Decisions, decisions...

Every year, investors confront a wall of worries, and 2024 is no exception. The difference now is that politics feel more intrusive than usual, and we have the largest expression of democracy ever, with four billion people potentially going to the polls. Although elections rarely make a difference to markets, given the contentious nature of some of the races it’s natural to ask whether this year they will.

Most long-term investors shrug when asked about politics, and looking at long term market charts we can see why. Apart from points when political events did real economic damage, even serious shocks made little difference to asset returns. So the real question for investors is not who will win which election, it’s whether the result will make a difference to the world economy. To guide our thinking, we divide the upcoming elections into three categories.

First and foremost is the United States, the world’s largest economy, with almost two thirds of the world’s stock market, and whose central bank and currency drive interest rates and exchange rates for most other economies. Clearly what happens in the US is important for all investors.

Second, we have regional elections, like those in India or South Africa, where outcomes will be important for the local populations, but might only represent minimal opportunities or risks for global investors.

Lastly, closer to home, we will at some point have elections in Ireland and the United Kingdom. The outcomes are not going to move global markets but could have impact where changes in taxes or pension rules could influence investors’ financial plans, rather than their portfolio allocations.

"It's the economy, stupid"

US political strategist James Carville famously advised the Clinton campaign in 1992 to focus on the economy, and history shows this to be one of the strongest indicators of presidential popularity and election success. However, the relationship has broken down in recent years, with President Biden trailing ex-President Trump in polls despite the surprisingly strong US economy.

Whether it’s the aftermath of the pandemic, the first serious inflation shock in forty years, or the corrosive culture wars, US politics have become so partisan that voters’ political views are informing their perception of the economy. We don’t know if this effect will fade, but rather than take a view on who will win, we ask instead what difference to the economy either winner would make.

Both candidates presided over highly expansionary fiscal policy in their first terms, and we’d expect more of the same in their second term. The difference would be more attempts to spend from a Biden administration and more tax cuts from a Trump presidency. Either approach would lower the chance of recession but increase inflation risk and further expand the US deficit and debt, putting upward pressure on bond yields and undermining the US dollar.

We also have a good sense for either president’s foreign policy. It would be more of the same ‘steady as she goes’ from Biden, supporting global institutions while putting American needs first. Or it would be impulsive, unilateral and transactional from Trump, with trade tariffs weakening global growth and raising domestic inflation. Either way, China will continue to be a target and Europe will need to decide how much to toe the US line.

Overall, we would expect neither winner to try to restrain the economy and balance the budget. While bad for long term balances, it means that neither candidate is likely to cause a recession by themselves. A second Trump term would bring more uncertainty and market volatility, but this doesn’t necessarily mean a lower market. To gauge this risk, we need to look elsewhere.

Do rates matter more than votes?

Even casual observers would have noticed that stock markets have been preoccupied in recent years by interest rates. Through the lows of 2022 and the rallies of 2023, all the big swings were driven by expectations for monetary policy, particularly from the US Federal Reserve (Fed). So it’s not a stretch to say that Fed policy decisions are more important for investors than who wins the US election.

Now it is fair to say that a quarter point change in interest rates, by itself, should not be a big deal. But multiple changes do add up, and markets do extrapolate rate changes into bond yields, which then affect borrowing costs for households and financing costs for companies and governments, so they are important. It’s also worth noting that most US borrowing is long-term fixed-rate, so rate changes take longer to impact the US economy than they do in the Eurozone and UK.

Coming into 2024 hopes for rate cuts were high, and we were worried that stocks were set up for disappointment. Yet during Q1, expectations fell from 6 quarter-point cuts for the year down to 3, and rather than tanking, the global index gained 11% (in EUR terms), buoyed by stronger US economic growth and corporate earnings. Compared to 2022-23, stocks now seem less sensitive to higher yields, viewing them less as a harbinger of recession and more as a reflection of stronger growth. In fact, before its March meeting, there was even talk that the Fed might not cut rates at all this year.

