Global equity market returns have been flattered by the excitement around generative artificial intelligence (AI), which has propelled a small number of large technology stocks higher. Interest rate rises, tighter credit and lower liquidity will eventually take their toll on economic activity, corporate profits and the valuation of risk assets.
Equity markets have risen against a backdrop of cautious investor sentiment and better-than-feared economic growth, and performance has been flattered by a small group of US technology companies.
Recent breakthroughs in AI have taken the NYFANG+ index up 80% from its November lows. Year to date, the seven largest companies in the S&P 500 have risen 47%, whilst the remaining 497 stocks are up just 5% in aggregate (in US$).[1]
The global economy is proving to be resilient to interest rate rises, but leading indicators and the extreme inversion of the yield curve suggest a more meaningful economic slowdown by the end of 2023 or early 2024. Economic growth is cooling, but strong corporate, consumer and bank balance sheets, in addition to long-term borrowing at low rates, have muted the effect of higher short-term interest rates.
Market commentary from similar periods, such as 1971 or 1980, shows that hopes for a soft economic landing are normal at this point in the cycle. It is tempting to assume that because higher interest rates and slower fiscal spending have not yet created an economic contraction, a recession is increasingly unlikely. This is complacent: monetary policy works with variable lags, making it difficult to judge the level of interest rates and the time required to finally reduce excess demand.
Corporate earnings may have peaked
Large companies have been able to raise prices rapidly in the past two years. This has supported revenue growth whilst offsetting cost inflation, pushing corporate earnings well above their historic trend. More recently, corporate profit expectations have stabilised and are expected to make little headway until 2024.
Volume growth is slowing to a crawl in some manufacturing industries as demand is sated and reduced by higher prices. Meanwhile, the lagged effect of wage increases and the hedging of input costs means overall costs could grow faster than revenues, pushing margins back towards pre-pandemic levels.
The US and European economies are highly dependent on consumer spending. In the US, pent-up savings are being run down, the cost of credit is rising and homeowners are less able to tap into the value of their homes. Meanwhile, credit card and auto loan delinquencies are rising. The surge in demand for physical goods during the pandemic is over and declining consumer confidence suggests demand for services will also wane.
Rates may still have further to rise
Inflation has begun to decline in most major economies, but is still uncomfortably high for central banks. In the US, the consumer price index (ex food and energy) is above 5%, whilst UK core CPI is an alarming 6.8%.[2] Although wage inflation has probably peaked, labour markets remain tight and wage growth remains an important component of sticky inflation. This poses a dilemma for central banks in deciding whether to tighten rates further, which could precipitate a deeper-than-necessary economic slowdown.
Some investors believe that US interest rates have already peaked and will be cut in coming quarters as inflation returns to a more comfortable level. However, the resumption of policy tightening seen in Canada and Australia, where rates were thought to have peaked, is an equally plausible scenario in the US if economic growth and inflation remain robust. Meanwhile, the European Central Bank (ECB) and Bank of England (BoE) have signalled further monetary tightening, despite the weakening outlook in these economies.
Liquidity could trump all
Liquidity can have more impact on market returns than the fundamentals of economic growth and company profits. Quantitative tightening (QT) has not been a major constraint on markets so far, thanks in part to emergency funding provided by the US Treasury when three US banks failed in March.
Following agreement of a new debt ceiling in the US, there is now an urgent need to replenish the Treasury General Account by selling at least $500 billion of US government bonds.[3] This may sap liquidity from markets, and the consequent reduction in availability of credit to small businesses and commercial real estate will take its toll. This, combined with the resumption of QT, could make liquidity a headwind for markets, just as economic growth slows, corporate profits come under pressure and unemployment rises.
Slow start from China
The reopening of China’s economy was expected to drive a resurgence of growth in Asia and offset the slowdown in Europe and the US. The reality has been less impactful: Chinese property and manufacturing industries have lagged, and the labour market remains weak.
There is some evidence that Chinese consumer spending is recovering, but the government’s pandemic policies and geopolitical tensions with Western powers have impaired confidence. The Chinese government has recently eased policy. Further easing combined with the removal of restrictions on group travel could help nurture a more durable recovery, which would benefit our Asia-orientated stocks.
Chinese companies listed in Hong Kong and on the mainland are cheap relative to global markets. This is an opportunity to add to select consumer and technology companies where sentiment is depressed and the potential for recovery underestimated.
AI buoys markets
The breakthrough in AI provided by large language models, or generative AI, has been a spur to equity markets since ChatGPT was released in 2022. Generative AI is likely to be a disruptive and transformative technology, but its current impact is concentrated in a handful of large semi-conductor and technology companies. Most of these companies trade at valuation multiples that imply rapid adoption and monetisation of generative AI. It remains to be seen whether this is over-optimistic.
AI will boost companies that can use it to enhance their products or deploy it to reduce costs faster than peers. A technology paradigm change also tends to be disruptive for some incumbent companies whilst creating new winners, many of which will emerge from private markets.
Waking up to the weather
The US Climate Prediction Center has confirmed that El Nino conditions are present. Previous El Nino effects, such as in 2014-16, included higher temperatures, prolonged droughts, extreme weather events, disease and inflated crop prices. Already this year, a step up in adverse climatic change is evident in Canada, Asia and Southern Europe, together with higher crop prices for coffee, sugar and cocoa.
Further manifestations of climate change should awaken policymakers and investors to the need for urgent change, which should be supportive of the companies in our Climate Change theme. We believe our portfolios are well positioned to help investors address many of the challenges of climate change and transition as evidenced by their low carbon footprints in comparison with global indices.[4]
Limited upside for the time being
The valuation of the US market, at 19.5x earnings[5], offers limited upside from a soft landing and considerable downside in the event of widespread de-risking and declining profit expectations.
Excluding the seven largest companies, the US market is valued at approximately 15x earnings, which appears fair at best, with cash yielding 5% and 10-year US government bonds at 3.7%.[6] The dominance of US markets in equity indices also limits upside for global equities, even if lower-valued markets such as Japan, China or the UK re-rate.
Until there is confidence that the global economy can escape late-cycle pressures, disruptive growth and defensive franchise companies will form the core of our global equity portfolios. We also continue to seek opportunities to diversify our exposure to an Asian economic recovery and to favoured thematic opportunities, for example in ageing and climate-related stocks.
As corporate profits and market valuations adjust lower there will be opportunities to add cyclical risk to portfolios. Until then, defensiveness and patience will be rewarded.
[1] Sarasin & Partners and MSCI ESG Manager, June 2023
[2] S&P Global, June 2023
[3] S&P Global, June 2023
[4] Office for National Statistics, 2023, as at April 2023, U.S. Bureau of Labor Statistics, 2023, as at April 2023
[5] FTI Consulting, 2023
[6] S&P Global, 2023
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