Constructive, with concerns

The economic picture warrants careful painting this quarter. There are positives in markets, but there are also plenty of causes for concern. This type of framing emerges several times in this title; on the one hand… and on the other… That’s the challenge of economics. It’s a balance of - sometimes competing - risks with rarely any complete certainty. Even data rarely offers true objectivity. Investors must navigate the nuance and decide the best course of action.

Most yearn for clarity, where everything is known and risks can be carefully mitigated. No doubt Mr Freud would have a lot to say about why that is. But like it or not, uncertainty abounded in April when markets tumbled following policy-induced panic. Although this turned out to be more noise than signal and generally markets are now back to - at least - where they were a year ago. Some tariff-related unknowns seem to have dissipated and although risks here remain, they are not as acute as they were. Soft data is weakening and most are forecasting growth to be lower this year, but not recessionary. There remains some ambiguity about economic growth.

It's this balance of data points, policy decisions and social factors that we digest and interpret day in, day out. We constantly assess markets and remain dynamic in our decision-making, always open to new ideas. Absolute certainty may be an elusive function of economics, but perhaps the subject is all the more interesting for it.

Growth is one of the most important economic indicators, typically referring to a rise in real gross domestic product (GDP). Economic growth should enable a rise in living standards and greater consumption of goods and services, subsequently encouraging investment and productive capacity.

Investors pay keen attention to growth as it creates a virtuous cycle of confidence and higher standards. We analyse various hard and soft indicators to predict its direction. (Note that hard data includes measurable and quantifiable information such as production, spending and job growth. Soft data includes more subjective measures such as sentiment indicators and surveys – or perceptions and expectations.) Soft data is valuable as expectations tend to shape the hard data that follows.

But growth has been a little harder to gauge this year as soft and hard data have diverged. 2025 hard data have reported steady US job growth and solid consumer spending. But soft data say consumer sentiment has dropped to lows not seen since the 2008 global financial crisis and business optimism shows ever-declining confidence. The risk is that negative sentiment becomes self-perpetuating, and weakness in the soft data turns into weakness in hard data and slowing – or negative - growth.

At the moment, we align slightly more with the hard data. We know that there’s been a slowdown in investment growth; the IPO market has been stuck. We are also seeing a slowdown in corporate spending, and if that slowdown becomes significant, it will become an issue later in the year. However, European spending is positive. Better growth lies ahead, and fiscal spending has improved; that’s definitely a good sign in the short term.

Some investors are allocating capital away from the US, and towards other important regions. But we think there are still great companies in the US, especially in the mid-cap space. We will not be disposing of our US exposure completely, but we will continue to be selective.

There is also broad consensus that soft data sources have become less dependable since the covid pandemic. Survey-based indicators seem to have lost their touch as potential respondents just don’t seem as keen to respond as they did, and those that do tend to let their political leanings cloud reality. This does make the results less reliable.

Finally, when considered in the context of the economic cycle, the disagreeing data does make some sense. We’re late cycle, which is susceptible to negative growth shocks (such as tariff uncertainty). This could throw out some worried soft data, but really the underlying fundamentals are still fairly robust. Looking ahead, our base case is a slowdown, not a recession, settling somewhere closer to historical trend levels of growth.

Europe has long been overlooked by investors who have sought opportunity in high growth US stocks instead. As growth has started to stall in the face of uncertainty, investors are starting to look over Europe once again, where value-laden stocks with solid fundamentals present opportunity. Growth in the region is now on a surprisingly positive trajectory.

European economies have been working hard to reform themselves since the 2011 Eurozone debt crisis. Almost 15 years later, this industry is starting to yield attractive results. Spain’s efforts to transition to a tourism and services-led economy is now driving strong growth. Portugal and Greece have also driven successful reforms which are starting to deliver robust economic change.

There’s also been an outflow of capital from the US. Will Europe be the beneficiary? Tariff impact on the eurozone is materially less damaging than the US as the region has plenty of other trading partners. There are now pickups in retail sales. Exports and manufacturing are also picking up as import prices are coming down. The eurozone consumer looks strong. Sentiment is improving, but admittedly from a very low base. And importantly, the region is still pretty cheap. European valuations are not challenging; maybe - finally - the price is right. Today’s valuation gap offers investors the opportunity to look beyond short-term market sentiment.

