Economic and market background

In August, new analysis revealed that the six-tonne Altar Stone, a massive slab of sandstone at the centre of the Stonehenge megalithic monument in Wiltshire, was probably transported over a distance of more than 400 miles to reach the site some 4,500 years ago. As the stone’s geochemical footprint was found to be a perfect match for bedrock found in northeastern Scotland, researchers struggled to comprehend the extraordinary journey, potentially over both land and sea, that the prehistoric site’s creators must have taken to move the hefty cargo.¹

Although most major equity indices moved higher over the third quarter of 2024 in local-currency terms, and the consensus for an economic soft landing remained intact at the end of the period, market participants also faced a somewhat rocky journey over the period.

The quarter began with a volatile July that featured political uncertainty in the US and a technology sector sell-off as investors rotated into smaller companies that are viewed as potentially bigger beneficiaries of lower rates. Risk assets then experienced a sharp pullback in early August. A weaker-than-expected US payrolls report induced a growth scare, while the US unemployment rate moved higher than consensus estimates, triggering predictions of a recession. In addition, the strengthening of the Japanese yen and an interest-rate hike by the Bank of Japan at the end of July prompted fears of an unwinding of ‘carry’ strategies in which traders had taken advantage of Japan’s low interest rates to borrow in yen and buy risky assets. This led Japan’s Topix index to suffer its biggest daily drop since ‘Black Monday’ in 1987.²

Amid this turbulence, which also saw the S&P 500 index of US equities decline by more than 6% during the first three trading days of August, the CBOE Volatility Index (VIX) experienced its biggest intra-day jump on record.³ While brutal in its intensity, the risk-off phase proved short-lived, with most major equity indices (apart from Japan) back in positive territory by the end of the month. The recovery was driven by the US Federal Reserve’s (Fed) indication that it would cut interest rates during September, as well as by a stabilisation in initial US jobless claims and upbeat US retail sales. Meanwhile, the Bank of Japan tempered its prior rhetoric of policy tightening.

CBOE Volatility Index (VIX) – price

Source: FactSet, October 2024

When it arrived in September, the Fed’s rate cut was in the form of a larger-than-usual 0.5% reduction.⁴ The start of the US central bank’s first easing cycle in more than four years was broadly welcomed by market participants, as Chair Jerome Powell underlined the Fed’s commitment to maintaining a low unemployment rate against a backdrop of lower inflation.

While the second quarter of 2024 had been characterised by narrow market leadership and the dominance of mega-cap technology names, Q3 saw a broadening of participation, with solid performance from some more defensive areas of the market and smaller-cap stocks. Meanwhile, after an extended period of weakness, Chinese equities rallied in late September, with the blue-chip CSI 300 index of Shanghai and Shenzhen-listed companies posting its best day since 2008 and rising almost 30% from its trough in February.⁵ The surge was sparked after the country’s central bank announced its most extensive monetary stimulus measures since the start of the 2020 Covid pandemic, with the aim of restoring confidence in the economy.

Total returns (%) to 30 September 2024

Source: FactSet, 1 October 2024. All equity market returns are sterling total returns.

The backdrop of declining interest-rate expectations was naturally favourable for bonds, with yields (which move inversely to prices) falling over the period, while the Japanese yen materially outperformed other major currencies. Elsewhere, gold delivered its largest quarterly increase since the first quarter of 2016,⁶ fuelled by falling interest rates and heightened tensions in the Middle East.

Sterling’s strength over the period meant that returns from overseas investments were muted for UK-based investors.

Regional overview

US Fed Chair Jerome Powell called the central bank’s half-percentage-point September interest-rate cut a “recalibration” intended to account for the sharp fall in inflation since last year, and indicated that the “strong start” to the easing cycle was intended to show policymakers’ commitment to keep any job market weakness at bay.⁷

Despite steady wage growth potentially boosting consumer spending and helping to ward off a recession, the US Bureau of Labor Statistics’ employment report released on 6 September indicated a slowdown in the labour market, with fewer jobs added in August than anticipated and downward revisions being made to June and July payroll growth figures.⁸

Powell stated that he thought the economy was still robust, noting that August’s data indicated a slight decrease in the unemployment rate to 4.2% from 4.3% in the previous month. Nevertheless, considering the time delay for monetary-policy adjustments to take effect and taking into account anecdotal reports from companies of reduced hiring rates, Powell argued for swift measures, stating that “the time to support the labour market is when it is strong, and not when you begin to see layoffs”.

The revised ‘dot plot’ projections by Federal Open Market Committee (FOMC) officials forecast that the benchmark interest rate would fall by another half percentage point by the end of this year and a full percentage point in 2025.

In Europe, despite a surge in the French services sector linked to the Olympic Games which bolstered the eurozone’s purchasing managers’ indices in August, September’s numbers revealed a significant contraction in the region’s business activity. Notably, Germany, the largest economy in the bloc, appears likely to have entered a recession as its large manufacturing sector has continued to struggle and growth has slowed in its services sector.

On 12 September, the European Central Bank (ECB) reduced interest rates by 0.25%,⁹ after a cut of the same magnitude in June, and hinted at further reductions owing to gradually falling inflation and faltering economic growth, with eurozone GDP set to expand by only 0.8% this year.¹⁰ ECB President Christine Lagarde observed that services sector inflation was still a concern, but that wage growth had slowed and corporate profits were absorbing rapid wage increases.

More dovish ECB policymakers, mainly from southern European countries, have argued that recession risks are increasing and that high interest rates are hindering growth excessively, increasing the potential for inflation to fall below the central bank’s target. This perspective was supported by Eurostat’s September data, which showed that headline inflation had dropped to 1.8%.¹¹

The UK’s economy grew by 0.5%in the second quarter, according to the Office for National Statistics,¹² providing some comfort for the country’s new Chancellor of the Exchequer Rachel Reeves as she prepares for her first Budget in late October, when some taxes are expected to rise. In addition, an improvement in the household saving ratio and a robust jobs market could boost consumer spending.

UK GDP

% change, quarter on quarter

Source: FactSet, October 2024

However, in what will have been less welcome news for the chancellor, British government debt rose to 100% of GDP in August for the first time since monthly records began in 1993.¹³ Bank of England records show that debt was last consistently at this level in the early 1960s, when the UK was still managing the financial after-effects of World War Two.

At its September meeting, the Bank of England kept interest rates on hold following a quarter-point cut in August.¹⁴ Governor Andrew Bailey expressed caution owing to persistent wage growth and divided opinions among policymakers on the rate at which long-term inflationary pressures were easing. However, he said he was “optimistic” that rates would fall further.

In late September, Shigeru Ishiba became Japan’s new prime minister, succeeding Fumio Kishida who resigned following a series of scandals. Speaking at a press conference, Ishiba emphasised the importance of boosting consumption to help Japan recover from prolonged economic stagnation.¹⁵ Japan’s economy grew by an annualised 2.9% in the second quarter, with real wages increasing for the second consecutive month in July, alleviating concerns about rising living costs affecting consumption.¹⁶ However, weak demand from China, slowing US growth and the yen’s recent recovery have posed challenges to the outlook.

Market volatility has remained a significant concern for Bank of Japan policymakers after the turbulence associated with the July interest-rate hike and hawkish comments from Governor Kazuo Ueda. The central bank maintained stable interest rates at its September meeting, and Ueda indicated that there was no immediate plan to increase borrowing costs further, particularly since the yen’s recovery had eased upward pressures on import costs. However, with data showing that Japan’s core consumer inflation accelerated for the fourth consecutive month in August,¹⁷ comfortably exceeding the central bank’s 2% target, expectations for additional rate hikes persist.

In a speech marking the 75th anniversary of the People’s Republic of China, the country’s President Xi Jinping warned of “rough seas” ahead,¹⁸ which many have taken as a reference to the country’s struggling economy, where deflationary pressures have persisted amid fears of a prolonged structural slowdown.

The People’s Bank of China’s extensive monetary stimulus package, announced in late September, includes plans to lower borrowing costs, enhance lending, and support the beleaguered property market. However, it remains to be seen whether it will sufficiently boost growth to meet the government’s annual target of around 5%, or whether further fiscal help will be needed to inject additional demand. Data from China’s National Bureau of Statistics showed that China’s factory activity shrank for a fifth successive month in September, while the services sector slowed.¹⁹

China purchasing managers’ indices

Source: FactSet, October 2024

Investment implications

The third quarter of 2024 gave investors plenty to sink their teeth into from a macroeconomic perspective. Perhaps most conspicuously, the Fed finally began to cut interest rates. The US central bank first indicated that its next move would be downwards as far back as December 2023. However, it has been cautious to pull the trigger after incorrectly understating the risk of inflation accelerating in 2021. Some perkier inflation data early this year checked the newfound dovishness, but since then price pressures have resumed their steady deceleration, with the Fed’s favoured measure of inflation – core personal consumption expenditures (PCE) – effectively back to target.

Alongside the continuing decrease in inflation, there has been clear evidence of a cooling in the US labour market. The US continues to create jobs, but there is now a more obvious equilibrium between supply and demand. At the August Jackson Hole Economic Symposium, Fed Chair Powell made it clear that the risks related to the Fed’s dual mandate of price stability and maximum employment had achieved a balance. This scenario prepared the way for the Fed to commence rate cuts at its September meeting, with Powell emphasising that at this point the greater risk was failing to adequately bolster the economy.

The debate has now moved on to where the terminal rate will land. The market has already priced in what the Fed expects to deliver in the rest of 2024 and 2025, but for yields to continue to decline it is likely that we will need to see signs of a recession in the US economy, which the data does not really support. Although the economy has decelerated, the slowdown might have been expected considering the rapid growth spurred by substantial monetary and fiscal stimulus as the US emerged from Covid lockdowns. While every economic cycle has its idiosyncrasies, it is reasonable to argue that this one has had more than most. Although a continuing slowdown does not necessarily guarantee a recession, many indicators typically associated with recessions are present, thereby raising the likelihood of one in the coming quarters.

10-year government bond yields (%)

Source: FactSet, October 2024

We have previously argued that certain global structural changes would lead to increasingly asynchronous economic cycles between regions. Supporting this view was the Bank of Japan’s (BoJ) decision to raise interest rates at its July meeting. Japan has been the poster child for lower interest rates, but a number of structural and cyclical developments mean that its central bank is likely just to be starting the process of hiking them. The BoJ is likely to move cautiously as it embarks on a rate-raising cycle; nevertheless, divergence between two systemically important central banks (in Japan and the US) is a sign of the times.

The yen appreciated into and out of the BoJ meeting, with the latter stages of the move in the currency coinciding with a spike in cross-market volatility, sparking fears of an unwinding of the yen carry trade. Although this trade deeply influences global financial markets, and more market volatility could result from a stronger yen, we do not believe it poses a systemic risk by itself as some suggest. Instead, it can be seen as an opportunity. Many investors complained that central banks manipulated markets with overly loose monetary policy following the 2008 global financial crisis, and in this context we believe a normalisation of monetary policy can only be a good thing for economic vitality.

Typically, the Fed kicking off a rate-cutting cycle with a jumbo half-percentage-point cut would be the most notable macro development. However, on this occasion, Beijing was unwilling to allow Powell the stage to himself, and the quarter ended with a slew of policy announcements intended to resuscitate the ailing Chinese economy and financial markets.

