Investment thoughts from our Real Return team

After the events of 2022 and the first quarter of this year, financial markets were comparatively quiet in the months of April to June. As such, the decline in equity and bond market volatility that began in October 2022 has continued.

Markets began the quarter still grappling with the fallout from the failure of Silicon Valley Bank (SVB), with many fearing the worst, particularly given that the US Federal Reserve (Fed) was deemed by some to have erroneously hiked interest rates at its March meeting while the regional banking turmoil was still in full swing. While the shares of US regional banks went on to make new lows in the second quarter, US and global equities found their footing, closing out the quarter at new highs for the year. Emerging signs of systemic risk had been soothed and the banking crisis contained thanks to the Fed fulfilling its role as the lender of last resort and providing liquidity to those banks in need.

Worries about US regional banks gave way to concerns about whether the US government was set to default if politicians in Washington failed to agree to raise the debt ceiling. In retrospect, agreement was relatively easy to come by – the threshold for US government debt was raised a further $4 trillion to $35 trillion. A trillion here, a trillion there, and pretty soon you’re talking real money.

The policy-induced rally out of the mid-March lows following SVB’s collapse paused in April, with global equities entering a holding pattern while hands were wrung over events in Washington, DC. However, beneath the surface of the indices, technology stocks continued to build on the first quarter’s gains as the artificial intelligence (AI) narrative gained momentum. When global equity markets resumed their journey higher in June, those companies judged to be the enablers and beneficiaries of AI were in the vanguard.

New AI, same old greed and fear?

Many column inches have been dedicated to the transformative potential of AI. We will not contribute further to this discussion in this particular piece, given the vast coverage around the subject across media outlets in recent months. What we will say is that a high degree of optimism was priced into many stocks over the course of the second quarter. Whether the advantages to future financial performance inferred by recent price moves will be realised will only be revealed with time.

But while many speculate as to the types of future breakthroughs that AI will make possible, our interest lies in another form of speculation. Coming into 2023, the large-cap tech/growth names that had led the post-financial crisis bull market had fallen out of favour with markets. It was no coincidence that this followed substantial share-price declines in 2022, with the NYSE FANG+ Index down -40.1% over the year. After more than ten years of crowding into those companies that were able to deliver earnings growth in a world of low nominal growth and non-existent bond yields, many investors were left licking their wounds.

The acceleration of nominal growth during 2022, alongside the rapid move of bond yields to levels not seen in over a decade, challenged the central thesis upon which ten-plus years of accumulated positioning was predicated. The consensus began to coalesce around the idea of a new inflation regime, one in which interest rates would move higher for longer, thereby serving as a headwind to long-duration equities. By the end of the year, those stocks that had been mainstays of most investor portfolios had been eschewed in favour of other companies. Additionally, many tech and growth names had become consensus short positions.

When the broad equity market found a floor in October 2022, the process of squeezing shorts began, and the subsequent deceleration of inflation and stabilisation of bond yields began to challenge the thesis that growth equities would remain under pressure. As the shares of tech companies began to edge higher, concerns about the growth outlook emerged and investors began to remind themselves of the ability of many large-cap growth companies to grow their earnings in even the worst of economic times. Then came the AI revolution, adding the kicker to already gathering momentum. By June 2023, market participants were buying record call volumes on tech names such as Nvidia. This marked a complete reversal from the third quarter of 2022 when market participants were buying record put volumes in individual growth stocks.

AI will no doubt go on to shape the world in which we live. However, with respect to the near-term market outlook, the swing from fear of loss in late 2022 to mounting signs of fear of missing out at the end of the second quarter is of greater relevance.

Soft landing dead ahead?

Some market participants are arguing that tech’s resurgence is an indication that a soft landing is in motion. With global bond yields largely below their Q4 2022 highs, credit spreads contained and commodity prices declining, it is a reasonable case to make. No doubt another reason why there is growing confidence in a soft landing is that the widely forecast recession at the start of the year has failed to materialise. The fact that this monetary-policy tightening cycle has been so aggressive has also informed expectations of a recession, as did the equity-market declines of 2022.

