View From The Top: For real?
View from the very top: These have been good times for those who participated in 2023’s equity market rally. Such rallies can become self-sustaining, particularly if investors fear that they may be missing out. A more sober assessment would suggest that not only have market returns been highly distorted by the distinct outperformance of a few significantly-weighted names, but also that the macro environment remains highly uncertain. Beware of complacency. A recession may still happen, particularly since Central Banks continue to struggle to repress inflationary pressures and stand committed in their fight to quash inflation fully. Further tightening until something breaks may well be the order of the day. Nonetheless, for as long as the economy is showing resilience and corporate earnings are holding at least stable, equities can remain in vogue, valuation considerations notwithstanding. Fixed income may offer a better risk-reward at this stage of the cycle. Our counsel: be patient – don’t chase the market – but highly opportunistic too.
- Equities: Take whatever narrative you want, but equities globally are at (or close to) 12-month highs. The upside has been partially driven by the fact that corporate earnings have generally been less bad than feared, sustaining forward estimates for now. Nonetheless, after such a strong H1 rally, the scope for near-term upside to equities is more limited, even if bubbles can sometimes prove self-sustaining for longer than expected. Looking ahead, we believe that a higher rate environment where inflation is present only raises the risks to earnings, with visibility for 2024 estimates currently low. Against this background, stock-picking matters. We continue to favour a balance across both growth and value.
- Fixed Income/Credit: US bond yields have risen from their Q2 lows as the prospect of further rate increases has grown. While we do see a generally better risk-reward profile in bonds versus equities (based on yield), a rally in bonds will only likely prove sustainable once the US economy weakens, inflation falls further and the Fed potentially capitulates. Our approach emphasises keeping it simple and favours owning high-quality credit (both government and corporate).
- Gold: The price of gold has fallen from its recent highs (given its negative correlation with real bond yields), but we continue to see a place for its in portfolios, given gold’s role both as a real asset and a safe haven; think of it as a hedge against geopolitical uncertainty and inflation.
- Alternative Assets: Assets with collateral-backed cashflows should also feature in portfolios if investors are keen to seek protection against inflation. Nonetheless, we believe it is important to be highly selective in this broad and diverse area. For commercial real estate, unrealised losses and higher funding costs may cause problems over time.
- Cash: We believe this asset class has its attractions given both its yield and its uncorrelated returns. At the same time, we see a continued case for tactical and unemotional deployment into other undervalued areas of the market.
- Currencies: The US Dollar has struggled to regain ground this year, having hit a 20-year high last October. Relative Dollar weakness will continue to be supportive for emerging markets. In general terms, we are believers in currency mean reversion.
If the headlines are to be believed, many investors in the first half of 2023 partied like it was 1999. AI has been the hot topic of the year, so much so that one taxi driver recently even told your author that he needed to get involved. This is where the benefit of market experience counts. Your author was not only partying in 1999 but also already working in financial services then, unlike many of today’s market participants currently enthralled in market hubris. Our view is that the current boom in certain pockets of the market looks over-extended. The market may be due a pause. We counsel patience yet also opportunism.
Pinch yourself, but yes, global equities gained 14.0% in the year-to-date, with the S&P 500 Index rising 15.9%. The NASDAQ Index has done even better, up 38.8%. If you’d owned the NYSE FANG+ Index you would have made 74.1%, while holding NVIDIA – the poster child for AI – would have returned investors 189.5% since the start of the year.
These are impressive figures for sure, but they are also suggestive of a very distorted market. Consider that three stocks (NVIDIA, Apple and Tesla) have been responsible for c40% of the S&P 500 Index’s return year-to-date, while if you were to add in Microsoft and Amazon, then this quintet would account for over 60% of the Index’s return. Put another way, fewer than 30% of the names within the S&P 500 Index have beaten the Index year-to-date, a lower figure than at the peak of the 1999 TMT boom and indeed the lowest in 32 years.
A more sobering picture is presented when you consider the equal-weighted return for the S&P 500 Index year-to-date: just 6.0%. Data for the MSCI World Index tell a similar story. Consider that on a headline basis, the US constitutes a 68.9% weight in the Index, with its largest constituent (Apple) at a 5.3%. An equal weighted MSCI World Index would have returned 7.7% year-to-date.
Two other interrelated considerations also deserve clear mention. Don’t forget about valuation, particularly in the context of a still very uncertain macro environment. Put simply, headline multiples are discounting an awful lot and may not prove sustainable. Investors today are paying a multiple of 205x current earnings for NVIDIA. The ‘big-three’ names in the S&P 500 Index trade on a P/E of over 60x and the top-5 on a multiple of more than 30x. The rest of the Index, for context, trades on less than 20x (all data cited above, per Bloomberg).