The Chinese economy has experienced a relative malaise since 2021. Initially this was attributed to draconian Covid lockdowns, but as China exited the pandemic it became clear that its underlying economy was weak versus recent history. In summary, we have been of the view that China has found itself in a ‘balance-sheet recession’ – a recession driven by high levels of private-sector debt (the term was coined by economist Richard Koo in his diagnosis of the Japanese economy after the bursting of its bubble in the late 1980s/early 1990s). Additionally, given the state of the national balance sheet, China has been unable to use fiscal and monetary policy to support the economy while the Fed has been running tight monetary policy. It is not coincidence that China turned its hand to stimulus on the heels of the Fed beginning its rate-cutting cycle.

Although China’s economy still faces structural issues, significant policy easing could bring cyclical improvements. Nevertheless, there are still question marks over whether words will be backed up by action. Historically, this has not always happened, and President Xi has been hesitant to boost the property sector. Even if he has had a change of heart, it is unclear whether the population still trusts property as an instrument of speculation after the authorities’ attempts to deflate property prices. While extreme positioning and negative sentiment towards Chinese equities means the policy inflection has scope to realise a significant equity-market rebound, overcoming the deeper structural challenges facing the Chinese economy is an altogether different challenge.

To summarise, a decisive policy pivot has taken place during the third quarter. The start of the Fed’s easing cycle has paved the way for other central banks, many of which have already begun cutting interest rates, to lower policy rates too. Despite the deliberate economic decoupling of the US and China over almost a decade, the respective economies remain deeply intertwined. Since 2021, China has acted as a deflationary force globally, countering the inflationary trends originating primarily from developed economies, in particular the US and Europe. It would be ironic if an uptick in China’s economy were to reignite global inflationary pressures at a cyclical level just as market participants are becoming confident that the inflation issue has been resolved.

If the Fed’s action successfully halts the nascent deterioration in the labour market, the US economy might achieve a soft landing. Economic acceleration could follow if interest-rate-sensitive sectors respond to Fed easing, potentially extending the cycle. Additionally, with bipartisan agreement in Washington on the merits of using fiscal policy to support the economy, we are likely to see more ‘priming of the pump’, regardless of the outcome of the upcoming presidential election. On the other hand, it is also possible that the Fed’s move has come too late, meaning the die has already been cast for a US recession in the quarters ahead, particularly if China’s stimulus efforts prove inadequate.

Conclusion

After journeying through an eventful third quarter, investors find themselves facing a different set of questions. The Fed’s initiation of a rate-cutting cycle, marked by a notable half-percentage-point reduction, reflects a shift towards easing monetary policies globally, with the ECB and Bank of England among those central banks also cutting rates over the summer.

Policymakers’ key concern over the last couple of years – inflation – has significantly receded but not vanished entirely. Meanwhile, although an economic soft landing remains in prospect for the time being, labour markets are beginning to slow down. Central bankers are therefore striking a delicate balance as they seek to foster continued economic growth while keeping inflation within its target range.

Investors must navigate other developments that create the potential for heightened volatility, including political uncertainty in the US and the escalating conflict in the Middle East. Additionally, the effects of China’s stimulus on both its own and global economies should be closely monitored.

Given this rapidly evolving investment landscape, investors will need to remain vigilant and adaptable in seeking to identify the opportunities and avoid the hazards over the final months of 2024.

It is good to have an end to journey toward; but it is the journey that matters, in the end.

Ursula K. Le Guin, US author, 1929-2018

¹ Stonehenge’s hefty Altar Stone came all the way from Scotland, Reuters, 14 August 2024
² US stocks finish sharply lower to close out global market rout, Financial Times, 5 August 2024
³ Source: FactSet, 30 August 2024.
⁴ Stocks shine, Treasury yields rise as rate cut stokes risk appetite, Reuters, 19 September 2024
⁵ China stocks surge in biggest single-day rally since 2008 on stimulus cheer, Reuters, 30 September 2024
⁶ Source: FactSet, 30 September 2024
⁷ Fed unveils oversized rate cut as it gains ‘greater confidence’ about inflation, Reuters, 19 September 2024
⁸ Unemployment falls, suggests orderly US labor-market slowdown, Reuters, 6 September 2024
⁹ ECB cuts interest rates as growth dwindles, Reuters, 12 September 2024
¹⁰ ECB cuts growth forecasts, still sees inflation at target in late 2025, Reuters, 12 September 2024
¹¹ Euro zone inflation dips below 2%, strengthening rate cut case, Reuters, 1 October 2024
¹² UK revises down economic growth but signs of strength remain, Reuters, 30 September 2024
¹³ UK debt hits 100% of GDP, adding to Rachel Reeves’ headache, Reuters, 20 September 2024
¹⁴ Cautious Bank of England hold rates, extends bond reduction plan, Reuters, 19 September 2024
¹⁵ Shigeru Ishiba to be Japan’s leader, winning on fifth attempt, Reuters, 27 September 2024
¹⁶ BOJ signals no rush in raising rates again, keeps policy steady, Reuters, 19 September 2024
¹⁷ Japan’s core inflation accelerates for 4th month in August, Reuters, 20 September 2024
¹⁸ Xi Jinping forecasts ‘rough seas’ on 75th anniversary of People’s Republic of China, The Guardian, 1 October 2024
¹⁹ China’s factory, service sector activity skids, Reuters, 30 September 2024

After reaching the milestone of the Real Return strategy’s 20-year anniversary, the Real Return team reflect on the highly varied and unpredictable backdrop that they have navigated since the strategy’s inception. While many competitors in the diversified growth space have fallen by the wayside, the strategy has stayed true to its original philosophy while evolving its approach to address a changing landscape.

The genesis of the Real Return strategy, when it was first set up in 2004 under the leadership of former Newton veteran Iain Stewart, centred on the concept of a long-term savings vehicle that should be highly flexible and exhibit asymmetry of return by balancing participation in risk-asset markets with a strong emphasis on capital preservation. Rather than relying on models to forecast market returns, insight and perspective were gained through long-term thematic research, allowing the team to make sense of a complex, interconnected world and provide ideas for security selection. Risk was defined as a permanent loss of capital rather than volatility which, although commonly used as a risk proxy, may in fact represent an opportunity.

The global financial crisis and its aftermath

Much of the first ten years of the strategy’s existence was dominated by the fallout from the 2007-8 global financial crisis, an extended cycle prolonged by repeated waves of monetary largesse and supressed volatility, and characterised by historically low interest rates.

During the run-up to the crisis, the team foresaw challenges within many major economies, namely the build-up of debt and excess leverage in the financial system, and indeed this development was encapsulated in the Newton ‘debt and credit’ theme.

The acid test for the strategy occurred in 2008 when the financial crisis unfolded in full force. The strategy was able to benefit from a combination of its direct equity protection, significant cash exposure diversified out of sterling into safe-haven currencies, and indirect hedges in the form of call options on government bonds and gold. It was during this period that the appeal of having a fully flexible strategy was appreciated by clients, while the shortcomings of pursuing an equity index-tracking strategy were keenly felt. The strategy ended 2008 in positive territory, amid carnage in equity markets.

The team quickly capitalised on attractively valued securities during the indiscriminate sell-off that ensued, and the period served as something of a blueprint for how to make full use of the wide range of tools available. Indeed, the success of the strategy gave rise to US-dollar and euro versions, launched in 2009 and 2010 respectively, in response to demand from international investors.

The strategy further evolved in 2018 with the creation of a separate sustainable version, in recognition of the priorities of a subset of clients. This version of the strategy focuses not only on seeking to deliver a long-term performance objective, but also on investing in issuers that positively manage the material impacts of their operations and products on the environment and society.

Lessons learned from unpredictable markets

The Real Return strategy has experienced a range of difficult periods through its long history, many of which were navigated successfully, while others served as a ‘lesson learned’.

For example, 2017 was a challenging year during which the team underestimated the impact on markets of quantitative easing (the process by which central banks purchase government bonds or other financial assets to stimulate economic activity) and portfolios suffered the cost from the strategy’s derivative protection. Indeed, one of the takeaways from this period was that we were navigating a market backdrop that was being manipulated by policymakers to an extent never seen before.

In contrast, 2019 was an example of when the strategy’s rich blend of asset classes pulled their weight. Both the strategy’s core of return-seeking assets and its insulating layer of ‘stabilising’ assets (which aims to hedge perceived risks and dampen volatility) generated positive returns, illustrating the benefit of diversification across asset classes and harnessing different sources of returns. While the team had increased exposure to core return-seeking assets, reflecting a pickup in global growth, this was matched with substantial offsetting positions and therefore did not result in a significant increase in the strategy’s overall risk.

Perhaps one of the most seismic periods for the strategy was the outbreak of the coronavirus pandemic in Q1 2020. The team was fairly constructive going into 2020, owing to a combination of improving economic data, less macro uncertainty, and continued intervention by central banks to support markets. However, it was concerned about investors’ seeming nonchalance about the impact of the virus and took some risk off the table while simultaneously increasing cash as the ultimate safe-haven asset. This underestimated the extraordinary monetary and fiscal stimulus that ensued, which greatly improved the outlook for risk assets. Once this was identified, the team quickly assessed the implications and increased the portfolio’s return-seeking core, focusing it on high-quality businesses that were well placed to survive the economic uncertainty. These moves enabled the strategy to claw back initial losses and end the calendar year 2020 in positive territory.

2022 is also worthy of mention, given that it was the only calendar year in which the strategy posted a negative return. A backdrop of stressed market conditions caused by the rapid, steep rise in interest rates affected a swathe of asset classes. While the team actively shifted the asset allocation to navigate this difficult period, with the benefit of hindsight it should have taken advantage of oversold conditions in October to close out the strategy’s short positions on equity-market indices.

Thematic research focus

These contrasting periods illustrate the need to be flexible and nimble, as well as quickly assessing scenarios, particularly where there is no ‘playbook’ to follow. While a sound investment process represents the backbone of any strategy, we believe a key determinant of the strategy’s outcomes has been the experience of navigating challenging market conditions using thematic research as a compass. Dominant macro themes, both monetary and geopolitical in nature, such as an increasingly complex and financialised backdrop, governments intervening in economies more actively, and competition between great powers, help identify evolving opportunities and risks.

For example, at the time of the strategy’s launch, China was viewed by investors as an exciting new frontier, offering unprecedented opportunities. Today the baton has been passed to India, with China now viewed with more caution owing to the government’s ‘common prosperity’ wealth redistribution agenda, and as geopolitical tensions between China and the West have risen.

Enriching the asset-class mix

The other area of development within the portfolio has been the asset-class mix which has been progressively enriched, in part to reflect the evolution of markets. When the strategy was first launched, it could broadly be described as a modern balanced portfolio with a focus on traditional asset classes: equities, bonds and cash. Derivatives on major market indices were also used for protective purposes very early on in the strategy’s history. The team added gold in 2005 as an indirect hedge, and the fourth quarter of 2018 saw alternative assets take on a larger role in the toolkit. Their appeal was their less-than-perfect correlation to traditional assets and, in areas such as renewables and infrastructure, they have offered an explicit inflation linkage which has proved particularly helpful more recently as inflation has surged. This diversification of the sources of return has provided a buffer against more challenging market conditions, although we recognise that such assets are not immune to volatility when market conditions worsen.

The use of derivatives has enabled us to calibrate the size of the return-seeking core and stabilising layer, benefiting from the liquid nature of these instruments while still enabling our long-term views to prevail in respect of physical positions in securities.

Keeping the client objective in focus

As a team, we have matured together over the years (and many of us are still here, which is unusual in an industry with notoriously high turnover). We have taken stock of previous experiences and have weathered some difficult times, notably the sudden death of the strategy’s investment leader, Suzanne Hutchins, in late 2022. The shocking news tested our resilience and cohesion. However, as we had been working together for many years, we already understood and appreciated each other’s strengths, and that enabled us to support each other strongly in taking the strategy forward. It was a tough period for the team, but we never lost our focus on seeking to fulfil the strategy’s original client goal.