Is the market right to be more relaxed about rates? At least in the US, consumers continue to spend, and corporate profits are growing again. However, signs of stress are emerging. Lower income consumers have exhausted their excess COVID-19 savings, and defaults are rising for both corporate and personal borrowers. After stalling the Eurozone and UK economies, higher rates are hurting certain sectors in the US too.

Another reason that markets should care about rates is that they are more a reflection of higher inflation than higher growth, and the bad news here is that after the big drop last year, US inflation has stopped falling. ‘Super core’ inflation, i.e. services ex housing costs, is ticking up again in the US and Eurozone, and is stubbornly high in the UK. We believe that weaker growth will prevent another inflation crisis, but central banks are right to be wary of the risk.

Bringing it back to politics, there is a school of thought that says the Fed wants to avoid becoming politicised and therefore will be reluctant to change rates in front of the US election in November. We note however that this has not stopped the Fed in the past. It cut rates in the three months before the 2008, 1992, 1984 and 1976 elections, and hiked just before the 1988 and 1980 votes.

In summary, we believe that central banks are ready to cut rates this summer, and given the ongoing inflation risk they won’t cut more than the market currently expects (3 ¼% cuts this year) unless the economy weakens significantly. Of course, three Fed cuts in a strong economy are all the stock market needed in 1998 to turn a bull market into a bubble. This brings us to another important decision …

Should we chase the hot market?

After gaining 19% in 2023, the world index rose by a further 11% (in EUR terms) in Q1, the best quarter since the post-COVID-crash bounce in Q2 2020. Most major indices reached new all-time highs, although this does happen in most years as markets trend upwards. Of particular note was the Japanese market which surpassed its previous peak for the first time since its bubble burst in 1989.

A simple read of the market would suggest that the largest stocks are immune to higher interest rates. Last year saw an unusually large gap in returns between the normal market index, which is ‘cap-weighted’, meaning the largest companies have the most weight in the data, and the lesser-known ‘equal-weighted’ index. In the US, this was driven by the well-known ‘Magnificent 7’ tech stocks¹, but the effect also spread to Europe and Japan, although not to the UK.

There is a reasonable argument that larger companies are more resilient to macro turbulence, including interest rates, and many of these companies enjoy dominant positions in sectors which are difficult to compete in. But at some point, stretched valuations mean that even strong companies can deliver weak returns, and commentators have drawn parallels to the 1990s tech bubble.

The good news here is that, at least at the index level, valuations are high but not that extreme. This is partly because these large companies have mostly delivered stronger earnings growth, keeping their price/earnings ratio from running too far. Also, in a sign that this is not a repeat of the late 1990s, less profitable stocks, including several members of the Magnificent 7, have sold off this year when their earnings did not keep up with their high expectations.

Does this mean we should ignore the high valuations and stay invested? Not entirely. While some stock prices have adjusted, there is still a widespread disconnect between valuations and realistic earnings prospects, and not just in the US anymore. This is not a strong enough reason to get out of the market, especially when momentum is so strong and the economy continues to surprise to the upside, but it does mean we should be more careful with the stocks we own.

The equal-weighted index is cheaper, because it over-weights smaller cap stocks, that are cheaper again. But small caps are cheaper for several reasons, including their higher sensitivity to labour costs and interest rates. Value stocks in general are cheaper but more macro-sensitive too, and we still have concerns over the impact of higher rates. So our preferred route is to use active managers who can distinguish between rational and irrational exuberance, and between value and value traps.

The market hasn't lost its mind - yet

In summary, even though the stock market ran further than we expected in Q1, it was at least partly justified by the better-than-expected economic and earnings growth. We have also been encouraged that in general earnings seem to matter again, and that more speculative stocks have been left behind by those with more realistic growth prospects.

We look forward apprehensively to the US election, and remind ourselves that the political fireworks will probably do little damage to the world economy, and therefore to our financial assets. We keep an eye on inflation and console ourselves that central bankers prefer their jobs to be boring, rather than popularity contests. And for our most important decision, we stay invested and resist the temptation to try to game the electoral outcomes.

¹ The Magnificent 7 are Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla.