Economic realism in an optimistic environment

Be steady and well-ordered in your life so that you can be fierce and original in your work.

Gustave Flaubert

Spring’s green shoots arrived with some green shoots in the market. As the seasons changed, so did the outlook for equities as global indices reached all-time highs, with the Magnificent Seven leading the way. Oil rallied thanks to supply issues tightening the market and disruptions in the Red Sea, and gold began to shine in earnest, as an attractive alternative to bonds. Sticky inflation slightly dampened Spring’s sunny spirits and hampered fixed income performance. Bond yields rose and prices fell (prices and yields move inversely), and persistently higher interest rates will continue this theme.

We are cautiously positioned for choppy waters ahead, but see some bright spots in Japan, distressed credit, and emerging market equities. The possibility of recession can’t be completely ruled out, but with equity indices around all-time highs, the market seems to be positioning for a soft landing; we’re not completely convinced.

Realism or pessimism?

There’s usually a clear distinction between realism and pessimism, but when the outlook for reality looks a little gloomy, the two can be conflated. Is a newsreader narrating their 10pm headlines a pessimist or a realist? We believe we land on the side of realism, not pessimism, reflected by our current views on the US. We are cautioning ourselves against the generally positive investor sentiment but acknowledge that the risk of recession has lessened. This is not a voice of pessimism amongst all the optimism, it’s simply realistic.

The US government is unlikely to tighten its purse strings ahead of November’s election; a thriving economy is a big vote winner. US consumer spending was strong last year, and that strength has continued into 2024. Spending by both consumers and governments is supportive of growth and will stave off a recession, but not forever.

Although consumer data is strong and sentiment is more optimistic, we don’t think the risk of recession has vanished.

We’re worried consumers are overspending. They’re too highly levered and won’t be able to repay their loans, and there’s evidence of that in rising delinquencies (the state of being in arrears). These are typically high for younger people, but we’re now starting to see delinquencies creep up to Millennials as well. A continued spread up the age groups, all the way to pensioners, will come with a major economic cost.

Persistent election-year government spending will heat the economy up. Temporary jobs (the vacancies) are falling – companies are cutting back and the temporary workers are getting less traction. Unemployment is rising, although fairly moderately. So, although consumer data is strong and sentiment is more optimistic, we don’t think the risk of recession has vanished. And importantly, the pace of disinflation has abated.

Rate cuts rowed back

As higher interest rates seemed to temper inflation last year, markets were expecting the US Central Bank, the Federal Reserve (the Fed), to cut rates six or seven times in 2024. These looser conditions led to a mood of buoyant risk taking, which may now be starting to turn. It’s slowly dawning on the market that we’re unlikely to see seven cuts, and in fact there’s a chance we’ll see none at all. Inflation is generally trending down, but it did rise slightly in March; overall, it looks far stickier than anyone wanted.

The Fed are worried about this and have slowly pivoted to a position of higher rates for longer, which contravenes last year’s expectations. But markets don’t seem too bothered about it as equities are up and investors are optimistically preparing for a soft landing (when interest rates are raised just enough to stop an economy from overheating and experiencing high inflation).

We accept that markets are priced to perfection, but we can’t help but look at the falling temporary jobs. Nonfarm payrolls don’t paint a particularly pretty picture either as numbers appear strong upon initial release but are then revised down the following month. Murky data makes this indicator a little hard to read.

Inflation hasn’t fallen as much as we wanted, and we are worried the growth in the economy is going to overheat. No one can afford to keep spending at this rate forever. So, how are we positioned?

Sticky inflation steers us away from bonds, as inflation erodes their real returns, and their prices are generally lower in a higher interest rate environment. To build more robust portfolios, we’re looking for diversification from alternatives, with eyes peeled for quality and pockets of value. Although we don’t see opportunity in fixed income, we are looking at distressed credit, as many are struggling to afford to refinance their projects at a higher rate. As the economist John Maynard Keynes said, “The market can remain irrational longer than you can remain solvent.” Highly motivated sellers offer buyers attractive opportunities.

The end of an historic era

March saw the Bank of Japan (BoJ) end the country’s historic era of negative interest rates, and marked their first rate hike in 17 years, up to 0.1%. Long-term deflationary pressures meant they were the last country in the world with a negative interest rate policy, and the move – although small – marked a significant mental shift.

A rise in interest rates generally pushes up the value of the currency, but even though Japanese rates finally went into positive territory, the Yen remained at the same levels it’s been trading at for some time. That could be because the rate hike was too small to have an impact, or perhaps it was already priced in as the move was widely anticipated. The question is, what will the path of rate hikes look like from now on?