Where are we now against a backdrop of significant global uncertainty and opportunity? This is arguably a sweet spot for the strategy: volatile markets with shorter cycles of greater amplitude are conditions in which the strategy should thrive. The need to shift asset allocation to reflect market vicissitudes is more relevant than ever, as is the need to design portfolios to be future-proof and robust. We thank our client base for their loyalty over the years and believe that the next decade should favour the strategy’s process, incorporating a judgement-based assessment of fundamentals, backed by a sound risk-management process and quantitative measures.

Key lessons we have learned over the years are to expect the unexpected, and that having confidence and a deep understanding of what we own and why we own it should pay off in challenging conditions. Moreover, the ability to embed some downside protection and make a careful, measured assessment of the most effective tools to implement is invaluable and aligns us with our clients’ objectives.

Past performance is not a guide to future performance. Your capital may be at risk. The value of investments and the income from them can fall as well as rise and investors may not get back the original amount invested.

Newton Real Return strategy – key investment risks

• Performance aim risk: The performance aim is not a guarantee, may not be achieved and a capital loss may occur. Strategies which have a higher performance aim generally take more risk to achieve this and so have a greater potential for returns to vary significantly.
• Currency risk: This strategy invests in international markets which means it is exposed to changes in currency rates which could affect the value of the strategy.
• Derivatives risk: Derivatives are highly sensitive to changes in the value of the asset from which their value is derived. A small movement in the value of the underlying asset can cause a large movement in the value of the derivative. This can increase the sizes of losses and gains, causing the value of your investment to fluctuate. When using derivatives, the strategy can lose significantly more than the amount it has invested in derivatives.
• Changes in interest rates & inflation risk: Investments in bonds/money market securities are affected by interest rates and inflation trends which may negatively affect the value of the strategy.
• Credit ratings and unrated securities risk: Bonds with a low credit rating or unrated bonds have a greater risk of default. These investments may negatively affect the value of the strategy.
• Credit risk: The issuer of a security held by the strategy may not pay income or repay capital to the strategy when due.
• Emerging markets risk: Emerging markets have additional risks due to less-developed market practices.
• Liquidity risk: The strategy may not always find another party willing to purchase an asset that the strategy wants to sell which could impact the strategy’s ability to sell the asset or to sell the asset at its current value.
• Shanghai-Hong Kong Stock Connect and/or the Shenzhen-Hong Kong Stock Connect (‘Stock Connect’) risk: The strategy may invest in China A shares through Stock Connect programmes. These may be subject to regulatory changes and quota limitations. An operational constraint such as a suspension in trading could negatively affect the strategy’s ability to achieve its investment objective.
• China interbank bond market and Bond Connect risk: The strategy may invest in the China interbank bond market through connection between the related Mainland and Hong Kong financial infrastructure institutions. These maybe subject to regulatory changes, settlement risk and quota limitations. An operational constraint such as a suspension in trading could negatively affect the strategy’s ability to achieve its investment objective.
• CoCos risk: Contingent convertible securities (CoCos) convert from debt to equity when the issuer’s capital drops below a pre-defined level. This may result in the security converting into equities at a discounted share price, the value of the security being written down, temporarily or permanently, and/or coupon payments ceasing or being deferred.
• Counterparty risk: The insolvency of any institutions providing services such as custody of assets or acting as a counterparty to derivatives or other contractual arrangements, may expose the strategy to financial loss.
• Investment in infrastructure companies risk: The value of investments in Infrastructure Companies may be negatively impacted by changes in the regulatory, economic or political environment in which they operate.

Newton Real Return strategy – investment performance

Returns to 30 June 2024

12-month returns

Performance is stated gross and net of management fees. The net-of-fee returns are calculated by deducting an annual management charge of 0.75% from the strategy’s gross-of-fee returns. The impact of management fees can be material. A fee schedule providing further detail is available on request.
Performance benchmark: The strategy seeks to deliver a total return of SONIA (30-day compounded) +4%* per annum over rolling 5-year periods, from a globally diversified portfolio. In doing so, the strategy aims to achieve a positive return on a rolling 3-year basis. However, a positive return is not guaranteed and a capital loss may occur.
*For the period to 30 September 2021, the performance benchmark was 1-month LIBOR +4%.

Analysis of themes may vary depending on the type of security, investment rationale and investment strategy. Newton will make investment decisions that are not based on themes and may conclude that other attributes of an investment outweigh the thematic structure the security has been assigned to.

With a familiar picture of rising public spending, loose fiscal discipline and anemic economic growth in many developed markets, we expect to see both shocks and opportunities ahead for global fixed-income investors.

The ‘regime change’ in the macroeconomic backdrop has seen quantitative easing and low interest rates give way to higher inflation. It also signifies the arrival of shorter, more violent and unpredictable business cycles. For us, these conditions show similarities to market conditions last seen in the 1970s.

Such a backdrop can complicate both strategies and timing decisions for investment managers, and we believe bond investors need to adopt a fresh, more unconstrained approach. Nevertheless, we do believe some attractive yield will be on offer for those whose strategies succeed.

Reshoring Efforts and Debt Challenges

Despite the recent success of central banks in targeting inflation, we believe the higher-for-longer inflation backdrop will endure for some time yet. We anticipate that financial markets will increasingly be called upon to fund both the reshoring of supply chains and rising national fiscal deficits.

During the pandemic, much of the private sector borrowed cheaply and extended the maturity profile of its debt. Many governments also borrowed, but, in some cases, did not extend the debt maturity profile at a time when interest rates were close to historic lows.

Sovereign debt burdens are now a key market talking point for many nations, in terms of the possible risks that may lie ahead. We have seen on a few occasions how market-driven events can quickly lead to major corrections in bond yields. We saw it in the eurozone sovereign debt crisis, and in other fiscal mishaps that have played out in the past. Our view is that policymakers will need to tread carefully in an environment where inflation is higher and stickier than witnessed over the last few decades.

US Risks

One country we believe fixed-income investors should watch closely is the US. Against a backdrop of high and rising US debt, we believe there is quite a high probability that the US Treasury market could see a sharp market correction within the next five years, regardless of who wins the upcoming US presidential election.

Recent data suggests the US jobs market may be softening, while other US economic warning signs include recent rises in credit card and auto loan defaults, as well as small business bankruptcies.

While it may have become taboo in some quarters to utter the ‘R’ word, some economic signals suggest the likelihood of a US recession is, in fact, increasing. Ironically, we note these latest warning signs are building just as wider talk around recession appears to have evaporated.

Our view is that the evolving economic backdrop will require some deft handling by the US Federal Reserve in terms of its interest-rate maneuvers.

Rising Yields

Despite this uncertain backdrop, higher yields do create opportunities for fixed-income investors who can time their market interventions correctly and take advantage of wider dislocations and pockets of opportunity. We believe fixed-income markets can still throw up alpha, and that we are currently in a market cycle that is conducive to generating income from bond investments. Yield matters, and there is considerable demand from sectors of the market, such as pension funds and retirees, for the higher yields that fixed income can now deliver. In our view, it is possible to construct a diversified bond portfolio that provides yields similar to those available from credit, while being more resilient.

Unconstrained Approach

We believe that over the next few months, fixed-income opportunities appear compelling, even if the medium-term picture is less clear. In our view, the uncertain market conditions call for an active and unconstrained approach to fixed income, along with dynamic decision making, careful market navigation and strong security selection. Despite some continuing macroeconomic challenges, we believe there is significant value to be found across bond markets at this time.

The significant margin of victory achieved by the Labour Party at the recent UK general election was not a surprise, but how does it fit with our expectations for the UK’s gilt market and broader economy?

Overall, we anticipate that the new political landscape could prove positive for the gilt market over the near to medium term. Our view is that as the inflationary impact of Russia’s invasion of Ukraine continues to slowly roll out of the inflation data, the real yield now on offer from gilts looks more attractive than it has for some time.

UK growth has been anaemic despite a significant government budgetary overspend over the last few years. Labour ruled out income-tax hikes in its manifesto, and, now in power, the party is at great pains to explain that specific policies are ‘fully funded’, or ‘fully costed’. This indicates to us that the new government is wary of being labelled profligate as it may not receive the same leeway from much of the UK press as was afforded to its Conservative Party counterparts while in power. We anticipate that Labour may need to pick its expenditure battles wisely.

Spending constraint

In the latest quarterly report from the UK Treasury Debt Management Office (DMO) we note that the UK’s projected annual financing requirements are likely to call for further spending constraint. The UK debt-to-GDP ratio is expected to peak in 2025-26, while gross debt issuance should peak in 2025 at around £300bn, with a projected net-debt issuance of around £125bn. This elevated borrowing programme, initiated by the previous government, is now being serviced at higher borrowing costs as interest rates have risen to try to counter the recent period of high inflation (see chart below).

UK annual financing requirements (£bn)

Source: DMO, Office for Budget Responsibility, 31 December 2023. Values based on Autumn Statement 2023 estimates and projections. Net issuance in the chart above is defined as gross issuance net of gilt redemptions.

We suspect that these governmental budgetary pressures may weigh on growth, rather than boost it. While there are other measures (such as the recent cut in National Insurance contributions) which may boost overall consumer spending, we expect these budgetary pressures to have a greater effect, which may, in turn, need to be offset by tax rises (ex-income tax) further down the line.

The fiscal cupboard is bare

Although Labour won a significant majority in the House of Commons, the fiscal cupboard is bare, which means the party is likely to be denied the ideal ‘honeymoon period’ often afforded to new governments. We suspect that the new government will continue to hammer home the message of just how bad the economic backdrop it inherited is and how it will take time to repair the damage, with Labour acting as a ‘new broom’.  

However, the incoming government does appear to offer something that has been in short supply in the UK over the last decade, which is stability. Over the last few years, we have not only had a revolving door at 10 Downing Street, but also a high degree of churn in other offices of state and heads of departments. This new perceived stability of governance could ultimately lead to lower borrowing costs owing to greater stability of policy and of decision makers, and we expect it may afford investors greater predictability.

UK – a mixed economic bag

We have seen a mixed bag of UK data over recent weeks. Services inflation and wage growth (dominated by services numbers) have remained high, while the labour market is softening. With inflation hovering around the Bank of England’s 2% target, the bank may now be able to cut rates without facing significant resistance.

The UK interest rate is at 5.25%, a full 3.25% ahead of consumer price inflation, 1.75% more than core inflation, and almost 5% ahead of GDP (not to mention a long way above money supply growth). We think the UK’s policy rate could therefore be deemed restrictive, and struggle to see what might turn the UK’s growth trajectory around. Question marks remain over medium-term government expenditure, growth in the European Union (EU) – the UK’s main trading partner, and the prospect of US trade tariffs looming amid global growth concerns, which could all hit the UK’s open and mercantile economy.

Housing plans seek to boost growth

Aside from going for the low-hanging fruit, such as instigating a less fractious relationship with the EU, Labour is looking to boost growth by hanging its hat on a pump-priming strategy of extreme levels of house building. The new government’s target of 300,000 houses per year represents the highest level since 1979, when the new Conservative government of Margaret Thatcher heralded the end of large-scale local authority housebuilding.

Green energy developments

The new government also has ambitious plans to transform energy generation in the UK by setting up a national energy company called Great British Energy. This could become an interesting development over the next few years but comes during a period in which government levels of indebtedness are at generationally high levels.

The project seeks to protect the UK’s energy security, reduce carbon emissions and harness the untapped natural power sources at its disposal. The UK has ample wind, a huge length of coastline to tap tidal power, a reasonable degree of sunshine and world-leading academic and scientific institutions, at a time when the market for sustainable financing continues to grow.