But the global economy has weathered the aggressive monetary-policy tightening far better than the majority of market participants expected. One of the reasons economies have been resilient in the face of aggressive rate hikes is that private-sector balance sheets were in much better shape following the fiscal transfers engineered by governments in response to Covid, and forced saving brought about by lockdowns. Additionally, many companies and households took advantage of low interest rates to ‘term out’ their debt. However, at some point, the excess savings accumulated through lockdowns will be depleted and debt will have to be rolled at higher interest rates.

We are seeing mounting evidence in the macro and micro data that the tailwind to economic growth provided by excess savings is dwindling. Furthermore, it is premature to conclude that central banks are done. While year-on-year inflation data cooled from multi-decade highs, we are seeing nascent signs of ‘stickiness’.

This is perhaps most evident in the UK, which has seen some of the most acute inflationary pressures. May saw the UK’s headline consumer price inflation (CPI) up 8.7% compared to the same month in the previous year, the same figure as in April, while core CPI reaccelerated to 7.1% from 6.8%. The May CPI print dashed any hopes that the Bank of England (BoE) could steer the economy to a soft landing. April data showed that wage growth was running at 7.5% year on year.

After adopting some more dovish tones around the start of the year, the BoE has had to reassert its commitment to return inflation to target. With the blunt instrument of monetary policy, the only way the BoE is going to be able to get inflation down to 2% is by raising interest rates to such an extent that it kills demand for labour. This will happen through several channels; however, with some two million fixed-rate mortgages due to reset to floating rates over the next 12 months, the principal means will be to impose higher interest costs on households, suppressing their discretionary spending.

The UK’s Institute of Fiscal Studies highlighted in a recent report that around a quarter of the UK’s 14 million adults with a mortgage are set to come off a fixed-term deal between the fourth quarter of 2022 and the fourth quarter of 2023:

On average those in mortgage-holding households will pay almost £280 more each month, with 30-39-year olds paying almost £360 more. This will be a significant hit to mortgagors’ disposable incomes (i.e. incomes after mortgage payments) at a time that families are already under strain – on average disposable incomes will fall by 8.3%, with those aged 30-39 again seeing the biggest hit (almost 11%). For some the rise will be substantially larger: almost 1.4 million – 690,000 of whom are under 40 – will see their disposable incomes fall by over 20%. ¹

Institute of Fiscal Studies

In turn, reduced household demand will lead to job losses in businesses serving the household sector and crimped investment, which will further depress demand.

Here we can see the long and variable lags of monetary policy at play. On average, there is an 18-month lag between the beginning of a hiking cycle and the onset of recession. For most economies we are now in this ballpark; this is not to say that recession is now guaranteed, but perhaps that calls for recession in 2022 looked premature. On this basis, there is a case to be made that central banks should pause and allow the lagged effects of rate hikes to take effect on the economy. However, given central banks maintained extremely accommodative monetary policy even as inflation was accelerating, for which they are now lampooned, they are now intent on affirming their commitment to the cause of returning inflation to target.

Following May’s inflation data, the BoE raised the policy rate by 0.5% after shifting down to 0.25% increases at the prior two meetings. The Bank of Canada resumed rate hikes with a 0.25% increase in June after holding at the previous two reviews. The European Central Bank hiked interest rates twice in the quarter by 0.25%, and following some perkier inflation data in the region, was at pains to impress that the job was not done. The Fed was the relative dove as it opted to keep interest rates on hold for the first time since it began hiking in March 2022, having served up a cumulative 5% of rate hikes over the period.

There is a credible case to be made that, while central banks in aggregate are still raising interest rates, we are close to the end of this hiking cycle. But, more importantly, central banks remain committed to reducing the size of their bloated balance sheets. The October 2022 low in global risk assets coincided with a resumption of central-bank balance-sheet expansion. We have talked about the link between central-bank balance sheets and the overall price level of financial assets at length over the years, so we will save a repeat of that discussion. The key point is that, while central banks are becoming less aggressive on the policy rate front, the liquidity tailwind from central-bank balance-sheet expansion since October 2022 is set to dissipate, if it has not done so already, and is set to intensify as a headwind into the second half of the year. Furthermore, the liquidity outlook is set to deteriorate at a point in time when we are beginning to see signs of the prematurely anticipated economic weakness.

