By Julian Howard (pictured), lead investment director, multi asset solutions, Gam Investments
One of supergroup Genesis’s less-known hits of the 1980s called ‘Land of Confusion’ described a world in which people are told nothing is wrong despite contradictory evidence. Today’s investors have a similar dissonance to contend with.
Benign stock markets since October, along with low corporate borrowing costs, appear to be disguising several problems. The US economy is now set to grow by just 0.8% in 2024, as the negative effects of recent monetary policy tightening slowly creep in, shows the Bloomberg consensus survey of economists.
US banking sector and debt ceiling issues are largely being ignored by investors.
The next few months will determine whether 2022’s poor equity market returns will succeed or whether 2023 will become the third consecutive year of unexpected market havoc.
Investors are too often pessimistic, but some fears about today’s market backdrop are justified.
Rising interest rates
The US Federal Reserve may have recently hinted at a pause in its tightening cycle now that the deposit rate stands at a relatively high 5.25% and headline inflation is hovering just below 5%. But the Bank of England and European Central Bank (ECB) are very much still using monetary policy to tackle price rises.
Consequently, investors are steering towards bank deposits or money market funds amid these high interest rates. This can slow economic growth. Regional banks play a key role in the real economy through lending. The banking system’s ‘confidence trick’ relies on depositors keeping their money at an institution. However, Silicon Valley Bank’s swift demise in March was partially caused by a social media-induced exodus of depositors favouring higher rate-paying institutions or money market funds.
Unviable banks do not lend money. The sheer pace of interest rate rises in a short period of time is generating prolonged systemic and economic risks from this sector.
Equity returns
Higher interest rates have reduced the relative reward investors receive for holding stocks. In the US, the largest region in the MSCI All Country (AC) World Index, the forward earnings yield of the S&P 500 is less than 2% more than the risk-free US Treasury yield of 3.5%. Historically, this has boded ill for future market returns. Investors are unlikely to own more stocks if they can already earn good risk-free rates.
Investors may have become complacent about the US’s debt ceiling woes, given previous debt ceiling limits have always been averted by the eleventh hour. Stock market volatility is also low, US Treasury yields have fallen to 3.5% this year and the US dollar, as measured by the Bloomberg Dollar Spot Index, remains relatively firm on a five-year view.
Markets think a deal would only fail due to partisan reasons. The unwillingness of today’s US lawmakers to strike a deal is worrying. With a very narrow majority in the House, Republicans may be unwilling to compromise, which could derail the current administration’s ambitious spending programme. The true consequences of a ‘no deal’ would be far graver, as the Council of Economic Advisors estimates a protracted default could starve the US of more than 6% points of economic growth.
So, are equity investors right? Reassuringly, US unemployment stands at just 3.5%. Yet that does not justify the MSCI AC World Index’s stellar 16.3% return from 14 October 2022 through to 8 May this year.
Similarly, US investment grade and junk firms as of 9 May need only pay 1.6% and 4.7% respectively, over and above the 10-year US Treasury yield for debt financing, reflecting lenders’ risk appetite. Investors may be relaxed as long-term interest rates, though higher than they were, remain effectively capped and are supportive of risk assets. This is down to central banks’ enormous accumulation of bonds after successive bouts of quantitative easing (QE), which has the effect of pushing down yields.
Despite the supposed ‘capping’ of market interest rates by bloated central bank balance sheets, equity earnings yields are insufficiently attractive. Similar to volatility, times of unsettling calm are best handled by focusing less on fevered analysis and trading. Rather, investors should focus on robust suitability-driven portfolio construction that can handle such periods without hurting long-term objectives. For most, this means combining the long-run growth opportunity of equities with capital preservation strategies that can smooth out volatility and uncertainty.
Investors who are prepared have two reasons to be happy:
- – Contradictory market indicators are arguably a better phenomenon than the overwhelming consensus and complacency that characterised both the late 1990s technology boom and the 2008 Global Financial Crisis.
- – While higher interest rates can be a challenge, they still represent a low-risk way of generating consistent returns in the non-equity portion of a blended portfolio, via short-dated fixed income and cash holdings.
Today’s land of confusion may prove less memorable than its 1986 musical namesake, but investors need not be anxious either.