Necessity is the mother of invention, and we are hopeful that the project could prove effective, but there is inevitably a cost to innovation and an inherent riskiness involved in seeking to achieve a first-mover advantage. We believe the new government needs to convince the UK population that while the cost/benefit analysis of establishing this initiative may produce an initial increase in energy bills to finance the change in energy mix, it should prove more beneficial over the longer term.

Economic And Market Background

In what is set to be the biggest election year in history, with four billion people – more than half the world’s population – going to the polls,¹ financial-market participants were on edge during the second quarter as a series of high-stakes votes spurred market volatility.

Although it subsequently recovered, India’s stock market experienced its worst day in more than four years at the start of June after Prime Minister Narendra Modi’s Bharatiya Janata Party unexpectedly lost its parliamentary majority,² putting at risk an aggressive reform agenda. In France, President Emmanual Macron called a snap parliamentary election after the far-right National Rally made major gains at the expense of his centrist alliance in the June European Parliament elections. With the prospect of a new government adding significantly to France’s already large debt pile, the spread on 10-year French government bonds (the extra return investors demand to buy France’s debt over Germany’s) reached its highest level since the 2012 eurozone crisis.³

Meanwhile, UK Prime Minister Rishi Sunak called a general election for July 4, an earlier date than many had predicted, and a stumbling performance from US President Joe Biden in a TV debate with his rival Donald Trump at the end of June heightened the uncertainty surrounding the November election in the world’s largest economy.

Nevertheless, global equity markets made further gains over the quarter, driven by technology stocks and especially the ‘magnificent seven’ mega-cap businesses, which helped the S&P 500 and Nasdaq indices of US stocks to reach new record highs in June. Notably, Nvidia, the leading supplier of chips used to train artificial intelligence (AI) models, briefly became the world’s most valuable company on June 18 as its market capitalization reached more than $3.3 trillion.⁴ The company’s shares rose by a staggering 150% over the first six months of the year, and the stock alone has been responsible for around 30% of the S&P 500’s gains over the same period.⁵ The dominance of a small number of technology names has fueled growing concerns over market concentration.

Equity markets did come under pressure at times, especially in April, as hopes of interest-rate cuts were dampened amid signs of continued strength in the US economy and stubborn inflation. On top of this, geopolitics returned to the fore as tensions in the Middle East between Israel and Iran briefly escalated, driving a spike in energy prices.

Towards the end of the quarter, the US Federal Reserve (Fed) reaffirmed a hawkish narrative as it left interest rates unchanged at its June meeting, with the median forecast from its policymakers projecting just one rate cut before the end of the year.⁶ However, with US monthly inflation unchanged in May according to the Fed’s preferred personal consumption expenditures (PCE) measure, as a small increase in the cost of services was offset by the biggest fall in goods prices in six months,⁷ hopes were boosted for an economic ‘soft landing’ in which inflation cools without triggering a recession and a sharp rise in unemployment.

Elsewhere, the European Central Bank (ECB) moved ahead of its US and UK counterparts as it lowered borrowing costs for the first time in almost five years, reducing its deposit rate by 0.25% to 3.75%,⁸ although it would not commit to a specific path for future cuts, partly owing to persistent price and wage pressures. In contrast, the Bank of Japan opted to keep its short-term target rate unchanged at 0-0.1% at its June meeting, although it announced that it would provide more details in late July of a plan to start trimming bond purchases.⁹ Affected in part by the continuing interest-rate differential with the US, the yen slumped to a 38-year low against the US dollar during the quarter.

With market participants adjusting their expectations for near-term rate cuts downwards, government bonds struggled over the quarter, with the yield on the benchmark 10-year US Treasury rising by around 18 basis points. Gold, meanwhile, made its third successive quarterly gain, hitting a record high in May.¹⁰

Interest-Rate Projections by Members of the Federal Open Market Committee

Each dot indicates the value of an individual participant’s judgement of the appropriate target level for the federal funds rate at the end of the specified calendar year or over the longer run.
Source: US Federal Reserve, June 12, 2024.

Total Returns (%) to June 30, 2024

Source: FactSet, July 1, 2024. All equity market returns are US-dollar total returns.

Regional Overview

Figures from the US Commerce Department’s Bureau of Economic Analysis indicated that the US economy grew at 1.4% during the first quarter of 2024, its slowest pace in almost two years.¹¹ However, while the trade deficit widened, domestic demand remained resilient, with a pickup in business investment and a continued housing recovery. According to the Labor Department, non-farm payrolls rose by 272,000 in May, far ahead of consensus expectations.¹²

Hiring has been strong across the breadth of the economy, with the health-care sector providing the biggest employment gains as companies have sought to increase staffing levels after losing workers during the Covid pandemic. Wage growth also accelerated, rising 4.1% year on year.

The Fed expects inflation to decline gradually, with the PCE price index forecast to be virtually unchanged from its current level at the end of the year, as growth remains slightly above trend and unemployment stays low. The Federal Open Market Committee indicated in its June policy statement that while “modest further progress” has been made towards its 2% inflation objective, interest-rate reductions would not be appropriate until it has “gained greater confidence” that price pressures will continue to ease.¹³

In contrast to its US counterpart, the European Central Bank decided to begin its easing cycle in June but has similarly cautioned over the timing of any future moves, stressing how it will continue to follow a “data-dependent and meeting-by-meeting approach”, with many economists predicting there will be no more than two further cuts this year.

The eurozone’s economy jumped back from a mild recession in the first quarter as Germany, its largest economy, returned to growth, while the French and Spanish economies also gained some momentum.¹⁴ There was further positive news, with a key indicator showing that business activity had expanded at its quickest rate in a year in May, as a result of an expanding services industry. The HCOB purchasing managers’ index rose to 52.2 and remained above 50 (the level which separates growth from contraction) for the third consecutive month.¹⁵

Nevertheless, with Europe’s manufacturing sector still in contraction, overall growth is expected to be sluggish. The International Monetary Fund (IMF) has forecast that the eurozone’s GDP will rise by just 0.8% in 2024, not least because consumer sentiment in France and Germany remains weak.

Ahead of its general election, the UK received some positive economic news which indicated that the economy had bounced back from recession, with GDP expanding by 0.7% in the first three months of the year from the previous quarter, according to the Office for National Statistics.¹⁶ Real (inflation-adjusted) household disposal income per head also increased by 2.4% over the last year, boosted by fast wage growth in a tight labor market. Nevertheless, it was still 0.6% lower than in the final quarter of 2019, just before the start of the pandemic.

UK Households: Real Disposable Income per Head

Chained volume measure £, seasonally adjusted

Source: UK Office for National Statistics, June 28, 2024

At its June meeting, the Bank of England’s Monetary Policy Committee (MPC) voted to keep interest rates on hold, although its policy minutes indicated the decision had been “finely balanced” for some MPC members.¹⁷ Headline consumer price inflation returned to its 2% target in May for the first time in almost three years, but the central bank expects it to rise again later in the year once the effects of past energy price declines have fallen out of annual inflation data. Services price inflation has remained significantly higher at 5.7%, and pay growth remains elevated.¹⁸

While the Bank of Japan (BoJ) kept interest rates on hold in June, it hinted that a hike may be on the cards at its meeting scheduled for the end of July, as it also seeks to start cutting its bond purchases and reducing the size of its enormous balance sheet, which currently represents around 125% of the country’s GDP.¹⁹ The weakening yen has put further pressure on the BoJ as rising import costs threaten to push inflation well above its 2% target.

The central bank’s decision will be complicated, however, by a revision to GDP data which suggested that Japan’s economy may have shrunk by 2.9% on an annualized basis in the first quarter.²⁰ This was more than initially reported and is likely to result in a cut to growth forecasts. Domestic consumption has been weak as households and small businesses have been squeezed by the higher costs of imported goods, although the tourism sector and exports have benefited from a more competitive exchange rate. Policymakers are hoping that large pay rises agreed with Japanese companies in April, and planned income tax cuts, will provide a boost during the second half of the year.

US Dollar/Japanese Yen Rate

Source: FactSet, July 2024

After China’s GDP jumped by 5.3% in the first quarter compared to the previous year, beating expectations, the IMF upgraded its growth forecast, saying it expects China’s economy to grow by 5% in 2024.²¹ In May, China announced what it termed “historic” steps to stabilize its troubled property sector. State-owned firms are set to buy some apartments, while China’s central bank is introducing a relending facility for affordable housing and is further lowering mortgage interest rates and downpayment requirements. While these policy measures could take time to take effect, data for May suggested a further worsening in the property sector, with both investment and new home prices declining further.

Manufacturing investment showed strong growth of 9.6% in the first five months of the year,²² underpinned by policy support, and exports have helped to boost the economy. However, the European Union’s announcement in June that it intends to impose tariffs of up to 38% on imports of Chinese electric vehicles highlights potential trade challenges to come.²³

Investment Implications

During the year so far, and indeed for most of 2023, financial-market participants have been considering when economies would react negatively to increases in interest rates. The impact of higher rates appears to have been gradual, which has led some central banks to start cutting rates and others to talk about cutting them later this year. With inflation having declined from its peak, central banks have some leeway to reduce rates from their elevated levels.

For risk assets such as equities, the gradual economic slowdown, easing of inflation and ‘dovish’ central bank narrative have been sufficient to extend rallies. As market participants continue to debate the likelihood of a more significant economic slowdown, they will be evaluating the legacy of the build-up in government debt and stubborn inflation levels, as well as the potential impact of political change. We believe this trio of influences will continue to cause volatility in markets in the second half of 2024 and beyond.

In terms of the outlook for growth, the much-heralded ‘soft landing’ appears to be within reach, especially if central banks are quick to take the top off their high cash rates. However, in our view, the odds of a downturn becoming more severe and developing into a proper hard landing are higher than the possibility of world economic growth reaccelerating and pushing inflation (and then interest rates) to new highs. On balance, the soft-landing scenario still appears most likely, but it has previously proved a difficult act for central bankers to pull off.

Once employment slows, along with investment, it can affect consumer confidence and therefore spending, leading businesses to reduce their inventories and, in turn, employment. This then depresses consumer sentiment further, and a full-blown recession can quickly emerge. The good news is that central banks have significant room to cut interest rates to arrest an accumulation of negative sentiment.

One feature of the current economic landscape is the continued global divergence in growth. Notably, the US economy has experienced persistently strong GDP growth, benefiting from its domestic energy sources, large fiscal stimulus and innovation in its technology sector. Europe has struggled as it has had to contend with (until recently) higher energy costs, combined with a lack of innovation. China, meanwhile, has continued to work through the legacy issues related to the crisis in its property sector. Heavy investment in new technologies, however, has given it the edge in producing electric vehicles and renewable-energy infrastructure, thereby exporting deflation to the rest of the world and prompting tariff increases from some countries. Other emerging-market economies are a mixed bag, but many have the ability to cut domestic rates if inflation continues to fall.

Real GDP Growth

% change, year on year

Source: FactSet, July 2024

Political noise has been an increasing concern for markets since the 2008 global financial crisis and the eurozone sovereign debt crisis that followed. Growing wealth inequality, as income and living standards stagnated for many while the wealthy benefited from rising asset prices, left many voters disenchanted with incumbent, largely centrist, governments, and fueled demand for more radical policies. The economic effects of the Covid pandemic later accelerated this trend. Once in office, populist politicians have tended to be as hamstrung by debt and low productivity as their predecessors, and many get ejected, prompting voters to look for the next party or leader that promises an easy or radical fix to complex problems.