We are optimistic about Japan. Positive inflation and positive wage growth will support the domestic economy and their monetary policy will start to normalise.

Inflation will play a key role in the BoJ’s decision, and it’s been rising too. Japan’s March CPI came in at 2.8%, up from February’s 2.2%. Wage negotiations contributed to inflation’s rise in the heavily unionised country. Every March, the management of major Japanese firms meet unions for wage talks across industries, known as the ‘shunto’ spring wage talks. This year, wages came in higher than expected, which should be good news for inflation and ultimately, interest rates.

We are optimistic about Japan. Positive inflation and positive wage growth will support the domestic economy and their monetary policy will start to normalise. Our existing holdings have performed well, and the outlook for equities looks good. We also expect their currency to appreciate against the US Dollar/Euro, further pushing returns up (as we would also benefit from the appreciation of Yen to Dollar).

2024: inflation loiters

Election year spending may be heating up the US economy, and consumer data is more optimistic, but the chance of recession hasn’t completely abated. Indebted consumers will have to repay their loans one day, which they’ll find even harder with inflation eating into their disposable income .

This sticky inflation has changed expectations for 2024 interest rates cuts, from half a dozen down to potentially none at all. Although equity indices are at all-time highs, the mood of buoyant risk taking may be starting to turn as jobs data gives some cause for concern. We continue to view gold as preferable to fixed income in this environment. The precious metal provides protection against inflation and would be a safe haven if we see a selloff in equity markets.

Investment strategy and outlook

Looking ahead, we can’t rule out the possibility of a recession and see it as a likely outcome if unemployment increases dramatically. But the other possibility is for the economy to stay stronger and rates to stay higher for longer, which is where we are now, and that wouldn’t make for a happy ending either. Rates being higher for longer means borrowing costs are higher for longer and those economies with severe budget deficits will suffer. Households with lots of borrowing will also incur pain. The impact of higher rates may take time to bite, but some eventual discomfort is almost inevitable.

We currently have higher than expected inflation and quite high interest rates. Spending from government and consumers simply fuels prices even higher, and then the economy overheats. Consumers spend more than they can afford, maxing out credit cards, and eventually…the chickens will come home to roost.

Higher inflation isn’t necessarily good news either, especially the choppy inflation we’re seeing now. It becomes very difficult to run a business if you don’t know what prices you’ll have to sell at – will you even turn a profit? Managing stock becomes difficult – how much is efficient to hold, with prices changing all the time? In a way, higher inflation imposes a tax on economic efficiency as owners are less optimal in their resource allocation. Then inflation becomes pervasive, with it being harder to run an efficient business. That’s how economies get stuck in inflationary periods.

We do see some strength in manufacturing data, which is starting to pick up. The past three years saw a downturn in manufacturing which was a knock-on impact of the Covid pandemic, when everyone stayed at home and only bought services. The weakness from the latter half of last year now appears to have levelled out.

The strength we see in manufacturing is slightly offset by forward-looking indicators related to the consumer, which are still quite weak. The outlook for consumer sentiment is poor, which feeds through into retail sales and general growth. That side of things looks like it’s slowing down. The balance between the two will determine the path for the economy through the rest of the year.

Our higher conviction view is less about the possibility of a recession, and more about an absence of a happy ending.

Overall, we have some positive views and some negative ones. We’ve always been sceptical of a soft landing, or perfect outcome; that’s a cyclical downturn which avoids recession, and a bid by governments to slow down inflation. But the market is positioning for this, evident in equity indices which are at all-time highs, not pricing in any downside risk. Credit markets are likewise pricing in no risk of slowdown. We think this soft landing will be difficult to achieve, although not completely impossible. Some care and consideration needs to be taken. Our higher conviction view is less about the possibility of a recession, and more about an absence of a happy ending.

The choppy waters we’re in now are difficult to read, so portfolios need to be positioned for various outcomes. We are cautious, but we try to drive returns by investing in the best opportunities, and we see them in Japan, distressed debt, and emerging markets.

Broadly speaking, there are periods when emerging markets do well from both an economic and currency position, and that’s when the US Dollar is weakening. This is one of the long-term themes in the portfolios. Plus, emerging markets didn’t have as much bail-out money during Covid, so they are now in a position to cut their rates, and those economies are doing fine. We recently added an active manager to our emerging markets exposure, hoping to add value through their stock selection skill over the tailwind of strong market returns.

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