2023 has been full of surprises: an impending recession that never quite happens, global equity markets that continue to rally and US technology stocks whose valuations – inflated by hopes of artificial intelligence (AI) – keep expanding.
For long-term investors though, all this seems worryingly at odds with market indicators that have guided us well for decades. Recessions, for example, have consistently been predicted by a negative yield differential between short and long-dated bonds. Today this measure is inverted to an almost record degree, but US growth now seems to be accelerating. Rising interest rates should also reduce the returns on risk assets, but equity markets are still climbing. Finally, higher rates are typically anathema to expensive growth stocks – yet, the valuation of technology stocks keeps expanding.
So, should we be worried when so many of our tried and tested indicators are sending out messages so at odds with market behaviour? Yes, the indicators themselves might not function well in a world of pandemics and wars, or perhaps the message is more simple – there is trouble ahead for global investors.
The recession that never was
Looking at economic data released over the last month it is hard to avoid the conclusion that US growth is now re-accelerating. Housing, fixed investment and employment are all firming up – quite contrary to expectations. This mini-growth surge is happening despite another three US rate rises this year, with two more likely over the summer (taking the autumn peak for rates close to 6%). The US Federal Reserve is also squeezing liquidity further, by shrinking its balance sheet through quantitative tightening (QT). Yes, the US regional banking crisis briefly interrupted this policy earlier in the year, but now, along with most other developed market central banks, the Federal Reserve is reducing its balance sheet by $100 billion every month. But to what effect? Despite using all the weapons in the central bank armoury, the US economy is actually speeding up.
For investors this is particularly disconcerting, because the most reliable measure we have for forecasting slowdowns – the so-called ‘inversion of the yield curve’ – is also screaming recession. This indicator, which looks at the difference between short and long rates, has reliably called out recessions for at least 35 years. As you can see in chart 1, the yield curve is currently highly inverted; it too is forecasting a sharp slowdown despite a real US economy that is quietly accelerating.
‘Fighting the Fed’ suddenly appears to be a profitable strategy
The yield curve is not the only indicator that has been giving out false signals. Consider the long-held belief that higher interest rates imply lower returns for risk assets. Warren Buffett described it succinctly when he said that “interest rates are to asset prices what gravity is to the apple.” Look, though, at markets today and the reverse is true: world equities have rallied 23% in US dollar terms from their October 2022 lows, despite one of the sharpest rate tightening cycles in history. Other assets are rallying too; corporate bond spreads have tightened this year, while Bitcoin (the high priest of investment excess) has almost doubled.
Market behaviour is also challenging another investment maxim, namely ‘don’t fight the Fed.’ Federal Reserve Chairman Powell spoke determinedly in Portugal last week, when he stated: “If you look at the data over the last quarter, what you see is stronger than expected growth…so that tells us that although policy is restrictive, it may not be restrictive enough and it has not been restrictive for long enough." So, the central bankers’ warnings on tighter policy couldn’t be clearer, but markets have again chosen to ignore them. Not only have equities rallied, but market volatility has also collapsed. The VIX index of S&P 500 volatility is currently at 14, well below its 20-year average – see chart 2. So yes, perhaps one can take on the Fed today, and win.
We all thought growth stocks and rising rates didn’t mix
My final assumption that looks to be in the doghouse today, is the belief that rising interest rates are bad for the performance of growth stocks. The theory seems logical: higher rates mean that earnings growth tomorrow is worth less than earnings generated today. The argument implies that value stocks should typically outperform growth stocks when interest rates are rising. Yet, once again it seems the opposite is occurring – the high-growth Nasdaq index is leading market returns, while world growth indices are strongly outperforming value.
Some of this growth rally can rightly be ascribed to the excitement surrounding AI. The returns from the so-called Magnificent Seven (Apple, Microsoft, Google, Amazon, Meta, Nvidia and Tesla), companies which are seen as the early AI winners, have been extraordinary. For the year to date these seven have, on occasion, accounted for more than 100% of the S&P 500 total return. For the technology sector the result has been a sharp rise in valuations. So yes, AI is a powerful long-term investment theme, but can it really justify the surge in the valuation of growth stocks, when interest rates are rising at their fastest pace in decades?
