Markets to continue climbing a “wall of worry”

Ravenscroft CIO Kevin Boscher considers the possibilities of recession, what we may see next with inflation, and what it all means for markets.

There have been several surprising developments from an investment perspective over recent months. Firstly, the widely anticipated recession in the US and Europe has not yet materialised, thanks largely to strong employment markets and resilient consumers. Secondly, although inflation has clearly peaked in the developed markets, it is not falling as quickly as many had hoped or anticipated, with a resultant move higher in interest rate expectations and a hardening of central bank rhetoric. Thirdly, optimism around the re-opening of China after three years of Covid lockdowns has faded as the economic data, especially consumer demand, has disappointed. Given this, it is not too difficult to understand why bond yields have moved higher over the past quarter, especially in the UK, where inflation is proving to be much stickier than expected. Perhaps more surprising is the fact that equity markets have generally held up quite well, although headline numbers are being flattered by the strong outperformance from an increasingly narrow range of US FAANG plus stocks on the back of AI excitement and the prospect of a less hawkish Fed. Although there are plenty of reasons for caution, I am optimistic that both bonds and equities are in the early stages of a longer-term bull market.

Outlook for growth

I have often maintained that equities need three main pillars to potentially deliver stellar returns: reasonable economic and earnings growth, valuations which do not appear stretched relative to the long-term history and macro backdrop and enough liquidity to meet the needs of both the economy and investors. Starting with the growth outlook, although there are clear signs that US and European economic activity is softening and a recession looks likely, there are sound reasons why growth has so far held up better than expected, despite a significant tightening of monetary conditions. One of the key reasons is that the US, UK and European consumers, who account for roughly two-thirds of economic activity, have been able to continue spending through a period of rising prices thanks to a strong employment market, some wage growth and unusually high pent-up savings as a result of the huge pandemic-related monetary and fiscal easing. Growth has also been supported by lower energy prices and reasonably strong housing and stock markets.

Another important consideration is that the full impact of monetary tightening is yet to come through - it usually takes effect with a considerable lag. Not only has this been one of the fastest and steepest increases in rates on record, but the full impact of quantitative tightening (QT) is also largely unknown. As the various tailwinds fade and interest rate hikes bite, the resilience of global activity in early 2023 is unlikely to last. Despite this, central banks remain in a hawkish mood and are indicating that rates are yet to peak with no cuts on the cards for some time. At their recent forum, central bankers also confirmed that some economic hardship is inevitable, but moderate weakness in activity will not change their tightening bias since their priority is to bring inflation much closer to the 2% target. However, it is also evident that central banks are very unsure about how much tightening is needed. These are extremely uncertain and challenging times, and the Fed, Bank of England and European Central Bank have all stressed the need to be data dependent. Whilst their tendency is to err on the side of being too tight, if necessary, they could change their tone relatively quickly if inflation shows clear signs of falling or should growth materially disappoint. Another feature of this cycle is that the growth and inflation outlook vary significantly from country to country.

Given the various offsetting props to growth - including low unemployment, relatively strong private sector balance sheets and lower energy prices – it is likely that any recessions in developed markets will be modest. However, if the Fed makes a mistake and keeps policy too restrictive (which is a distinct possibility), then the recession will be deeper and longer than markets are currently anticipating. It is also important to remember that in periods of high inflation, nominal growth tends to stay positive in a recession, as was the case in the 1970s and early 80s. This is very significant for earnings and corporate profitability since revenues and profits tend to hold up much better when companies have pricing power, such as now. Earnings so far this year have largely surprised to the upside, although this is partly due to a prior and significant markdown in expectations. There is widespread concern that forward earnings forecasts are too optimistic, given the prospect of an imminent recession. However, assuming any slowdown is mild, and given the more optimistic revenue picture, it is possible that forward profits have already bottomed and earnings will continue to surprise on the upside. It is also true that nominal incomes are holding up better in the current inflationary environment thanks to some wage growth and low unemployment.

What next for inflation

 The combination of recession, a tighter credit environment, lower savings rates and the lagged impact from higher rates should enable core inflation (and services inflation in particular) to recede further over the coming months. Although the market, and indeed the Fed, expect rates to move higher before the end of this year, widening disinflation should eventually allow the Fed to ease policy without inducing an economic or financial crisis. The BoE and ECB, on the other hand, have more work to do to reduce demand and bring core inflation under control; hence rates will peak and start falling later than in the US. The UK is struggling with a very tight post-Brexit labour market, weak productivity, and high imported food and energy costs. Even here, however, inflation could fall quite quickly once recession and a global slowdown kick in, and it is unlikely, in my view, that rates will peak above 6% as markets currently expect.

As a note of caution, however, some commentators are putting forward a credible case of why developed economy inflation will settle in a 3-4% range for this cycle due to some of the aforementioned trends. If this is the case, then central banks would face a dilemma since they would have to choose between taking rates to a level that resulted in a much more severe recession or tolerating a higher base level of inflation. Given the high and rising global debt backdrop, my hunch is that they would choose the latter and continue to pursue financial repression as a highly indebted economy is very sensitive to higher rates. Central banks would be very reluctant to bring about a debt deflationary bust, as would governments who are increasingly focused on expansionary fiscal policies to address their growing list of expenditure challenges. We are already seeing clear warning signs that there is a natural ceiling to how high rates can go without causing major issues, with problems for US banks, UK pension funds, commercial and residential property markets, and UK utility companies.

