How much longer?

As we discuss portfolio returns, and our outlook, with clients, it comes up time and again how unusual things have been in recent years. Whether it’s the state of the economy or the behaviour of markets, the discussions tend to come back to variations of “how much longer can this persist?” or “how much longer can that be avoided?”. So, in this outlook, we attempt to address many of these important questions.

Inflation and interest rates – higher for longer?

First is the conjoined problem of inflation and interest rates. Markets got very excited in the fourth quarter of last year at the idea that the post-COVID-19 inflation crisis was over and that rate cuts were imminent. Instead, during the first quarter of this year, inflation ticked up again and expectations for cuts were pushed back to later in the year. How much longer do we have to wait for lower inflation and interest rates?

Looking beneath the headline inflation data revealed a stubborn streak now known as ‘supercore’inflation. Supercore inflation measures just services costs excluding housing and is strongly related to wage growth. Here we see the large decline in European inflation and the recent US uptick topping out. The job market is still tight in the Western world but at the margin it is softening in the US and UK, which gives us some comfort that wage growth is slowing and with it broader inflation.

Central bankers are generally cautious types and don’t want to damage their credibility by moving rates too soon. The ECB (European Central Bank) has already started to cut but President Lagarde warned markets they would not rush. Nevertheless, we expect another two cuts this year, and we expect the Fed (US Federal Reserve) and BOE (Bank of England) to follow in the coming months.

There is a school of thought that says the Fed will want to avoid a political storm by cutting US rates before the presidential election in November, but they have changed rates in front of elections before and we don’t expect this time to be any different. Current expectations for one or two quarter-point cuts feel about right to us.

The BOE has a trickier situation in the UK. Although headline CPI (consumer price inflation) fell to the official 2% target in May, helped by lower energy prices, underlying core service inflation is still going strong and wage growth is over 5%. BOE economists do expect CPI to rise again, but not by enough to stop them cutting rates once or twice this year, and again next year.

The economy versus interest rates

The rate cuts that markets expect are relatively small and will still leave the cost of money well above average levels for this century and above theoretical estimates of neutral. In a highly indebted world, how much longer can the global economy carry this higher interest burden? In fact, some commentators claim that the fall in inflation is an early symptom of an oncoming recession.

It’s worth noting that even though the US economy powered through the rate hiking cycle, parts of it didn’t. The more rate-sensitive housing and manufacturing sectors already suffered mild recessions in 2022-23, as did the Eurozone and the UK. With more dependency on variable rate lending and foreign energy, European economies were more vulnerable to inflation problems, but they should also benefit more now that energy prices have stabilised, and rates are starting to come down.

Apart from energy resources and longer-term fixed-rate borrowing, how did the US economy weather the inflation and rate cycle so much better? It was due to the American consumer who kept on spending, and to President Biden’s government who kept pouring money into the economy, under the guise of COVID-19 stimulus and then various development bills (the Inflation Reduction Act and the CHIPS Act1). How much longer can these twin forces keep pushing the economy?

First is the consumer. In aggregate, the excess COVID-19 savings are spent, but higher-income consumers still have large cash balances, whereas lower-income consumers, who suffered the most from higher inflation, are now feeling the pinch. Stresses are emerging, with delinquencies rising in credit cards, auto loans and student loans. It’s interesting to note that consumer expectations are unusually negative for the state of the economy, and this is beginning to be reflected in weaker retail sales.

Another unusual feature of the post-COVID-19 economy has been the tightness of the job market. Many older workers chose not to return to work, and firms were desperate to find or hang on to staff, leading to very low unemployment and high wage growth. However, this is now turning around with unemployment rates ticking up, and so we expect slower wage growth to follow, helping the central banks with inflation but dampening consumption too.

The better news is that whoever wins the US election, we don’t expect austerity any time soon. With the 2024 budget deficit already at 7% and government debt approaching 120% of GDP, for how long can they keep on borrowing to increase spending (Biden) or cut taxes (Trump)? As long as markets let them. This means higher bond yields than before but only a USD collapse if other currency blocs have competitive rates and more convincing policies.

The sleeping dragon awakes?

For most of the 21st century, the largest source of economic growth has been the so-called emerging economies, led by China. Although detrimental to Western wages, Chinese production kept global prices down, and Chinese stimulus provided a useful global boost during the GFC (Global Financial Crisis). However, the COVID-19 crisis diminished China’s contribution to the world economy, especially during the recovery. How much longer before China is firing on all cylinders again?

