes we’d even talk to each other. Of the four channels we were blessed with, game shows used to be a big draw and none more so than ‘Play your Cards Right’. During the 1990’s, with Bruce Forsyth as host, it regularly attracted 8-10 million viewers, which paled in comparison to the 1980’s when up to 15 million people tuned in. But there were only 3 TV channels then and conversations were obviously not flowing around the troubled nation. In ‘Play your Cards Right’, contestants would have to answer questions to take control of a row of playing cards and then guess whether the next playing card was either higher or lower, whilst the audience shouted wildly, before Brucie did the grand reveal and the contestant either left disappointed or ultimately went on to win the grand prize. Usually, it was something practical. Like a jetski.
My memory may be failing me on some of the finer points here (the Price is Right, may have been the jetski one), but markets are reacting like a hysterical ‘Play your Cards Right’ audience, shouting higher or lower to each and every bit of economic data with more vigour and excitement than is truly warranted. The trouble for the Federal Reserve is the damage they caused to their own ‘forward guidance’ back in early 2022, when the current Chair of the Fed Jerome Powell, rubbished the chance of an interest rate hike of 0.75% being on the horizon. To subsequently then enforce a full 0.75% hike four times during 2022 destroyed forward guidance as a signalling tool to markets and forced the reliance (& over-dependency) on backward-looking data, which is a challenge when the data isn’t rock solid too.
Sooner or later, the realisation that inflation is no longer enemy number one will begin to be digested by central bankers and politicians alike. The rate of inflation has been steadily falling for the last couple of years, quickly at first and more steadily of late. The timing of the energy price cap in the UK has helped bring CPI into line, food inflation has slowed and goods are in outright deflation. In the States, idioms like ‘owners equivalent rent’ (the amount a homeowner would pay if they sold their house and rented it) are keeping headline inflation rates higher than the ‘real world’ experience. There are reasons to believe risks to inflation are to the downside – narrowing budget deficits, less accommodating monetary policy (QE), weaker retail sales and normalised supply chains will help suppress inflation in the coming months.
Growth and Inflation Numbers: More of the same
Thanks, as ever, to our friends at Schroders for the latest consensus forecasts, which as at May 2024 are:
Source: Shroders Talking Point, Q2 2024
If the consensus is to be believed, growth numbers are looking a little bit healthier than previously thought, with marginally better headline growth figures across several countries, but this is in ‘splitting hairs’ territory, rather than any ‘giant stride’ forward. The difference between 0.1% GDP up or down in households across the land is neither here nor there, with future revisions to the numbers almost certainly being more substantial than that. Formal UK GDP data gets confirmed many years after anyone actually cares.
Overall, the global economic outlook looks more resilient than anticipated some quarters ago and labour markets are not showing obvious signs of stress through the unemployment numbers. In China, weakness remains as it continues to struggle resurrecting consumer demand.
Portfolio Outlook – Time and Patience Required
From a yield perspective, fixed income is looking attractively positioned, particularly in comparison to what investors have been used to since the Great Financial Crisis. There are nuances though. Corporate credit is looking somewhat expensive, but again is delivering a good headline level of income. Credit spreads (the difference in yield between government bonds and corporate bonds of the same maturity and a measure of the attractiveness of corporate credit over government debt) are looking relatively tight and there’s a risk that they widen should the economic outlook weaken or concerns about corporate health elevate. This would be a headwind for corporate bonds. That said, we are still expecting 2024 to deliver solid returns from the asset class and continue to use a selection of investment grade corporate and strategic bond funds, whilst adding to US & UK government bonds in recent months and reducing some cautious multi-asset funds. Whilst there are arguments for and against using passive funds in fixed income markets (and we’re historically mostly users of active, go-anywhere strategic bond funds), there’s a time and a place for passive. For the years after the financial crisis, where yields were rock bottom with little margin of safety, there was a good argument for using actively managed funds. With fixed income being more of a yield story for now, with a potential steady tailwind from falling central bank policy rates, we’re happy to increase the allocation to passive fixed income, at least temporarily.
We have had two years of very narrow equity markets; energy in 2022 and mega-cap US tech in 2023 delivering an oversized amount of the total return from equity markets. The latter has, for the most part, continued into 2024. There are some highly cash generative companies in areas such as mega-cap US equities, but they also look on a rich premium. We continue to believe that valuation is an integral and important part of the investing equation. As such, over the last few years, we have been gradually edging away from areas we believe to show signs of elevated valuation and have sought out (or remain happy to continue to hold) pockets of assets which look relatively attractively valued that can also deliver an ongoing dividend or interest payment. In more risk accepting portfolios, we have been adding to smaller companies in tranches over some time now, starting in the UK, then extending to the US. With the benefit of hindsight, this looks a little premature, particularly in the US where the dominance of larger companies continues and has made for a headwind for Core portfolios over their Passive alternates. That said, smaller company valuations in the US look relatively more attractive than larger companies (fractionally below their 15-year median) and they look outright cheap in the UK. We continue to believe that smaller companies are potentially well placed to benefit from a strengthening of the economy and consumer spending, particularly in the UK, as well as being beneficiaries of interest rates turning to a downward path. But some more patience is required.
COLWMA – Winners, so humble thanks
We were delighted to be nominated in the ‘Best Market Newsletter’ category of the City of London Wealth Management Awards in April. We were even more delighted and, this time thrilled to boot, to find ourselves sitting in the grand City surroundings of the Guildhall Grand Hall in early April, and in front of our peers, walk off with the winner’s trophy. A very genuine ‘thank you’ to all those who voted!
Conclusion – “Is it raining? I hadn’t noticed”
For investors, it has been raining for so long and so hard over recent years, that in some areas we haven’t noticed some signs for optimism. The broad economic backdrop has proven to be more resilient than feared, so unless central banks refuse to start cutting policy rates, the illusion of a soft economic landing may indeed become reality. Employment remains healthy and real-terms wages are turning positive. Politics and geopolitics remain an elevated risk but should not be the driver for portfolio strategy.
Instead, we look at fixed income with renewed interest as both a source for strong income returns, but also an asset class that can deliver a solid investment return after years of ultra-low interest rates. A strong and stable income stream is an excellent starting point for future investment returns.
We look to maintain current equity weightings as this is the asset class that is going to be the foundation stone and driving force of future portfolio performance. The premise for central banks beginning to ease policy is that inflation is back under control and the economy is steady. This is not a bad backdrop for equity investors who can also source solid dividends and buybacks, that accompanied with time and patience, will allow them to capture some areas of value that are on offer.
‘Slow and steady’ may not be the most emotive rallying cry, but it remains the investment strategy of the day.
From all of us in the investment team, Emma, Will, Becky, Kim, Hayley and me, we thank you for continuing to place your trust with us in managing your portfolio.
