Stock Market & Economic Commentary - July 2024

“Don’t follow the crowd, let the crowd follow you.” Margaret Thatcher 1925-2013. British stateswoman, conservative politician, and Prime Minister 1979-1990.

Economic Update

As inflation has fallen, central banks have started to reduce interest rates. Switzerland led the way, cutting rates in March and again in June. Sweden moved in May with the Euro area and Canada cutting rates for the first time in this cycle in June. Financial markets expect both the Bank of England (BoE) and the Federal Reserve to follow suit in September.

Interest rates may be heading down but this is unlikely to mark a return to the sub 1% interest rates that were the norm in the West before inflation surged.

The exceptional forces that drove interest rates to record lows are dissipating. The hyper-globalisation of the 1990s and early 2000s that helped drive import costs lower is over. Geopolitical tensions and a greater focus on national autonomy have created new frictions and costs in the global trading system which are likely to add to inflation.

China’s population boom, which helped drive industrialisation and a surge in cheap imports to the West, has also run its course. In China and the West, a shrinking pool of workers and growing demand from an ageing population suggest that wage pressures, and therefore inflation, are likely to remain elevated.

The demand for capital is shifting too. Before the pandemic, investment ran at low levels in rich countries, depressing demand for capital and pushing interest rates lower. Today the energy transition and the need for investment in defence, technology and supply chains require vast levels of investment. Although the pandemic has passed, governments are continuing to borrow on a vast scale to fund spending. The IMF forecasts that the US will run a budget deficit in excess of 6.0% of GDP for the rest of this decade. This is not a US phenomenon. IMF forecasts show all G7 countries posting deficits through to the end of this decade.

Governments fund themselves by issuing bonds. Following the financial crisis that process was made easier in most western countries because central banks bought government bonds to drive market interest rates lower and support demand. But with the pandemic over, and the financial crisis a distant memory, central banks now want to tighten monetary policy. To do so the Federal Reserve, the European Central Bank (ECB) and the BoE are selling their holdings of government bonds into the market. Just as quantitative easing reduced interest rates, so unwinding the policy leads to higher interest rates. This is likely to act as an upward force on market interest rates for several more years.

The other exceptional forces that forced down interest rates were the financial crisis and then, 11 years later, the pandemic. Central banks sought to counter the devastating effect of these shocks by collapsing interest rates. If the global economy can avoid shocks on this scale – and we would be unfortunate not to do so in the next few years – central banks are likely to run interest rates at higher levels.

Financial markets think that the era of cheap money is over. In the US and UK, ten-year bonds currently yield just over 4.0%. That suggests that markets see interest rates averaging somewhere around 4.0% over the next ten years.

That would represent a large increase in the cost of capital compared to 2009-21. It’s a change that would have implications for debt levels, asset prices and the structure of household and corporate balance sheets. We need to be ready for a new era of higher interest rates.

Stock Markets.

“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so!” Mark Twain 1835-1910 American writer, humourist, and essayist.

Sensible, logical, and completely wrong.

The investment industry is one that creates grand theories about how the world will evolve.

There is good reason for this; 100% of the value of a company is in the future and none is in the past. What happens next in the world will be decisive in determining which investments will be successful and which won’t.

We live in a world of forecasts and predictions, but why are so many of them wrong?

Forecasting the future is both possible and impossible. It is possible to see that generation by generation the world becomes cleaner, healthier, safer, and more inclusive. This belief fundamentally underpins the reason why people invest. Why they sacrifice one £ of spending today to have the luxury of one £+ in the future. Based on history the forecast of better times ahead is highly likely to be correct.

Equally, the future can feel impossible to predict. In the last five years, we have lived through a pandemic, a land war in Europe, and a rapid rise in inflation. Few, if any, predicted these events.

From an investment perspective, perhaps the most damaging forecast was in October 2022 when Bloomberg published an article stating, based on their model of the US economy, that there was a 100% chance of a recession happening in 2023. Those who followed this advice, which was completely wrong, missed out on more than a year of strong returns for equities.

The forecasts which get investors in trouble are the ones that sound sensible and logical but are incorrect. Ridiculous forecasts, based on no fact or rationale, are not a problem as they are easy to dismiss.

To be fair, the forecast of a US recession in 2023 was sensible and logical as there had been no precedent of interest rates going up as rapidly as they did in 2022 and it not causing a recession. What the forecasters missed was that the US economy had become much less sensitive to interest rates since the last time interest rates increased rapidly, and therefore proved to be more resilient. Significant government spending helped too.

What forecasts today are sensible and logical but could be completely wrong? Two current forecasts are:

The first is that equity markets are too narrow, and this will end badly. This seems a sensible and logical observation. If we look at previous periods when markets have been this narrow, including the technology boom and bust of the late 1990s, these were predated by an increase in concentration around a small number of companies. In 1999 these companies included Cisco, Lucent, Nokia, and Intel and all were poor investments in subsequent years. Today markets are concentrated around Amazon, Nvidia, Microsoft, Apple, and Meta, to name a few.

Will this end badly? Nobody can be sure, but while the excitement about the internet in 1999 has similarities with artificial intelligence today, there are also differences. Today’s largest companies have established market positions and products of a size and quality that the technology companies of the late 1990s never had. They are also much more reasonably valued, despite their strong share prices. This is because they have all grown their profitability rapidly and in some cases as fast as their share prices have risen.

This is primarily an earnings-led bull market, rather than a valuation-led one. It may also become the case that markets begin to broaden out as the benefits of AI to all companies, such as increased productivity, become apparent. Indeed, there are already signs in the US markets that a rotation out of the tech-laden Nasdaq into the broader market and smaller companies has begun.