Falling global liquidity, especially the US Dollar money supply, has been problematic for markets, Dollar debtors and global growth over the past couple of years. A shortage of Dollars outside of the US, together with aggressive rate rises and a stronger Dollar, have led to a significant tightening of financing conditions for many emerging markets and global trade-related companies. China is a good example of this at present since part of the explanation for why the re-opening is not going as expected is that Chinese consumers and companies are busy paying down their Dollar debts rather than embarking on a huge consumption and investment boom. Historically, financial or economic crises have often started with such an event, such as the Asian financial crisis in the mid-1990s and the market panic in late 2018. A weaker liquidity environment also negatively impacts economic activity and means less money is available to support financial markets. Conditions are likely to remain tight for a while longer and until the Fed either ends QT, starts reducing rates or a combination of both. The Fed is also able to add liquidity through temporary swap arrangements with other central banks, whilst additional sources of global liquidity include other central banks, government fiscal policies and bank lending. Beyond the next few months, however, a less hawkish Fed, lower energy prices, falling inflation and the end of central bank QT should lead to an improvement in global liquidity.

Investment overview

 From a valuation perspective, equities look attractive in both absolute and relative terms after a difficult couple of years. This is especially true outside of the US and in the UK and emerging markets. Even in the US, valuations look much more reasonable if the more expensive FAANG and other mega-cap growth stocks are excluded. Equities look less attractive relative to bonds, but this is partly because bonds themselves are cheap after one of the biggest sell-off in decades. Some sectors and stocks remain relatively expensive, such as large-cap technology companies, but even here much of the excess valuation has eased materially over the past two years. Also, if earnings have bottomed and expectations start to improve for 2024 onwards, then this will help bring down valuations further on a forward-looking basis. It’s also important to remember that part of any equity derating during a recession comes from a decline in the multiples that investors are prepared to pay for stocks. Provided that rates and bond yields start to decline over the next year or so, this will enable multiples to expand and valuations to improve further.

Assuming the macro environment evolves as expected over the next year or so, this should be bullish for bonds thanks to weaker growth, falling inflation, more dovish central banks, and an end to QT. In addition, and very importantly, yields across most government, corporate and emerging market sub-sectors stand at multi-decade highs and look very appealing, even relative to cash. This is particularly true in short-dated UK Gilts, where yields (to maturity) offer the prospect of reasonable capital gains, especially if rates peak below the current market expectation of 6%. Care is required in some areas of credit, such as lower-quality high-yield issues since a worse-than-expected recession could see debt defaults and spreads (over equivalent government issues) spike higher. Bonds remain unloved and many investors are underweight in the asset class, hence prices could correct sharply higher once sentiment and fundamentals turn. Government bonds should also provide some protection should growth disappoint. After a very difficult period, bond investors can look forward to better times ahead, and current yields seem to present a significant opportunity on a longer-term view.

It is also true that cash is once again an attractive asset class offering decent yields together with a safe shelter and a source of liquidity for investors during periods of market volatility. It is probable that equities and bonds deliver returns in excess of cash over the longer term, especially when measured in real (after inflation) terms, but cash is certainly an attractive and high-yielding asset class in its own right. Commodities have struggled over recent months, mainly due to a disappointingly weak China. However, we remain bullish longer-term given supply shortages, growing global demand, an improving growth outlook beyond the near term and the prospect of a weaker Dollar once the Fed pivots. Currency volatility has picked up materially of late and is likely to stay elevated for some time due to diverging economic and interest rate outlooks and rising geopolitical tensions. Currencies are notoriously difficult to predict, but rising volatility usually leads to greater fluctuations in other asset classes. Given the expected macro backdrop, we expect the Dollar to gradually decline over the next few years, which will be beneficial for global growth and markets.  

The global economic and political outlook is very uncertain, and nobody (including central banks) can be certain where we are headed. We have not been through a pandemic followed by a war, energy crisis and inflation shock before and, based on this, economic models are unlikely to accurately predict the future. It is possible to make a case that the Fed (and indeed BoE and ECB) will soon be reversing policy and cutting rates, perhaps quite aggressively, whilst it is also feasible that the Fed will maintain its hawkish stance and rates will move higher and stay there into 2024. In addition, the world economy is going through a period of de-synchronised activity, with recessions likely in many developed economies, whilst China and other emerging economies are in recovery mode. Similarly, inflation has peaked in the US and is falling quite rapidly, whereas it remains sticky and slow to ease in the UK and Europe. China and other parts of Asia are closer to deflation. In such an environment, policymaking is extremely difficult, and we are likely to see a diverging approach here as well, with the Fed expected to cut rates and China ease policy at the same time as the BoE and ECB continue to move rates higher.

Conclusion

In my view, the most probable base case is that the next year or so will feel quite disinflationary as recession kicks in, and this will enable rates to gradually start falling either later this year or early next. Hence, we are likely in a cyclical bull market for equities. A meaningful rally in bonds should also take place once inflation falls further and the Fed capitulates. Investors should continue to maintain an equity bias in balanced portfolios for the time being, but bonds, and indeed cash, also add sensible diversification and opportunity. A combination of a mild recession, accelerating disinflation and a turn in the interest rate cycle will be bullish for risk assets and investors. Longer-term, we are more likely to return to a period of elevated economic and inflation volatility (fire) as outlined above, although even here there is some doubt as the strong secular trends, which have put downward pressure on inflation and interest rates since the late 1980s, are still dominating, as recently highlighted by the International Monetary Fund (ice). We are confident that our long-term themes can continue to generate attractive returns in whatever environment lies ahead. In addition, our changing world theme is very much intact as the global economic and geopolitical order and framework evolve. We remain optimistic that we are in the early stages of a recovery period for risk assets but are ready to adapt our investment strategy and approach as events unfold and as required in order to ensure that we continue to generate strong returns for our clients.

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