Over the last quarter, despite the dampening effect of higher interest rates and the impact of higher inflation, many economies have recorded modest levels of economic growth. Overall the investment outlook has been brightening, as inflation and interest rates appear to be stabilising. In addition, consumer demand has remained remarkably resilient, helped by lower energy prices over the last few quarters. Policymakers remain concerned about rising prices and we remain concerned that the effects of high interest rates will continue to be felt for the foreseeable future. A meaningful period of tighter financial conditions still seems likely, and corporate earnings growth looks set to slow. As a result we maintain our belief that a well-diversified, cautious approach is paramount.
Tensions between the US and China are perhaps the biggest source of risk for the global economy and financial markets. The interdependence of companies in both geographies is such that the economic implications of a deterioration in diplomatic relations would be significant. Should tensions escalate, apart from the obvious risk to Chinese and Taiwanese stocks, the highest risk may be for large-cap US stocks, many of which derive significant revenues or rely on supply chains from China. European and Japanese financial markets could also be expected to be impacted for similar reasons. On the flip side, should the tensions ease, we could expect gains for Chinese equities.
As for the war in Ukraine, the waning of support for Ukraine and the potential for Trump to be elected next year who might seek an immediate settlement, suggests that Putin needs to hold on and let this play out to achieve his goals. This is a significant long term problem for European security and stability, where the limited consensus is fracturing.
However, our biggest concern and the rationale behind our cautious approach is the lagged effect of tighter monetary policy not least when considering corporate and individual refinancing of debt at much higher rates. Economies that have been robust so far may find this environment increasingly challenging as the full effects of higher interest rates play out. Although most economies are still growing, including the UK domestic economy, several indicators for future prospects have deteriorated. Headline inflation rates have moderated in many Western economies, but remain above central bank targets. Whilst I feel that interest rates may not materially rise from here, a prolonged period of tight financial conditions appears likely as central banks seek to reduce inflation further. Additionally, household savings, which have helped finance consumers’ spending, are rapidly diminishing and consumers have now burned through the savings amassed during the pandemic.
There might be a limit to how far inflation can fall. This is in part fuelled by wage rises and other areas, such as energy where the recent increase in the oil price toward $100 could lead to a revision of inflation expectations. OPEC’s production cuts have caused the oil price to gain around 20% since mid-June. At current levels, oil will move from a deflationary to inflationary force in the final quarter of this year, something which has not yet been factored in to inflation expectations.
It is worth highlighting that recent equity market strength has been largely driven by a select number of technology stocks, the so-called ‘Magnificent Seven’ big tech firms – Apple, Amazon, Google parent Alphabet, Facebook parent Meta Platforms, Microsoft, Nvidia, and Tesla. These collectively account for nearly 34% of the total market capitalisation of the S&P 500 and have contributed nearly all of the performance year to date, whilst the remaining holdings in the index have collectively fallen by 2%. One should not forget that the tech heavy NASDAQ index fell -33% in 2022 and to this end share prices of the ‘Magnificent 7’ may be vulnerable if future profit expectations need to be scaled back. Artificial Intelligence (AI) has the potential to materially change industries and businesses, but we are concerned that AI enthusiasm has got ahead of itself, as outlined by the number of mentions of AI in recent company results.
It is important to highlight that Apple alone makes up 8% of the S&P index and whilst many investment managers have increased the overall direct equity asset allocation to the US from two years ago, the preference still remains to have broader diversification across all asset classes and holdings in soundly financed companies with genuine pricing power which we feel still offer the best opportunity to protect portfolios from inflation and the impact of higher rates globally.
Longer-dated bond yields are at attractive levels relative to recent history. However, post-pandemic governments are generally playing a more prominent role in managing the economic cycle, spending heavily on welfare, defence and the green transition. With debt levels already high, significant further debt issuance may bring about a steepening of yield curves. In this environment I would favour investing directly in shorter duration UK conventional gilts. Holdings in shorter-dated bonds, spread across different currencies can provide diversification as well as a guaranteed nominal return. Additionally, the bonds can be sold quickly to fund an increase in equity weightings when confidence improves.
Our preference remains concentrating on reducing the use of collective funds in the UK, US and Europe and building up holdings in those direct equities where the longer-term outlook appears to be positive and where valuations are underpinned by fundamentals. In overseas markets, such as Japan where there is good reason to be optimistic about the outlook for the Japanese economy, collective funds have been used with positive results to take advantage of the broad-based recovery in consumer spending and business investment.
To conclude, our focus remains on selecting well-managed blue chip companies, with strong global market positions and genuine pricing power, where valuations are underpinned by fundamentals and to hold for the long-term. A period of market weakness could provide a reasonable point to materially increase equity allocations to more cyclical orientated domestic companies, but we are not there yet.
The value of securities and the income from them can fall as well as rise. Past performance should not be seen as an indicator of future returns. All views expressed are those of the author and should not be considered a recommendation or solicitation to buy or sell any products or securities.