So why are indicators that have served investors well for years, suddenly sending out so many false messages? To try and answer this let’s look at what has really changed in this cycle. Most commentators agree now that we are entering a new economic regime, in the aftermath of the global pandemic and a violent war in the heart of Europe. In response, Western electorates are demanding greater public and private investment. In the public sector they want higher spending on defence, energy transition and healthcare for an ageing and pandemic-vulnerable society. In the private sector, companies are facing demands for supply chain resilience and a re-shoring of production from perceived hostile regimes, alongside a huge technological shift towards software. These trends are of course multi-decade events, but it seems that war and pandemics have been catalysts in sharply accelerating the shift.
If we are right, this synchronised need for public and private investment will raise demand for funding, resulting in higher neutral interest rates. For investment markets, however, what matters is not that rates will be high, but why they will be high. If rates are resetting higher because inefficient public investment is crowding out private investment, then central banks will need to tilt hawkish to temper inflation. A higher discount rate without an accompanying pick-up in growth will dampen equity market prospects. If, on the other hand, nominal rates are rising because we are on the cusp of a big step-up in productivity, then the economy will likely be much more resilient. In this scenario investors will be readier to look through higher rates today, if they can see stronger and more enduring earnings tomorrow.
So which way do we jump?
Investors are at a very important crossroads: do they embrace technology-led productivity and carry on reaping the rewards from global growth stocks, or do they heed the warnings from the yield curve and other well-seasoned indicators, and sharply reduce risk? The answer, as so often in investment, is that they should act somewhere in between.
Yes, we must make sure that tomorrow’s growth themes are well represented in portfolios, but we also need a defensive core, that can anchor the wider portfolio in the event of a sell-off and/or recession. In other words, let’s hope for the best, but plan for the worst.
To try and achieve this, our strategy can be summarised as follows:
- The recent rise in UK gilt yields leaves high-quality corporate bonds yielding in excess of six percent – an attractive level. Yes, British core inflation is still rising, but the message from Europe and the US is that price rises should slow later in the year. If, of course, a global recession finally arrives, then bond prices should rise sharply and yields fall. At current yields we are moving to an overweight positioning.
- Sterling cash deposits, yielding close to five percent (and rising) have become a credible asset once more, after a decade of deliberately repressed returns. We also believe that sterling can continue its steady appreciation (it was the best-performing currency among G10 again this quarter) as political stability and policy credibility improves, from the lows of the Truss government. Our target is for the pound to reach so called ‘purchasing power parity’ of around 1.35 to the dollar.
- We are holding our global equity positioning at neutral but buttressing it with portfolio insurance. Equity volatility has been falling sharply this year, making portfolio protection programmes – where mandates allow – particularly attractive and cost-effective.
- Within our equity holdings we have exposure to many AI-based technologies, but always as part of a much wider thematic portfolio. Indeed, many of our themes can still be expressed through value stocks. Our ageing theme, for example, focuses on attractively priced global pharmaceuticals, while our climate theme is heavily exposed to European and Asian capital goods stocks, with typically lower valuations and robust dividend growth.
- After several years of strong performance, many alternative assets have been weak in 2023. In particular, UK and global infrastructure funds have reacted to rising discount rates, with sharply widening discounts to net asset value. At current levels, yields on these positions also offer compelling value, with approximately two thirds of income flows tied to inflation-linked revenues.
In summary, 2023 is proving to be a year that has confounded almost all the experts, and turned on their heads many tried and tested market indicators. In response, we are still cautiously optimistic but, a bit like Warren Buffett’s apple, we know the risks of falling to earth are very real. The result for us is a core thematic equity portfolio, but one buttressed by UK bonds, cash and portfolio insurance, in the event that our gloomier indicators are finally right. Yes, returns may be lower than in a pure equity portfolio in the short term, but as rates continue to rise you need to start driving with half a foot on the brake.
 Federal Open Market Committee, June 2023
Macrobond, July 2023
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