We think there is opportunity in Europe, but only for the selective investor. Not all countries have made successful reforms, so simply investing in an index which covers Europe may be a risk. We have slightly overweight (relative to the global index) exposure to Europe in our portfolios , but only via active stock pickers selectively investing in their high conviction names, as opposed to through a broad index. Investment success in the region requires a more active stance.

China’s economy has faced slow growth over the past few years which the government has addressed with small bouts of stimulus. Real estate and new property prices have been particularly badly hit, and this is important as wealthy Chinese invest heavily in local real estate. When these prices fall it has a meaningful negative wealth effect, and consumption dries up. Chinese growth looked challenged and was predicted to miss its target.

It now looks like parts of the economy are starting to recover, although this is not a universal improvement; some parts of the Chinese economy remain in a bad way. But headline growth is predicted to make its target after all (a target which is materially higher than the rest of the world), and there are green shoots in other key areas. The good news is that their growth is rounded, not just driven by government spending and stimulus. This is partly the result of their successful efforts to tilt the economy away from being purely manufacturing into a more balanced economy with valuable local consumption.

Chinese equities looked cheap (on a relative basis with the rest of the world) and we took advantage of these low valuations to add direct equity exposure to portfolios back in 2019. This delivered some robust performance, but a lack of liquidity led us to sell our position in 2023. We’ve since added an active manager across broader emerging markets, allowing us access to better Chinese growth and the improved prospects of its surrounding countries. A weaker US dollar has greatly benefitted the emerging economies this year as some of their borrowing is denominated in the greenback.

Bear in mind there is always geopolitical risk in the region which you must consider when assessing local opportunities. Chinese valuations may be low – but are they low enough to warrant the other risks? Opinions are split. China as an investment opportunity can divide any investor roundtable. We like China, but we’re very careful where and how we add it, always bearing liquidity in mind. We believe the price is right at the moment, but if any geopolitical risks start to take flight, we’ll be able to sell down our exposure quickly.

Economics is rarely clear cut, and today's carefully positioned viewpoint is no different. We think there are plenty of positives across the global economic landscape. Liquidity support is ample with supportive monetary and fiscal policy. Momentum is strong. Financial conditions are also supportive, particularly thanks to the falling price of oil. Equity markets have bounced back, while rates have increased. Risk sentiment is pretty bullish. The US IPO market is starting to open back up. Bitcoin is back up at a high. Signs of exuberance are coming back into markets.

On the other hand, policy uncertainty is high which renders a large range of outcomes possible with many risks to mitigate. Tariff-associated risks are also high but not as high as they were. There remains the possibility of negative feedback loops leading to a trade war. This could then reduce consumer and business confidence and delay economic activity. Persistent inflationary pressures delay the timing of rate cuts. There’s a risk of inflation surprising to the upside given the policy measures undertaken and possible further deglobalisation. This could be the impetus for less efficient and more resilient supply chains. Rising long-term interest rates could then pressure a choking off of growth.

Looking at the short term, things seemingly look good. But risks are certainly there, risks of higher rates, policy risks and inflation risk. Inflation is coming down, but the US dollar has dropped, so we expect to see inflation rise again.

Our fundamental belief is the risk of recession is moderate but elevated compared to average levels. Today’s underlying conditions are not recessionary yet, but that could turn with a change in policy, and uncertainty there remains high. It doesn’t take much to put a late-cycle economy into recession.

Our focus at the moment is largely on the interplay between valuations and liquidity. Equity market valuations are relatively expensive, with a lot of good news for the economy priced in (or, at least, the potential bad news being wilfully ignored). Broadly speaking, investors do not seem fazed by current valuations. The seemingly easy financial conditions, led by a weaker dollar, low oil price and tight credit spreads, means liquidity is ample and markets are continuing to grind higher. We wait to see whether the recent uncertainty has fed through into company earnings for Q2. We’re well positioned for either valuations or momentum to win in the short term.

We are vigilant and ready to be dynamic. Our investment process allows us to act quickly and decisively when needed. We believe portfolios are ready to step in, either defensively or to take advantage of opportunities as they arise.

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