Political change can be unnerving for market participants if they do not know what comes next, but recent developments have rarely led markets to avert their focus from the economy and rates. After an initial wobble, markets have tended to continue their upward journey. The exceptions to this trend can come when governments threaten the durability of their debt (as occurred with former UK Prime Minister Liz Truss’s short-lived government in 2022) or interfere with the independence of their central banks (as happened in Turkey in 2023).

In the past, investors could usually look beyond a forthcoming election and invest through any short-term volatility, but now we are increasingly seeing elections with the potential (albeit still small) to cause a major upset.

In addition to politics, the outlook is clouded by high levels of government debt which must somehow be serviced. While we are not suggesting current levels of debt are unsustainable, the cost of servicing this debt has risen significantly over the last two years. In the UK, government debt interest payments now represent a greater cost (as a percentage of GDP) than education, defense or economic investment. The UK is not alone, and many governments face the same challenge of needing to increase health and defense spending while trying to pay for past support through a higher interest bill. This will severely limit any government’s ability to stimulate economic growth in the future. Some relief can come from lower official rates, but with inflation likely to remain consistently above 2% targets in many economies, interest-rate relief will have its limits.

When government debt increases, private-sector debt tends to fall, and this has indeed happened over the period since the global financial crisis. This puts the private sector in a better credit position and means that the next economic slowdown is more likely to be a cyclical one, which can be tackled with lower rates, rather than a systemic version that can be more difficult to bounce back from.

Conclusion

The global economy appears to have been more resilient than many had anticipated, with the US in particular seemingly absorbing the impact of higher interest rates, at least for now. As a result, a soft economic landing remains in prospect, especially as central banks have some flexibility to lower interest rates.

However, while inflation has moderated, it remains above target in major economies, which is limiting that flexibility. The mounting effects of higher rates are likely to weigh on economic activity as the year progresses, and elevated debt levels will make it difficult for governments to offer significant stimulus should a bigger downturn develop.

Investors must also contend with rising international and domestic political tensions which could spark market volatility, especially as key elections, notably in the US, approach.

With the ‘benign’ low-inflation and low-rate conditions of the previous decade now firmly behind us, there is likely to be greater divergence in the performance of economies, asset classes, and individual securities. We believe it will therefore be critical for investors to identify the long-term growth opportunities in areas supported by structural demand and pay close attention to fundamentals in order to separate the winners from the losers.

A politician thinks of the next election. A statesman, of the next generation.

James Freeman Clarke, American minister, theologian and author, 1810-1888

¹ 2024 is the biggest election year in history, The Economist, November 13, 2023.
² Indian shares post worst day in 4 years as polls show unexpectedly narrow Modi win, Reuters, June 4, 2024.
³ French debt risk premium hits highest since 2012 crisis ahead of election, Reuters, June 28, 2024.
⁴ Nvidia eclipses Microsoft as world’s most valuable company, Reuters, June 18, 2024.
⁵ Tech boom leads global markets through first half of 2024, Reuters, July 1, 2024.
⁶ Fed leaves rates unchanged, sees only one 2024 cut despite inflation progress, Reuters, June 12, 2024.
⁷ US inflation cools in May, boosting hopes of Fed rate cut, Reuters, June 28, 2024.
⁸ ECB cuts rates, keeps next move under wraps, Reuters, June 6, 2024.
⁹ Bank of Japan to trim bond buying, keeps rates steady, Reuters, June 14, 2024.
¹⁰ Source: FactSet, July 1, 2024.
¹¹ Gross Domestic Product (Third Estimate), Corporate Profits (Revised Estimate), and GDP by Industry, First Quarter 2024, Bureau of Economic Analysis, June 27, 2024.
¹² US job gains surge past expectations, wage growth quickens, Reuters, June 7, 2024.
¹³ Federal Reserve issues FOMC statement, federalreserve.gov, June 12, 2024.
¹⁴ Euro zone rebounds from recession as inflation steadies, Reuters, April 30, 2024.
¹⁵ Euro zone business activity expands at fastest rate in a year, Reuters, June 5, 2024.
¹⁶ UK economy picks up in early 2024, too late for election boost, Reuters, June 28, 2024.
¹⁷ Bank of England keeps rates at 5.25% ahead of UK election, Reuters, June 20, 2024.
¹⁸ UK inflation drops to 2% target for first time since 2021, Reuters, June 19, 2024
¹⁹ Bank of Japan opens door for a hawkish double surprise, Reuters, June 26, 2024
²⁰ Japan downgrades Q1 GDP on construction data corrections, Reuters, July 1, 2024
²¹ IMF upgrades China’s GDP growth forecasts but warns of risks ahead, Reuters, May 29, 2024.
²² China’s factory output disappoints, property sector stuck in doldrums, Reuters, June 17, 2024.
²³ EU to put tariffs of up to 38% on Chinese electric vehicles as trade war looms, The Guardian, June 12, 2024.

Economic and market background

In what is set to be the biggest election year in history, with four billion people – more than half the world’s population – going to the polls,¹ financial-market participants were on edge during the second quarter as a series of high-stakes votes spurred market volatility.

Although it subsequently recovered, India’s stock market experienced its worst day in more than four years at the start of June after Prime Minister Narendra Modi’s Bharatiya Janata Party unexpectedly lost its parliamentary majority,² putting at risk an aggressive reform agenda. In France, President Emmanual Macron called a snap parliamentary election after the far-right National Rally made major gains at the expense of his centrist alliance in the June European Parliament elections. With the prospect of a new government adding significantly to France’s already large debt pile, the spread on 10-year French government bonds (the extra return investors demand to buy France’s debt over Germany’s) reached its highest level since the 2012 eurozone crisis.³

Meanwhile, UK Prime Minister Rishi Sunak called a general election for 4 July, an earlier date than many had predicted, and a stumbling performance from US President Joe Biden in a TV debate with his rival Donald Trump at the end of June heightened the uncertainty surrounding the November election in the world’s largest economy.

Nevertheless, global equity markets made further gains over the quarter, driven by technology stocks and especially the ‘magnificent seven’ mega-cap businesses, which helped the S&P 500 and Nasdaq indices of US stocks to reach new record highs in June. Notably, Nvidia, the leading supplier of chips used to train artificial intelligence (AI) models, briefly became the world’s most valuable company on 18 June as its market capitalisation reached more than $3.3 trillion.⁴ The company’s shares rose by a staggering 150% over the first six months of the year, and the stock alone has been responsible for around 30% of the S&P 500’s gains over the same period.⁵ The dominance of a small number of technology names has fuelled growing concerns over market concentration.

Equity markets did come under pressure at times, especially in April, as hopes of interest-rate cuts were dampened amid signs of continued strength in the US economy and stubborn inflation. On top of this, geopolitics returned to the fore as tensions in the Middle East between Israel and Iran briefly escalated, driving a spike in energy prices.

Towards the end of the quarter, the US Federal Reserve (Fed) reaffirmed a hawkish narrative as it left interest rates unchanged at its June meeting, with the median forecast from its policymakers projecting just one rate cut before the end of the year.⁶ However, with US monthly inflation unchanged in May according to the Fed’s preferred personal consumption expenditures (PCE) measure, as a small increase in the cost of services was offset by the biggest fall in goods prices in six months,⁷ hopes were boosted for an economic ‘soft landing’ in which inflation cools without triggering a recession and a sharp rise in unemployment.

Elsewhere, the European Central Bank (ECB) moved ahead of its US and UK counterparts as it lowered borrowing costs for the first time in almost five years, reducing its deposit rate by 0.25% to 3.75%,⁸ although it would not commit to a specific path for future cuts, partly owing to persistent price and wage pressures. In contrast, the Bank of Japan opted to keep its short-term target rate unchanged at 0-0.1% at its June meeting, although it announced that it would provide more details in late July of a plan to start trimming bond purchases.⁹ Affected in part by the continuing interest-rate differential with the US, the yen slumped to a 38-year low against the US dollar during the quarter.

With market participants adjusting their expectations for near-term rate cuts downwards, government bonds struggled over the quarter, with the yield on the benchmark 10-year US Treasury rising by around 18 basis points. Gold, meanwhile, made its third successive quarterly gain, hitting a record high in May.¹⁰

Interest-rate projections by members of the Federal Open Market Committee

Each dot indicates the value of an individual participant’s judgement of the appropriate target level for the federal funds rate at the end of the specified calendar year or over the longer run.
Source: US Federal Reserve, 12 June 2024.

Total returns (%) to 30 June 2024

Source: FactSet, 1 July 2024. All equity market returns are sterling total returns.

Regional overview

Figures from the US Commerce Department’s Bureau of Economic Analysis indicated that the US economy grew at 1.4% during the first quarter of 2024, its slowest pace in almost two years.¹¹ However, while the trade deficit widened, domestic demand remained resilient, with a pickup in business investment and a continued housing recovery. According to the Labor Department, non-farm payrolls rose by 272,000 in May, far ahead of consensus expectations.¹² Hiring has been strong across the breadth of the economy, with the health-care sector providing the biggest employment gains as companies have sought to increase staffing levels after losing workers during the Covid pandemic. Wage growth also accelerated, rising 4.1% year on year.

The Fed expects inflation to decline gradually, with the PCE price index forecast to be virtually unchanged from its current level at the end of the year, as growth remains slightly above trend and unemployment stays low. The Federal Open Market Committee indicated in its June policy statement that while “modest further progress” has been made towards its 2% inflation objective, interest-rate reductions would not be appropriate until it has “gained greater confidence” that price pressures will continue to ease.¹³

In contrast to its US counterpart, the European Central Bank decided to begin its easing cycle in June but has similarly cautioned over the timing of any future moves, stressing how it will continue to follow a “data-dependent and meeting-by-meeting approach”, with many economists predicting there will be no more than two further cuts this year.

The eurozone’s economy jumped back from a mild recession in the first quarter as Germany, its largest economy, returned to growth, while the French and Spanish economies also gained some momentum.¹⁴ There was further positive news, with a key indicator showing that business activity had expanded at its quickest rate in a year in May, as a result of an expanding services industry. The HCOB purchasing managers’ index rose to 52.2 and remained above 50 (the level which separates growth from contraction) for the third consecutive month.¹⁵

Nevertheless, with Europe’s manufacturing sector still in contraction, overall growth is expected to be sluggish. The International Monetary Fund (IMF) has forecast that the eurozone’s GDP will rise by just 0.8% in 2024, not least because consumer sentiment in France and Germany remains weak.

Ahead of its general election, the UK received some positive economic news which indicated that the economy had bounced back from recession, with GDP expanding by 0.7% in the first three months of the year from the previous quarter, according to the Office for National Statistics.¹⁶ Real (inflation-adjusted) household disposal income per head also increased by 2.4% over the last year, boosted by fast wage growth in a tight labour market. Nevertheless, it was still 0.6% lower than in the final quarter of 2019, just before the start of the pandemic.

UK households: real disposable income per head

Chained volume measure £, seasonally adjusted

Source: UK Office for National Statistics, 28 June 2024

At its June meeting, the Bank of England’s Monetary Policy Committee (MPC) voted to keep interest rates on hold, although its policy minutes indicated the decision had been “finely balanced” for some MPC members.¹⁷ Headline consumer price inflation returned to its 2% target in May for the first time in almost three years, but the central bank expects it to rise again later in the year once the effects of past energy price declines have fallen out of annual inflation data. Services price inflation has remained significantly higher at 5.7%, and pay growth remains elevated.¹⁸

While the Bank of Japan (BoJ) kept interest rates on hold in June, it hinted that a hike may be on the cards at its meeting scheduled for the end of July, as it also seeks to start cutting its bond purchases and reducing the size of its enormous balance sheet, which currently represents around 125% of the country’s GDP.¹⁹ The weakening yen has put further pressure on the BoJ as rising import costs threaten to push inflation well above its 2% target.

