Resurgence or recession?

This year has been marked by considerable political upheaval, with regime changes across several major economies reshaping the global landscape. These shifts have triggered notable changes in financial conditions, including a sharp weakening of the US dollar, which has set ripples across markets.

Meanwhile, momentum remains striking. Liquidity continues to surge, and this influx of capital will inevitably seek investment opportunities. A significant portion of capital expenditure is being channelled into artificial intelligence (AI), which is skewing traditional capex metrics and contributing to elevated valuations. Concerns about a potential bubble are growing. Yet even if we are in one, history reminds us that bubbles can persist far longer than expected before they burst.

However, signs of deceleration are emerging. Inflation in the US is starting to pick up again and their labour market is showing strain, with job creation slowing, and asset valuations becoming increasingly difficult to justify. The question is: are we looking at a recession or a resurgence in markets? This is the paradigm all investors face in today’s uncertain climate.

In recent months, financial markets have experienced a surge in liquidity. Credit has become more readily available, and ample capital circulating through the system has spurred borrowing and investment activity. This influx of funding typically translates into heightened consumer spending and accelerated business growth, driving job creation and lifting overall economic output, a welcome boost for the global economy.

A combination of factors has underpinned the recent wave of favourable conditions, most notably, lower interest rates, a softer US dollar, and falling oil prices. Reduced interest rates lower the cost of borrowing, stimulating consumer spending and business investment. However, the potential for rising long-term rates remains a key risk to reverse this trend. A weaker US dollar enhances the affordability of dollar-denominated assets for foreign investors, boosting demand for them and injecting additional liquidity into the financial system. Lower oil prices reduce energy costs for businesses, freeing up capital for other uses.

These easy financial conditions are often associated with a ‘risk-on’ environment, where investor optimism drives capital into higher-risk assets in pursuit of greater returns. Recent activity does indeed show investment flowing into risk assets, with the Nasdaq and other major indices at all-time highs. Turning the liquidity taps on has seen investment flow into both public and private markets, reflecting a heightened appetite for risk.

Private capital markets have really started to unlock. The market may have slowed in terms of activity and distributions, but IPOs have come back, and activity is starting to return. This recent trend is evident at aggregate level, and we have witnessed it first hand in our portfolios, with deals and associated cash flows picking up in recent quarters.

But what’s striking about this surge in liquidity is that continues to find its way into risk assets amid persistent uncertainty. We believe this is largely driven by momentum, which remains a powerful force in the current environment. Momentum often brings further momentum, creating a self-reinforcing cycle of positive market dynamics.

Market sentiment has coalesced around the belief that momentum is here to stay. However, we think valuations - particularly in the US - are undeniably stretched. They’ve been expensive for some time, and while elevated valuations can persist, they’re especially concerning in the current climate of uncertainty and questions around the sustainability of growth.

If valuations continue to climb, could they potentially reach levels reminiscent of the dotcom era? Possibly. Everyone acknowledges that assets look pricey, yet capital continues to flow, and prices keep rising. That’s the essence of the liquidity-momentum dynamic. We’ve been highlighting US equity valuations as expensive for three years now, and they still are. But momentum and liquidity can sustain market rallies far beyond what fundamentals might justify.

For us, momentum is strong, liquidity is strong, but valuations are looking more dangerous. There’s a risk around medium-term growth. Our portfolios have been well-positioned to harness this momentum, allowing us to benefit from the broad-based uplift across multiple asset classes. We continue to place a high value on asymmetry in portfolios, with upside exposure to the more expensive parts of the market through options, ready to capture further momentum but with the downside protected. We will be closely monitoring growth, earnings, and interest rates to determine the ongoing robustness of the rally.

Is the current investor “throw caution to the wind” spirit warranted? Maybe, maybe not.

It’s possible the optimism in equity markets could be sustained, provided we continue to see clear evidence in corporate earnings that AI investments are translating into tangible monetisation. That’s where investor attention is sharply focused. If October and November earnings announcements fail to demonstrate bottom-line impact from AI spend, it may prompt a reassessment of risk appetite. In an environment already marked by high concentration in a few key names, such a shift could prove challenging.

We are also concerned about inflation’s persistence. It continues to exceed comfortable levels, and the risk of a renewed uptick looms large. Yet, in the face of this uncertainty, the Federal Reserve is moving forwards with rate cuts, driven by emerging signs of weakness in the labour market. If there is a true slowdown in the jobs market, the rise in unemployment will coincide with high services inflation which is a terrible mix for the US consumer. It would be a dangerous cliff edge for the US economy.