For its own reasons, China was slow to vaccinate effectively and kept their lockdown in place far longer than other countries. When they finally exited restrictions in early 2023, markets expected a surge in activity from Chinese consumers. However, unlike the US or Europe, there had been no COVID-19 largesse from the government and no excess savings ready to be unleashed.

The biggest domestic concern for China is the property sector. The price declines have dented consumer confidence and construction activity and held back the entire economy. The government has shown only limited appetite to stimulate the sector, leaving markets unimpressed. The third plenum of President Xi’s current term, an event which often brings economic policy change, is scheduled for mid-late July, and we will see if they are willing to take more significant steps.

Lastly, there’s the huge political question we often get – how much longer before China invades Taiwan? Of course, we don’t know when this might happen, but we do believe that if China were to attempt it via outright military action, it would want to be confident that it could survive the economic consequences. This means achieving self-sufficiency in resources, energy and technology, and this may not be reached for another five years or more.

The Wile E. Coyote stock market

Ultimately this is the question that investors keep returning to, especially those that haven’t fully participated in the current bull market – how much longer before this rally runs out of road? The obvious and honest answer is that nobody knows, so the better question is whether a sell-off is more likely in the current environment.

Markets are more vulnerable to sell-offs if their valuations are stretched, their earnings expectations are too high, their gains are too narrow, or if the economy is turning. Pessimists might say that the US market, with its huge Nvidia-led concentration, meets these conditions. Optimists would counter that equal-weighting US stocks tells a different story, and that European markets score more favourably along these lines, including an economy turning up rather than slowing down.

This brings us to another question we frequently hear – how much longer can the US technology sector keep beating the rest of the world market? In the long run, the US is structurally a higher growth economy than most other regions, especially Europe, and the tech-heavy nature of the US stock market means it should generate faster earnings growth indefinitely. The question for investors now is whether the valuation premium is too high to profit from this extra growth.

Tracking the major indices since 2020, we note that equity returns have been higher than usual, even though this short period includes a recession and two bear markets2. We also note that a large part of US equity returns came from valuations rising, almost as much as from real earnings growth and inflation. The opposite is true in Europe, where valuations have fallen by several percentage points, even though real earnings growth has outpaced the US, a surprise given the low growth narrative.

So, the global market isn’t necessarily headed for a fall, but there are areas where valuations or expectations are stretched, which are more vulnerable, particularly in the US. As we frequently observe, it is perfectly normal for markets to drop 5-10% during a year, on political events or unexpected economic data, and still deliver reasonable returns on the year. Also, so long as any adjustment in US equities is not severe, then European markets can outperform.

What’s an investor to do?

In summary, we believe that inflation is coming down towards target in the US and Europe, just more slowly than expected, and maybe partly because of weaker growth. This means that central banks will be able to gradually cut interest rates as expected, although we won’t be returning to the past decade of rock-bottom rates, just a few points lower than today.

In the US economy, we can see the consumer slowing down, but don’t expect government support to end any time soon, regardless of who is in the White House. The Eurozone and UK economies have emerged from their slowdowns, and while politics are getting more difficult in the Eurozone, the UK appears to be entering a new period of calm sensible leadership. Lastly, in China, we do not have high confidence that the government will stabilise and stimulate real growth there again soon.

Apart from a slowing US economy, the main concerns are the valuation and expectations embedded in the US stock market. The great British economist, John Maynard Keynes, who managed the endowment of Kings College, Cambridge during the 1920s stock market bubble, famously observed that “markets can stay irrational longer than you can stay solvent”. So, what to do about it?

First, we note that the exuberance is mainly focused on a narrow section of the market, so is not the same degree of irrationality that we saw in the 1990s or 1920s. Second, more capital is lost waiting for markets to fall than in most actual falls. So rather than sit this rally out, we prefer to rotate to less vulnerable parts of the market. This has meant slightly slower returns this year and last, but we believe a more diversified portfolio is a more stable path to long-term wealth growth. If markets do tumble, this will better enable us to take advantage of opportunities that arise.

1 Creating Helpful Incentives to Produce Semiconductors.

2 A bear market means a price decline of 20% or more.