The central bank’s decision will be complicated, however, by a revision to GDP data which suggested that Japan’s economy may have shrunk by 2.9% on an annualised basis in the first quarter.²⁰ This was more than initially reported and is likely to result in a cut to growth forecasts. Domestic consumption has been weak as households and small businesses have been squeezed by the higher costs of imported goods, although the tourism sector and exports have benefited from a more competitive exchange rate. Policymakers are hoping that large pay rises agreed with Japanese companies in April, and planned income tax cuts, will provide a boost during the second half of the year.

US dollar/Japanese yen rate

Source: FactSet, July 2024

After China’s GDP jumped by 5.3% in the first quarter compared to the previous year, beating expectations, the IMF upgraded its growth forecast, saying it expects China’s economy to grow by 5% in 2024.²¹ In May, China announced what it termed “historic” steps to stabilise its troubled property sector. State-owned firms are set to buy some apartments, while China’s central bank is introducing a relending facility for affordable housing and is further lowering mortgage interest rates and downpayment requirements. While these policy measures could take time to take effect, data for May suggested a further worsening in the property sector, with both investment and new home prices declining further.

Manufacturing investment showed strong growth of 9.6% in the first five months of the year,²² underpinned by policy support, and exports have helped to boost the economy. However, the European Union’s announcement in June that it intends to impose tariffs of up to 38% on imports of Chinese electric vehicles highlights potential trade challenges to come.²³

Investment implications

During the year so far, and indeed for most of 2023, financial-market participants have been considering when economies would react negatively to increases in interest rates. The impact of higher rates appears to have been gradual, which has led some central banks to start cutting rates and others to talk about cutting them later this year. With inflation having declined from its peak, central banks have some leeway to reduce rates from their elevated levels.

For risk assets such as equities, the gradual economic slowdown, easing of inflation and ‘dovish’ central bank narrative have been sufficient to extend rallies. As market participants continue to debate the likelihood of a more significant economic slowdown, they will be evaluating the legacy of the build-up in government debt and stubborn inflation levels, as well as the potential impact of political change. We believe this trio of influences will continue to cause volatility in markets in the second half of 2024 and beyond.

In terms of the outlook for growth, the much-heralded ‘soft landing’ appears to be within reach, especially if central banks are quick to take the top off their high cash rates. However, in our view, the odds of a downturn becoming more severe and developing into a proper hard landing are higher than the possibility of world economic growth reaccelerating and pushing inflation (and then interest rates) to new highs. On balance, the soft-landing scenario still appears most likely, but it has previously proved a difficult act for central bankers to pull off.

Once employment slows, along with investment, it can affect consumer confidence and therefore spending, leading businesses to reduce their inventories and, in turn, employment. This then depresses consumer sentiment further, and a full-blown recession can quickly emerge. The good news is that central banks have significant room to cut interest rates to arrest an accumulation of negative sentiment.

One feature of the current economic landscape is the continued global divergence in growth. Notably, the US economy has experienced persistently strong GDP growth, benefiting from its domestic energy sources, large fiscal stimulus and innovation in its technology sector. Europe has struggled as it has had to contend with (until recently) higher energy costs, combined with a lack of innovation. China, meanwhile, has continued to work through the legacy issues related to the crisis in its property sector. Heavy investment in new technologies, however, has given it the edge in producing electric vehicles and renewable-energy infrastructure, thereby exporting deflation to the rest of the world and prompting tariff increases from some countries. Other emerging-market economies are a mixed bag, but many have the ability to cut domestic rates if inflation continues to fall.

Real GDP growth

% change, year on year

Source: FactSet, July 2024

Political noise has been an increasing concern for markets since the 2008 global financial crisis and the eurozone sovereign debt crisis that followed. Growing wealth inequality, as income and living standards stagnated for many while the wealthy benefited from rising asset prices, left many voters disenchanted with incumbent, largely centrist, governments, and fuelled demand for more radical policies. The economic effects of the Covid pandemic later accelerated this trend. Once in office, populist politicians have tended to be as hamstrung by debt and low productivity as their predecessors, and many get ejected, prompting voters to look for the next party or leader that promises an easy or radical fix to complex problems.

Political change can be unnerving for market participants if they do not know what comes next, but recent developments have rarely led markets to avert their focus from the economy and rates. After an initial wobble, markets have tended to continue their upward journey. The exceptions to this trend can come when governments threaten the durability of their debt (as occurred with former UK Prime Minister Liz Truss’s short-lived government in 2022) or interfere with the independence of their central banks (as happened in Turkey in 2023).

In the past, investors could usually look beyond a forthcoming election and invest through any short-term volatility, but now we are increasingly seeing elections with the potential (albeit still small) to cause a major upset.

In addition to politics, the outlook is clouded by high levels of government debt which must somehow be serviced. While we are not suggesting current levels of debt are unsustainable, the cost of servicing this debt has risen significantly over the last two years. In the UK, government debt interest payments now represent a greater cost (as a percentage of GDP) than education, defence or economic investment. The UK is not alone, and many governments face the same challenge of needing to increase health and defence spending while trying to pay for past support through a higher interest bill. This will severely limit any government’s ability to stimulate economic growth in the future. Some relief can come from lower official rates, but with inflation likely to remain consistently above 2% targets in many economies, interest-rate relief will have its limits.

When government debt increases, private-sector debt tends to fall, and this has indeed happened over the period since the global financial crisis. This puts the private sector in a better credit position and means that the next economic slowdown is more likely to be a cyclical one, which can be tackled with lower rates, rather than a systemic version that can be more difficult to bounce back from.

Conclusion

The global economy appears to have been more resilient than many had anticipated, with the US in particular seemingly absorbing the impact of higher interest rates, at least for now. As a result, a soft economic landing remains in prospect, especially as central banks have some flexibility to lower interest rates.

However, while inflation has moderated, it remains above target in major economies, which is limiting that flexibility. The mounting effects of higher rates are likely to weigh on economic activity as the year progresses, and elevated debt levels will make it difficult for governments to offer significant stimulus should a bigger downturn develop.

Investors must also contend with rising international and domestic political tensions which could spark market volatility, especially as key elections, notably in the US, approach.

With the ‘benign’ low-inflation and low-rate conditions of the previous decade now firmly behind us, there is likely to be greater divergence in the performance of economies, asset classes, and individual securities. We believe it will therefore be critical for investors to identify the long-term growth opportunities in areas supported by structural demand and pay close attention to fundamentals in order to separate the winners from the losers.

A politician thinks of the next election. A statesman, of the next generation.

James Freeman Clarke, American minister, theologian and author, 1810-1888

¹ 2024 is the biggest election year in history, The Economist, 13 November 2023.
² Indian shares post worst day in 4 years as polls show unexpectedly narrow Modi win, Reuters, 4 June 2024.
³ French debt risk premium hits highest since 2012 crisis ahead of election, Reuters, 28 June 2024.
⁴ Nvidia eclipses Microsoft as world’s most valuable company, Reuters, 18 June 2024.
⁵ Tech boom leads global markets through first half of 2024, Reuters, 1 July 2024.
⁶ Fed leaves rates unchanged, sees only one 2024 cut despite inflation progress, Reuters, 12 June 2024.
⁷ US inflation cools in May, boosting hopes of Fed rate cut, Reuters, 28 June 2024.
⁸ ECB cuts rates, keeps next move under wraps, Reuters, 6 June 2024.
⁹ Bank of Japan to trim bond buying, keeps rates steady, Reuters, 14 June 2024.
¹⁰ Source: FactSet, 1 July 2024.
¹¹ Gross Domestic Product (Third Estimate), Corporate Profits (Revised Estimate), and GDP by Industry, First Quarter 2024, Bureau of Economic Analysis, 27 June 2024.
¹² US job gains surge past expectations, wage growth quickens, Reuters, 7 June 2024.
¹³ Federal Reserve issues FOMC statement, federalreserve.gov, 12 June 2024.
¹⁴ Euro zone rebounds from recession as inflation steadies, Reuters, 30 April 2024.
¹⁵ Euro zone business activity expands at fastest rate in a year, Reuters, 5 June 2024.
¹⁶ UK economy picks up in early 2024, too late for election boost, Reuters, 28 June 2024.
¹⁷ Bank of England keeps rates at 5.25% ahead of UK election, Reuters, 20 June 2024.
¹⁸ UK inflation drops to 2% target for first time since 2021, Reuters, 19 June 2024
¹⁹ Bank of Japan opens door for a hawkish double surprise, Reuters, 26 June 2024
²⁰ Japan downgrades Q1 GDP on construction data corrections, Reuters, 1 July 2024
²¹ IMF upgrades China’s GDP growth forecasts but warns of risks ahead, Reuters, 29 May 2024.
²² China’s factory output disappoints, property sector stuck in doldrums, Reuters, 17 June 2024.
²³ EU to put tariffs of up to 38% on Chinese electric vehicles as trade war looms, The Guardian, 12 June 2024.

Economic and market background

In what is set to be the biggest election year in history, with four billion people – more than half the world’s population – going to the polls,¹ financial-market participants were on edge during the second quarter as a series of high-stakes votes spurred market volatility.

Although it subsequently recovered, India’s stock market experienced its worst day in more than four years at the start of June after Prime Minister Narendra Modi’s Bharatiya Janata Party unexpectedly lost its parliamentary majority,² putting at risk an aggressive reform agenda. In France, President Emmanual Macron called a snap parliamentary election after the far-right National Rally made major gains at the expense of his centrist alliance in the June European Parliament elections. With the prospect of a new government adding significantly to France’s already large debt pile, the spread on 10-year French government bonds (the extra return investors demand to buy France’s debt over Germany’s) reached its highest level since the 2012 eurozone crisis.³

Meanwhile, UK Prime Minister Rishi Sunak called a general election for 4 July, an earlier date than many had predicted, and a stumbling performance from US President Joe Biden in a TV debate with his rival Donald Trump at the end of June heightened the uncertainty surrounding the November election in the world’s largest economy.

Nevertheless, global equity markets made further gains over the quarter, driven by technology stocks and especially the ‘magnificent seven’ mega-cap businesses, which helped the S&P 500 and Nasdaq indices of US stocks to reach new record highs in June. Notably, Nvidia, the leading supplier of chips used to train artificial intelligence (AI) models, briefly became the world’s most valuable company on 18 June as its market capitalisation reached more than $3.3 trillion.⁴ The company’s shares rose by a staggering 150% over the first six months of the year, and the stock alone has been responsible for around 30% of the S&P 500’s gains over the same period.⁵ The dominance of a small number of technology names has fuelled growing concerns over market concentration.

Equity markets did come under pressure at times, especially in April, as hopes of interest-rate cuts were dampened amid signs of continued strength in the US economy and stubborn inflation. On top of this, geopolitics returned to the fore as tensions in the Middle East between Israel and Iran briefly escalated, driving a spike in energy prices.

Towards the end of the quarter, the US Federal Reserve (Fed) reaffirmed a hawkish narrative as it left interest rates unchanged at its June meeting, with the median forecast from its policymakers projecting just one rate cut before the end of the year.⁶ However, with US monthly inflation unchanged in May according to the Fed’s preferred personal consumption expenditures (PCE) measure, as a small increase in the cost of services was offset by the biggest fall in goods prices in six months,⁷ hopes were boosted for an economic ‘soft landing’ in which inflation cools without triggering a recession and a sharp rise in unemployment.