FOMO has driven a large part of the rally in risk assets year-to-date. As a phenomenon, it’s also a classic inflator of bubbles. By not owning the ‘obvious’ stocks, investors have indeed missed out. However, participating now means paying up. It can sometimes be hard to stand in the way of a herd of bulls. Missing out on rallies can be painful, but so can the hangover after the party, generally even more so. Narrow market leadership is not reason enough to sell but may make the pain worse when the bubble does burst. Sure, global equities almost certainly did bottom in October 2022 (and few saw the AI rally coming), but this does not mean unambiguous plain sailing from here. Further, without the AI narrative, the market’s performance would be rockier and its participants’ optimism less assured.
Put another way, the rally may fray under the threat of more rate hikes and fears that the full impact of aggressive Central Bank policy has yet to be felt. Whether you like it or not, Central Banks continue to struggle to repress inflationary pressures. Correspondingly, were the Fed (and its peers) to reintroduce an element of fear through its policy decisions, this could presage some form of market collapse. At the least, beware of complacency; a recession may still happen. Arguably, it needs to happen, in order to fully quash inflation.
For sure, this has been a highly unusual cycle, with US inflation still at its highest since 1988 and unemployment at its lowest since 1968 (per Bloomberg). The economy’s resilience has been impressive – consider recent housing construction and retail sales data points. Central Banks may therefore continue to tighten until something breaks. Listen to the Fed and Jerome Powell says only that the FOMC is “close to where its destination is” on rates. Forget the rhetoric though and look at the ‘dot plot’ projections of the Open Committee members. Irrespective of June’s pause, 16 of the 18 members are calling for at least one more hike before year-end. Other Central Banks around the world also appear resolute in their fight against inflation, with rates having increased in the past month in Australia, Canada, the Eurozone (to the highest level in 20 years), Norway, Switzerland and the UK.
One lesson investors with experience should probably take on board is the familiar mantra: don’t fight the Fed. Put another way, Central Banks globally are unlikely to waver in their fight against inflation. To have described it (as Jerome Powell did) as ‘transitory’ was clearly the wrong call. Against this background, Central Banks are unlikely to risk credibility by stopping short of fully quashing inflation. With wages rising at c6% and housing costs at c8% (on an annual basis) and corporates continuing to pass on price increases as a way of protecting margins, inflation in the US has still to be considered sticky.
The biggest unknown is when 15 months of rate hikes start to have an impact. Strong consumer demand and excess savings in the US have probably to be seen as transitory factors only. What is more interesting to us is that the US Conference Board of Leading Indicators has now fallen for 14 consecutive months – its longest streak since the Financial Crisis. The US purchasing managers’ index for manufacturing has also dropped for 7 straight months, while the comparable services index is at its weakest since May 2020. A similarly bleak picture can be seen elsewhere, with factory orders in Germany, for example, at their lowest since 2013, excluding the pandemic (all data per Bloomberg). At the same time, don’t forget, liquidity is coming out of the market. Even with the Fed’s Bank-Term Financing Programme – initiated after the failure of Silicon Valley Bank in March – $95bn of quantitative tightening is occurring monthly in the US. Further, following the resolution of the debt ceiling debate (for now), the US Treasury is issuing new Treasury securities once again. With cash de facto going to the Treasury, liquidity is being withdrawn from other sources.
There is no historic precedent for avoiding recession with such aggressive hiking and an inverted yield curve. Causation and correlation remain a topic of intense debate, but logically, if you tighten policy hard enough to invert the curve, then it should hardly be surprising if you do get a recession. The US curve (the difference in the yield between 3-month and 10-year Treasuries) is at its most inverted since 1981, excluding March’s banking crisis. Bulls may wish to believe otherwise, but the economic cycle has not gone away.
Space does not permit for a discussion of the lengthy list of geopolitical uncertainties (China, Russia foremost) that could also impact sentiment. However, were we to seek to chart a middle ground, then it might be as follows: even if policy does work with a lag, for as long as the economy is doing well enough and so are corporate earnings, then equities can continue to go up. Fixed income may offer a better risk-reward profile at this stage of the cycle. Our overall stance supports well-diversified portfolios, which should be able to generate higher returns than either cash or inflation.
Alex Gunz, Fund Manager, Heptagon Capital
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