European woes

Europe has fared far better than many expected over the first half of 2023. A major tailwind has been the decline in energy prices which translated into an improving external position and a stronger euro. But there are now signs that the eurozone economy is beginning to cool.

To focus on one key segment, Germany’s manufacturing industries are running into strengthening cyclical headwinds. Over the last year, they have been relatively successful at passing on higher input costs for materials and energy to customers, thereby protecting margins, while the process of working through order backlogs has supported volumes. However, this was only possible while nominal demand remained robust, and this situation is beginning to change.

The German statistics agency’s index of new factory orders has been trending down since mid-2021, with more manufacturers seeing shrinking order books than growing ones. With backlogs increasingly cleared and global growth slowing, production volumes are unlikely to be sustained, which should have a significant negative impact on pricing power. In combination with considerable upward pressure on wages, profitability is set to be squeezed. Such a combination has historically led to cost-cutting staff reductions at German factories and indicates a tougher outlook for the wider economy. If this pattern is repeated across the eurozone economy, it is likely investors will have a genuine recession – not just a technical one – to worry about in the coming quarters.

Not with a bang but a whimper

One jurisdiction where the central bank is not hawkish is China. After Beijing abandoned its zero-Covid strategy in late 2022, there was hope that China’s economic reopening would boost global growth. However, despite some green economic shoots earlier in the year, China has failed to live up to expectations. Property, still the fulcrum of the country’s debt-laden economy, continues to weigh on broader activity, with the export sector increasingly a headwind as global demand slows.

Slowing economic momentum spurred Chinese policymakers to action over the quarter, with the People’s Bank of China (PBOC) lowering its key seven-day reverse repurchase policy rate by 0.1% in mid-June. Cuts to other rates, including the benchmark loan prime rates, followed. Right on cue, debate has resumed around whether Beijing will deploy kitchen sink-type stimulus to resuscitate an ailing domestic economy.

In our view, China is grappling with its fourth non-performing loan crisis of the post-global financial crisis era. Resources are being directed to ‘evergreening’ a mounting stock of bad debt as the credit employed to fund stimulus past increasingly turns sour. With global systemically important central banks still tightening monetary policy, Beijing is unable to utilise the PBOC’s balance sheet to deal with the issue without putting undue pressure on its currency. As such, China looks set to continue to underwhelm markets amid the near-quarterly round of optimism based on expectations of stimulus in response to a slowing economy.

We remain of the view that those looking for large-scale stimulus in China do not understand the extent to which Beijing is constrained in its ability to do so. As its ability to engineer cyclical upswings fades, the structural challenges facing China’s economy may increasingly come to dominate economic and financial-market outcomes.

Conclusion

The market outlook is subject to numerous cross-currents. The global economy has remained remarkably robust despite pockets of weakness, particularly in China and the manufacturing sector. Nevertheless, global demand is slowing, and the conditions that historically have been consistent with more conservative behaviour from businesses and households are increasingly in place, particularly as returns on capital decline at the aggregate level.

The outlook, however, remains clouded, as it has for much of this cycle, by the continued lagged impact of the fiscal largesse of the Covid crisis. While central banks have continued to increase interest rates in 2023, their balance sheets bottomed in October 2022 and have broadly expanded into the second quarter of 2023. A forward-looking view suggests that this liquidity tailwind is on the cusp of rolling over, and the experience of the post-financial crisis period is that balance-sheet policy is of greater consequence than interest-rate policy when it comes to markets.

At the time of writing, there are few conspicuous reasons to adopt a defensive stance with respect to risk assets. However, with the consensus having moved from ‘imminent recession’ at the end of 2022 to ‘soft landing’ at the halfway point of 2023, a number of key macro financial variables are exhibiting cause for caution.

¹ Interest rate hikes could see 1.4 million people lose 20% of their disposable income, Tom Waters and Thomas Wernham, Institute for Fiscal Studies, 21 June 2023