Is the Fed going to continue cutting rates while inflation is coming in hot? Are they going to be able to deliver on the rate cuts that investors are expecting? We're closely monitoring their actions and the data informing them.

Markets are already responding to these uncertainties. Bond yields are falling, and investor demand for gold remains strong, reflecting a persistent appetite for safe-haven assets. Interestingly, gold is now attracting a broader investor base. While central banks and other institutions have been the primary drivers of gold purchases in recent months, we’re now seeing material inflows into gold ETFs, marking a shift towards retail investment. The question is: are investors chasing performance, or are they seeking protection? Either way, the rush into gold reflects a growing unease under the surface.

Our own analysis suggests a broader economic slowdown is underway. The divergence between hard data, such as employment figures and softer sentiment indicators is becoming more pronounced. Notably, downward revisions to job numbers earlier this year reinforce our view, and we see mounting evidence that the economy is starting to lose momentum. From the evidence, we see it as an even chance whether this is a mid to late-cycle slowdown or the beginning of a more meaningful downturn in the business cycle.

We believe credit markets are currently mispriced and appear excessively expensive. Credit spreads over Treasuries continue to narrow, offering increasingly limited compensation for taking on credit risk, whilst term premia are relatively low, providing little reward for duration. The risk-reward profile is not attractive; spreads are still compressed relative to fundamental risk.

Investors are being paid very little above government bond yields for assuming corporate credit risk. In the event of a slowdown, spreads could widen significantly, as we saw in March and April, when they moved out by around 300bps. Historically, in similar conditions, spreads might widen by as much as 1,000 bps, which would then present a more compelling opportunity.

Investor appetite for credit remains strong, however, with the headline yields appealing given the range of government bond yields, particularly considering how low yields were for a prolonged period post 2009 up until 2022. Arguably credit spreads being as low as they are is a reflection of limited default activity, although this has been brought into question with recent high-profile defaults and Jamie Dimon’s comments about potential cockroaches in credits markets.

We will have to wait and see whether there are more cockroaches to be seen, or if the credit market is a termite mound set to completely collapse. In the meantime, we see little opportunity in traditional credit markets given the stretched valuations and asymmetric risk. As a result, we have minimal exposure to traditional credit in our portfolios.

The global economic outlook presents numerous signs of encouragement. Liquidity is abundant, bolstered by accommodating monetary and fiscal policies. Momentum is robust, and financial conditions are favourable, helped in part by declining oil prices. Equity markets have rebounded, interest rates have fallen, and investor sentiment leans towards optimism. The US IPO market is showing signs of revival and market exuberance is beginning to reemerge.

However, significant policy uncertainty casts a wide net of potential outcomes, each accompanied by its own set of risks. While tariff-related concerns persist, they’ve eased from previous levels. The threat of negative feedback loops triggering a trade war remains, which could dampen consumer and business confidence and stall economic progress. Ongoing inflationary pressures are delaying anticipated rate cuts, and there's a possibility that it could accelerate unexpectedly due to recent policy actions and further shifts away from globalisation. Rising long-term interest rates could pose a threat to sustained growth.

In the near term, conditions appear favourable. Yet, risks remain, particularly those tied to rising interest rates, policy shifts, and inflation. Although inflation has been trending downward, the weakening of the US dollar suggests a potential rebound in price pressures.

We maintain that the likelihood of a recession is lessening but still above historical norms. Current fundamentals don’t point to an imminent downturn, but a shift in policy could quickly alter that trajectory. Late-cycle economies are especially vulnerable to such changes.

Our current emphasis is on the relationship between market valuations and liquidity. Stock valuations are on the higher side and much of the economic optimism already priced in, but perhaps negative scenarios are being overlooked. Overall, investors appear unfazed by these elevated valuations. Supportive financial conditions, driven by a softer dollar, lower oil prices, and narrow credit spreads, continue to fuel market gains. We’re watching closely to see if recent uncertainties have impacted the latest corporate earnings. In the short term, we’re well positioned to benefit from either valuation-driven or momentum-driven market moves.

We remain alert and adaptable. Our investment strategy is designed to respond swiftly and decisively when necessary. We’re confident that our portfolios are prepared to act, whether to mitigate downside risks or seize emerging opportunities.

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