Elsewhere, the European Central Bank (ECB) moved ahead of its US and UK counterparts as it lowered borrowing costs for the first time in almost five years, reducing its deposit rate by 0.25% to 3.75%,⁸ although it would not commit to a specific path for future cuts, partly owing to persistent price and wage pressures. In contrast, the Bank of Japan opted to keep its short-term target rate unchanged at 0-0.1% at its June meeting, although it announced that it would provide more details in late July of a plan to start trimming bond purchases.⁹ Affected in part by the continuing interest-rate differential with the US, the yen slumped to a 38-year low against the US dollar during the quarter.

With market participants adjusting their expectations for near-term rate cuts downwards, government bonds struggled over the quarter, with the yield on the benchmark 10-year US Treasury rising by around 18 basis points. Gold, meanwhile, made its third successive quarterly gain, hitting a record high in May.¹⁰

Interest-rate projections by members of the Federal Open Market Committee

Each dot indicates the value of an individual participant’s judgement of the appropriate target level for the federal funds rate at the end of the specified calendar year or over the longer run.
Source: US Federal Reserve, 12 June 2024.

Total returns (%) to 30 June 2024

Source: FactSet, 1 July 2024. All equity market returns are sterling total returns.

Regional overview

Figures from the US Commerce Department’s Bureau of Economic Analysis indicated that the US economy grew at 1.4% during the first quarter of 2024, its slowest pace in almost two years.¹¹ However, while the trade deficit widened, domestic demand remained resilient, with a pickup in business investment and a continued housing recovery. According to the Labor Department, non-farm payrolls rose by 272,000 in May, far ahead of consensus expectations.¹² Hiring has been strong across the breadth of the economy, with the health-care sector providing the biggest employment gains as companies have sought to increase staffing levels after losing workers during the Covid pandemic. Wage growth also accelerated, rising 4.1% year on year.

The Fed expects inflation to decline gradually, with the PCE price index forecast to be virtually unchanged from its current level at the end of the year, as growth remains slightly above trend and unemployment stays low. The Federal Open Market Committee indicated in its June policy statement that while “modest further progress” has been made towards its 2% inflation objective, interest-rate reductions would not be appropriate until it has “gained greater confidence” that price pressures will continue to ease.¹³

In contrast to its US counterpart, the European Central Bank decided to begin its easing cycle in June but has similarly cautioned over the timing of any future moves, stressing how it will continue to follow a “data-dependent and meeting-by-meeting approach”, with many economists predicting there will be no more than two further cuts this year.

The eurozone’s economy jumped back from a mild recession in the first quarter as Germany, its largest economy, returned to growth, while the French and Spanish economies also gained some momentum.¹⁴ There was further positive news, with a key indicator showing that business activity had expanded at its quickest rate in a year in May, as a result of an expanding services industry. The HCOB purchasing managers’ index rose to 52.2 and remained above 50 (the level which separates growth from contraction) for the third consecutive month.¹⁵

Nevertheless, with Europe’s manufacturing sector still in contraction, overall growth is expected to be sluggish. The International Monetary Fund (IMF) has forecast that the eurozone’s GDP will rise by just 0.8% in 2024, not least because consumer sentiment in France and Germany remains weak.

Ahead of its general election, the UK received some positive economic news which indicated that the economy had bounced back from recession, with GDP expanding by 0.7% in the first three months of the year from the previous quarter, according to the Office for National Statistics.¹⁶ Real (inflation-adjusted) household disposal income per head also increased by 2.4% over the last year, boosted by fast wage growth in a tight labour market. Nevertheless, it was still 0.6% lower than in the final quarter of 2019, just before the start of the pandemic.

UK households: real disposable income per head

Chained volume measure £, seasonally adjusted

Source: UK Office for National Statistics, 28 June 2024

At its June meeting, the Bank of England’s Monetary Policy Committee (MPC) voted to keep interest rates on hold, although its policy minutes indicated the decision had been “finely balanced” for some MPC members.¹⁷ Headline consumer price inflation returned to its 2% target in May for the first time in almost three years, but the central bank expects it to rise again later in the year once the effects of past energy price declines have fallen out of annual inflation data. Services price inflation has remained significantly higher at 5.7%, and pay growth remains elevated.¹⁸

While the Bank of Japan (BoJ) kept interest rates on hold in June, it hinted that a hike may be on the cards at its meeting scheduled for the end of July, as it also seeks to start cutting its bond purchases and reducing the size of its enormous balance sheet, which currently represents around 125% of the country’s GDP.¹⁹ The weakening yen has put further pressure on the BoJ as rising import costs threaten to push inflation well above its 2% target.

The central bank’s decision will be complicated, however, by a revision to GDP data which suggested that Japan’s economy may have shrunk by 2.9% on an annualised basis in the first quarter.²⁰ This was more than initially reported and is likely to result in a cut to growth forecasts. Domestic consumption has been weak as households and small businesses have been squeezed by the higher costs of imported goods, although the tourism sector and exports have benefited from a more competitive exchange rate. Policymakers are hoping that large pay rises agreed with Japanese companies in April, and planned income tax cuts, will provide a boost during the second half of the year.

US dollar/Japanese yen rate

Source: FactSet, July 2024

After China’s GDP jumped by 5.3% in the first quarter compared to the previous year, beating expectations, the IMF upgraded its growth forecast, saying it expects China’s economy to grow by 5% in 2024.²¹ In May, China announced what it termed “historic” steps to stabilise its troubled property sector. State-owned firms are set to buy some apartments, while China’s central bank is introducing a relending facility for affordable housing and is further lowering mortgage interest rates and downpayment requirements. While these policy measures could take time to take effect, data for May suggested a further worsening in the property sector, with both investment and new home prices declining further.

Manufacturing investment showed strong growth of 9.6% in the first five months of the year,²² underpinned by policy support, and exports have helped to boost the economy. However, the European Union’s announcement in June that it intends to impose tariffs of up to 38% on imports of Chinese electric vehicles highlights potential trade challenges to come.²³

Investment implications

During the year so far, and indeed for most of 2023, financial-market participants have been considering when economies would react negatively to increases in interest rates. The impact of higher rates appears to have been gradual, which has led some central banks to start cutting rates and others to talk about cutting them later this year. With inflation having declined from its peak, central banks have some leeway to reduce rates from their elevated levels.

For risk assets such as equities, the gradual economic slowdown, easing of inflation and ‘dovish’ central bank narrative have been sufficient to extend rallies. As market participants continue to debate the likelihood of a more significant economic slowdown, they will be evaluating the legacy of the build-up in government debt and stubborn inflation levels, as well as the potential impact of political change. We believe this trio of influences will continue to cause volatility in markets in the second half of 2024 and beyond.

In terms of the outlook for growth, the much-heralded ‘soft landing’ appears to be within reach, especially if central banks are quick to take the top off their high cash rates. However, in our view, the odds of a downturn becoming more severe and developing into a proper hard landing are higher than the possibility of world economic growth reaccelerating and pushing inflation (and then interest rates) to new highs. On balance, the soft-landing scenario still appears most likely, but it has previously proved a difficult act for central bankers to pull off.

Once employment slows, along with investment, it can affect consumer confidence and therefore spending, leading businesses to reduce their inventories and, in turn, employment. This then depresses consumer sentiment further, and a full-blown recession can quickly emerge. The good news is that central banks have significant room to cut interest rates to arrest an accumulation of negative sentiment.

One feature of the current economic landscape is the continued global divergence in growth. Notably, the US economy has experienced persistently strong GDP growth, benefiting from its domestic energy sources, large fiscal stimulus and innovation in its technology sector. Europe has struggled as it has had to contend with (until recently) higher energy costs, combined with a lack of innovation. China, meanwhile, has continued to work through the legacy issues related to the crisis in its property sector. Heavy investment in new technologies, however, has given it the edge in producing electric vehicles and renewable-energy infrastructure, thereby exporting deflation to the rest of the world and prompting tariff increases from some countries. Other emerging-market economies are a mixed bag, but many have the ability to cut domestic rates if inflation continues to fall.

Real GDP growth

% change, year on year

Source: FactSet, July 2024

Political noise has been an increasing concern for markets since the 2008 global financial crisis and the eurozone sovereign debt crisis that followed. Growing wealth inequality, as income and living standards stagnated for many while the wealthy benefited from rising asset prices, left many voters disenchanted with incumbent, largely centrist, governments, and fuelled demand for more radical policies. The economic effects of the Covid pandemic later accelerated this trend. Once in office, populist politicians have tended to be as hamstrung by debt and low productivity as their predecessors, and many get ejected, prompting voters to look for the next party or leader that promises an easy or radical fix to complex problems.

Political change can be unnerving for market participants if they do not know what comes next, but recent developments have rarely led markets to avert their focus from the economy and rates. After an initial wobble, markets have tended to continue their upward journey. The exceptions to this trend can come when governments threaten the durability of their debt (as occurred with former UK Prime Minister Liz Truss’s short-lived government in 2022) or interfere with the independence of their central banks (as happened in Turkey in 2023).

In the past, investors could usually look beyond a forthcoming election and invest through any short-term volatility, but now we are increasingly seeing elections with the potential (albeit still small) to cause a major upset.

In addition to politics, the outlook is clouded by high levels of government debt which must somehow be serviced. While we are not suggesting current levels of debt are unsustainable, the cost of servicing this debt has risen significantly over the last two years. In the UK, government debt interest payments now represent a greater cost (as a percentage of GDP) than education, defence or economic investment. The UK is not alone, and many governments face the same challenge of needing to increase health and defence spending while trying to pay for past support through a higher interest bill. This will severely limit any government’s ability to stimulate economic growth in the future. Some relief can come from lower official rates, but with inflation likely to remain consistently above 2% targets in many economies, interest-rate relief will have its limits.

When government debt increases, private-sector debt tends to fall, and this has indeed happened over the period since the global financial crisis. This puts the private sector in a better credit position and means that the next economic slowdown is more likely to be a cyclical one, which can be tackled with lower rates, rather than a systemic version that can be more difficult to bounce back from.

Conclusion

The global economy appears to have been more resilient than many had anticipated, with the US in particular seemingly absorbing the impact of higher interest rates, at least for now. As a result, a soft economic landing remains in prospect, especially as central banks have some flexibility to lower interest rates.

However, while inflation has moderated, it remains above target in major economies, which is limiting that flexibility. The mounting effects of higher rates are likely to weigh on economic activity as the year progresses, and elevated debt levels will make it difficult for governments to offer significant stimulus should a bigger downturn develop.

Investors must also contend with rising international and domestic political tensions which could spark market volatility, especially as key elections, notably in the US, approach.

With the ‘benign’ low-inflation and low-rate conditions of the previous decade now firmly behind us, there is likely to be greater divergence in the performance of economies, asset classes, and individual securities. We believe it will therefore be critical for investors to identify the long-term growth opportunities in areas supported by structural demand and pay close attention to fundamentals in order to separate the winners from the losers.

A politician thinks of the next election. A statesman, of the next generation.