Another difference is the speed at which AI can be rolled out as general-purpose technology. Smartphones, cloud computing, and personal computers will be our interface and are all ubiquitous. It will still take time for AI to become pervasive, but it is likely to happen much faster than the internet.

Maybe the dominance of US technology companies will continue, and while sensible and logical, analysis might suggest we are at the tail end of a bull market in these names, more granular and current analysis might suggest otherwise. To be clear there is no definitive answer to this, but it is sensible to challenge the consensus view.

The second sensible, logical consensus view is the demise of China. There does appear, at a high level, to be a degradation of decision making as power consolidated around President Xi Jinping. This was first seen in Covid policies that were viewed as being counterproductive.

In more recent times it has been seen in an unwillingness to intervene in a substantial property bust. China’s decision to politically build bridges with Russia, to exchange components for commodities, has increasingly alienated the country from those who support Ukraine. This has led to the view that China is ‘un-investable.’

The Clarion funds and portfolios have a small exposure to Chinese equities, but China has a large influence on the global economy and therefore directly on the companies in which the funds and portfolios invest. What is perhaps less talked about is the record trade surpluses being seen in China, whereby its exports exceed its imports. Far from being the manufacturer of low-technology toys and gadgets, China is now the world’s largest producer of vehicles with brands like BYD.

A strong educational system and investment in manufacturing capacity and skills have left certain parts of the Chinese economy – those not connected to the property market – in a much stronger position than many believe. It is unlikely the property bust will continue forever, and when it does end China could be viewed to be in a better place than expected.

The general point here is that sensible and logical arguments don’t necessarily lead to the right conclusion. As Mark Twain succinctly put it all those years ago: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”

It is worth thinking about what we all ‘know for sure’ and consider if it could be wrong. This is where the real risk lies in investing.

The Roaring Twenties

The Roaring Twenties refers to the 1920s, a period of significant economic and societal progress. This decade came straight after a World War and a pandemic, so it is perhaps no surprise some commentators are drawing parallels with the 2020s.

In the original Roaring Twenties, pessimism was replaced with invention. The 1920s saw the large-scale use and development of cars, telephones, radio, electrical appliances, aviation, and films. Penicillin was discovered in 1928 and went on to become, and remains, a potent antibiotic which changed the path of medicine.

From 1920 to 1929, equities quadrupled in value. However, if you had been alive in 1920 and were fortunate enough to have made it through the first world war and the 1918-1920 flu pandemic, you would likely have had a very gloomy view of the future. Although the decade ended with the Great Depression in 1929, and a decade later the world was again at war, for nine years it was a time of great progression.

Some commentators are drawing parallels between the 2020s and the 1920s because of similar tensions between pessimism and innovation. After coming through a pandemic, witnessing the first land war in Europe for many decades, and a cost-of-living crisis, it is no surprise we may all feel a bit downbeat. These undoubtedly negative events do, however, mask a time of incredible social progress.

The digital economy is transforming the way we work, and with artificial intelligence likely to move into the mainstream in the coming years, it will only accelerate. The drive to decarbonise economic activity requires unprecedented investment in infrastructure, which has only just begun. Standards of healthcare continue to improve with innovative new cancer and obesity medicines.

All these trends are highly investable and are one reason why equity markets are close to all-time highs. History doesn’t repeat but it does rhyme, as the saying goes. We could look back in 2030 and say that the roaring twenties now describes the 2020s.

Half time

We have now passed the half-way stage of 2024. It has been a good year so far for equity investors, following on from a good 2023. Most markets are close to all-time highs, and the damage, which was done in 2022, as markets reacted badly to rising interest rates and the war in Ukraine, has largely been repaired. It is a good reminder that more difficult times for society, and for markets, can be an opportunity to buy good long-term investments at cheaper prices.

The second half of the year will be election-heavy, with the US presidential election at the forefront of everyone’s mind. History shows that the US economy and stock market do well despite politics, not because of it. The US stock market did well when Trump was President and has done well under Biden.

Some commentators also see slightly weaker economic data as a risk to markets. This could be temporary though, and if central banks cut interests rates in response, this would be positive for investment markets.

Alongside these concerns, there are many positives. The drive towards improving healthcare, digitising, and decarbonising the economy, infrastructure investment, and record wealth for consumers in key economies such as the US suggest a good environment for companies to grow their profits. If this is the case, this will support markets for the remainder of the year.

Equity investors remain bullish. According to a recent Bank of America survey, global fund managers are cutting holdings of cash to increase their exposure to riskier assets, including equities. Investors think that the global economy is on the mend and that the equity rally has further to run.

As always, we thank you for your continued support and we look forward to updating you regularly throughout 2024. Please get in touch if you have any questions.

Keith W Thompson

Clarion Group Chairman

July 2024

Creating better lives now and in the future for our clients, their families and those who are important to them.

Risk Warnings

Any investment performance figures referred to relate to past performance which is not a reliable indicator of future results and should not be the sole factor of consideration when selecting a product or strategy. The value of investments, and the income arising from them, can go down as well as up and is not guaranteed, which means that you may not get back what you invested. Unless indicated otherwise, performance figures are stated in British Pounds. Where performance figures are stated in other currencies, changes in exchange rates may also cause an investment to fluctuate in value.

The content of this article does not constitute financial advice, and you may wish to seek professional advice based on your individual circumstances before making any financial decisions.

Stock Market & Economic Commentary – July 2024