James Freeman Clarke, American minister, theologian and author, 1810-1888

¹ 2024 is the biggest election year in history, The Economist, 13 November 2023.
² Indian shares post worst day in 4 years as polls show unexpectedly narrow Modi win, Reuters, 4 June 2024.
³ French debt risk premium hits highest since 2012 crisis ahead of election, Reuters, 28 June 2024.
⁴ Nvidia eclipses Microsoft as world’s most valuable company, Reuters, 18 June 2024.
⁵ Tech boom leads global markets through first half of 2024, Reuters, 1 July 2024.
⁶ Fed leaves rates unchanged, sees only one 2024 cut despite inflation progress, Reuters, 12 June 2024.
⁷ US inflation cools in May, boosting hopes of Fed rate cut, Reuters, 28 June 2024.
⁸ ECB cuts rates, keeps next move under wraps, Reuters, 6 June 2024.
⁹ Bank of Japan to trim bond buying, keeps rates steady, Reuters, 14 June 2024.
¹⁰ Source: FactSet, 1 July 2024.
¹¹ Gross Domestic Product (Third Estimate), Corporate Profits (Revised Estimate), and GDP by Industry, First Quarter 2024, Bureau of Economic Analysis, 27 June 2024.
¹² US job gains surge past expectations, wage growth quickens, Reuters, 7 June 2024.
¹³ Federal Reserve issues FOMC statement, federalreserve.gov, 12 June 2024.
¹⁴ Euro zone rebounds from recession as inflation steadies, Reuters, 30 April 2024.
¹⁵ Euro zone business activity expands at fastest rate in a year, Reuters, 5 June 2024.
¹⁶ UK economy picks up in early 2024, too late for election boost, Reuters, 28 June 2024.
¹⁷ Bank of England keeps rates at 5.25% ahead of UK election, Reuters, 20 June 2024.
¹⁸ UK inflation drops to 2% target for first time since 2021, Reuters, 19 June 2024
¹⁹ Bank of Japan opens door for a hawkish double surprise, Reuters, 26 June 2024
²⁰ Japan downgrades Q1 GDP on construction data corrections, Reuters, 1 July 2024
²¹ IMF upgrades China’s GDP growth forecasts but warns of risks ahead, Reuters, 29 May 2024.
²² China’s factory output disappoints, property sector stuck in doldrums, Reuters, 17 June 2024.
²³ EU to put tariffs of up to 38% on Chinese electric vehicles as trade war looms, The Guardian, 12 June 2024.

Key Points

• We expect inflation and interest rates to persist at higher levels than in the previous market regime.
• Alongside this, elevated levels of post-Covid government debt create a drag on economies which, in turn, can lead to broadly more volatile market returns.
• With governments needing to maintain spending on health and defense, the appetite for fiscal policy to support growth is undermined by the interest bill.
• When the market trinity of inflation, debt and interest rates is on the rise, market anxiety rises, as does higher volatility.
• We believe we have entered this phase but there are early signs that calm can return.

It might appear to be stating the obvious, but for markets to be in a good mood, the market ‘trinity’ of inflation, debt and interest rates, all need to be well behaved. All three indicators are connected, of course, but if inflation remains stable and at low levels, interest rates do not need to be too elevated. Meanwhile, if government debt is stable and not too much of a burden, free markets are able to continue investing capital productively.

In this new market regime, we keep talking about how we expect inflation to remain consistently higher than previously and, as a result, interest rates will need to be higher too. Alongside this, elevated levels of post-Covid government debt create a drag on economies which, in turn, can lead to broadly more volatile market returns.

In this blog, we assess the current state of this trinity of market influencers through the lens of our macro themes.

Persistent Inflation

Inflation has been on a rollercoaster ride since the Covid pandemic, driven higher by labor misalignment and energy-price spikes following Russia’s invasion of Ukraine and the consequent need for energy-supply adjustments. There then followed a downward trend where the energy price effects fell away, only to be replaced by the legacy concerns over higher wage costs. Wage inflation, once entrenched, is always difficult to remove, especially when ageing demographics and spending patterns are creating high demand for labor at the same time as we are seeing a shortage of the right employees.

To control this scenario, central banks need to create an environment in which unemployment rises. Using interest rates to do this can be both blunt and slow. The latest US Employment Cost Index has reminded the market that wage inflation is not coming down; this is unsurprising, given that US employment remains strong and is yet to turn meaningfully. Against this economic backdrop, we believe the US central bank will remain careful not to remove the tight monetary policy too soon. With inflation creeping back up and thereby pushing interest-rate expectations higher again, the market has become anxious once more.

In a previous blog, Market Outlook: A Case of ‘Déjà Vu’, we suggested that this inflationary growth phase would follow the ‘Goldilocks’ market period (where the trinity of market indicators were in line) and that it would lead to market volatility. It appears that we may have now reached this phase.

Human Capital

There is one of our important macro themes at play here: human capital (the change in the type and cost of labor). This theme identifies the change in demographics that causes the shortage of labor, as well as the possibility that companies need to find alternatives. In the previous market regime, labor was relatively cheap and had little influence on the cost of production. Now, with wage growth running at higher levels than inflation, it is expensive, and increases the incentive to invest capital in alternatives (artificial intelligence and robots).

Recent data suggests there is a gradual deterioration in labor hiring, and this will eventually remove the need for higher rates. For the next few months though, we suspect that markets will continue to fret over inflation, with a heightened focus on the level of interest rates and central bank comments.

Government Debt

The third element of the market trinity, government debt, could prove to be important for the longer-term level of markets. Government debt levels have skyrocketed in recent years owing to the need to support the financial system after 2008 and the consumer during the pandemic. With government debt rising to levels not seen since the 1930s, and the cost of servicing that debt also on the rise, should we be concerned about the sustainability of that debt? We believe ‘yes’ is the answer, although there is always a ‘but’.

Our big government theme, which identifies the increased involvement of governments in the running of economies, concludes that high debt levels are here to stay. The post-Covid increase in social spending gave way to an increased focus on the need to be more self-sufficient in energy and supply lines.

General Government Debt Trends for Selected Developed Markets (% of GDP)

Source: Macrobond, International Monetary Fund Data as of April 5 2024

Furthermore, our geopolitical macro theme great power competition defines a period of heightened conflict resulting in a need for governments to increase defense spending. The chart below shows the change in defense spending for NATO members between 2019 and 2023 as a percentage of GDP.

NATO Defense Expenditure, % of GDP

Source: Macrobond and NATO, December 2023

Higher government debt levels may not be all bad news, however, as the offset to an increase in government debt is usually a reduction in private-sector debt. Taking the US as an example, since the 2008 global financial crisis we have seen a reduction in private-sector debt, particularly in financials (a direct response to the banking crisis) and households (which saw increased savings during the Covid pandemic).

Debt Concerns

The concern for the market, though, is that the cost of debt keeps rising and, eventually, governments cannot afford the interest-rate bill. With bond yields set to remain higher for longer (reflecting the higher inflation story), this seems a legitimate concern. In addition, with governments needing to maintain spending on health and defense, the appetite for fiscal policy to support growth is undermined by the interest bill.

Less flexibility on spending plans can result in frequent political change, as successive governments fail to fulfil their electoral policies, and a potential crowding out of other investments. We believe fears might grow that the debt is unsustainable, and investors may start to worry about default.

In the past, high debt levels have been managed through financial repression (post global financial crisis) and by inflating the problem away. If inflation is high, nominal GDP grows rapidly and so too does tax revenue. Ultimately, the debt becomes more affordable. This appears to be the phase we are in now. Meanwhile, forcing domestic investors to buy the bonds issued by the governments is also an approach which allows the debt to find buyers while we wait for inflation to have an impact. In some countries (Japan, for example) this may be required to allow the central banks to stop their bond purchases.

Could Calm Return?

When the market trinity of inflation, debt and interest rates is on the rise, market anxiety rises, as does higher volatility. We believe we have entered this phase but there are early signs that calm can return. Tighter monetary policy is starting to influence employment, thus reducing the need to have higher wages. Unfortunately, it may take some time for headline inflation to resume its downward trend which, in turn, will allow central banks to reduce interest rates. Higher-for-longer inflation and interest rates can raise awareness of the cost of high government debt levels, which also keeps markets nervous. And yet here too, we can see some solutions further down the road. In an upcoming blog, we will delve more deeply into the potential for deflation to become the dominant theme later in the year.

Charity investors continue to face a variety of challenges. We have seen rising geopolitical tensions across the globe, which is a cause of concern for many charity investors. What are the investment implications of geopolitical risk, and are there any other threats you would highlight?

Last year was a very turbulent period for geopolitics, with rising tensions between the US and China and conflict flaring in the Middle East, in addition to the ongoing Russia/Ukraine war. The future of these conflicts is unknown and remains a key source of risk as the world becomes more divided.

The high level of global debt in an environment of elevated interest rates also presents a major concern.

Climate change is, in our view, one of the most significant threats, but also an area of opportunity, as much investment is needed to support the transition to a low-carbon economy.

What are your thoughts on the current market environment and on the inflation outlook?

A year ago, as shown in the latest Newton Charity Investment Survey, the biggest concern for charities was inflation. It was felt then that central banks would have to create a significant slowdown in order to get inflation back on target.

I think it is clear that the inflation genie has not quite been pushed back into the bottle yet, and it is too early for the US Federal Reserve (Fed) to declare victory and start cutting rates. The concern is that services inflation has not yet resumed a disinflationary trend, primarily owing to the stickiness of shelter and health-care prices, which are known to move with a lag, and wages are still elevated. Therefore, not enough economic slack has been created to start cutting rates, and with financial conditions still loose, the Fed has indicated an intent to keep US policy rates elevated for longer. We still think the Fed may deliver two rate cuts this year, but the timing is being pushed to the third and fourth quarters.

US consumer price index inflation

Increased fiscal spending has benefitted certain parts of the market, such as the industrial sector, over the last couple of years. What is the money being spent on?

There is significant fiscal spending currently taking place, and the US Congress has passed three infrastructure items since 2021:

1. Infrastructure bill

2. Inflation Reduction Act

3. CHIPS Act

In a nutshell, the Inflation Reduction Act targets clean energy and the CHIPS Act is intended to incentivise the research and manufacturing of semiconductors in the US. The stocks that are expected to benefit from this increased spending have been outperforming until recently. The US$550bn infrastructure bill was passed to provide investment into infrastructure such as roads, bridges and water. Since 2021, just 0.2% of US GDP has been spent on traditional infrastructure.[1] Stocks that are materially tied to general infrastructure spending have outperformed the S&P 500 by nearly 60% since the bill was passed in November 2021,[2] suggesting that this could be just the beginning in terms of macro and market upside.

2024 is set to be the biggest year in history for elections. What is the outlook given the significant number of elections?

The global election cycle is underway, with a number of consequential elections taking place this year across key countries including the US and the UK. The market is currently focused on the November US election given major policy divergence between leading candidates Donald Trump and Joe Biden, the size of the US equity market, and the potential spillover to other economies.

In the US, a Biden/Democratic party loss could lead to major changes in key areas such as fiscal policy, trade policy (especially between the US and China), foreign policy (given the conflicts in the Middle East and Israel, and in Russia and Ukraine), and regulation (associated with the environment and clean energy). It is nearly impossible to call the election outcome at this point in time as there is significant uncertainty and potential for a November surprise given that polls are predicting a close race for the presidency and the Congress.

All in all, the key sectors and themes that could be beneficiaries of the policies that the candidates are proposing are traditional sources of energy under a Trump administration, and health care and green energy if Biden remains in the White House.

Against this volatile backdrop, we expect sector rotation to continue depending on the outlook for growth, inflation and interest rates. However, our focus remains on quality; higher inflation means it is even more important to look for stocks that can benefit from structural growth trends and that possess strong, robust business models with pricing power.

Your capital may be at risk. The value of investments and the income from them can fall as well as rise and investors may not get back the original amount invested.

[1] Source: Strategas.

[2] Source: Strategas.

Market expectations have moved on quite rapidly over recent months alongside the changing macro data. Fears of recession gave way to predictions of an economic ‘soft landing’, and, even more recently, a ‘no-landing’ scenario has been mooted as risk assets have continued to rally. Deputy CIO of multi-asset, Paul Brain, discusses the macro factors that might eventually dampen the more positive sentiment later this year with multimedia editor Matthew Goodburn.

Recorded 26 March 2024