Back
Summary
• Inflation is (slowly) coming back under control. Economic growth remains steady and, if anything, looks to be improving in the UK and Europe. This kind of benign macro backdrop is normally good for equities and they posted another solid quarter.
• That said, the US market is becoming increasingly narrowly focused on a few AI technology leaders. We therefore continue to like balancing our US exposure with cheaper, non-technology focused markets such as the UK and Europe. The cheap and unloved UK almost kept pace with the US in Q2.
• The UK may even benefit from a dullness dividend if Labour, with their large stable majority, are either neutral or pro-business. Political risk remains in the US however but we think Trump would probably be good for US equities but push bond yields higher.
• With growth remaining strong, there is no pressure on central banks to cut interest rates. Markets expected 7 UK interest rate cuts for 2024 at the start of the year compared to 2 today. This has pushed fixed income yields higher again and pushed bond prices down.
• However, we still think the main risk to our outlook remains a growth slowdown. If this happens we think central banks can and will cut rates again. This means bonds still look attractive to us even after a poor first half of the year, especially as today’s yields are back above inflation.
• Given the higher yields available on bonds, we are running lower than normal allocations to alternatives. We are, however, doing the
work to line up new alternative opportunities should interest rates start to fall again.
Q2 Overview: Equities
I don’t ever really struggle for something to write here, but the truth is there hasn’t really been a huge amount of change (outside of the political arena at least) to our views since my last quarterly note. And I am not complaining about that either: boring is normally better for investment returns than some of the periods of high drama (Covid, inflation shocks) that we have seen for the last few years. The analogy of the life of an airline pilot: long periods of quiet followed by brief bouts of terror is a pretty good one for investment markets and the managers who operate in them.
Absent a recession, the normal path for equities is to rise. This has certainly been the case for the last 18 months. Quite how we avoided a recession after one of the sharpest interest rate rises in history remains
a mystery to me (and many others, including most central bankers) but we did. And now manufacturing looks to be picking up again (Chart 1 shows the latest UK manufacturing data). Inflation is back under control (Chart 2) and where there are problems it is with wages (Chart 3) which (i) are probably lagging the 2022 inflation surge rather being the cause of any new trouble and (ii) is a pretty high quality problem to have given the longer term poor performance of real incomes in developed countries. If this is the main issue we have to worry about, I’ll take it.
That said, it is often these sorts of low volatility markets that are most vulnerable to surprises, especially given that many markets are up 20% or more from their October lows. It is tempting to say that valuations are a problem and they certainly look extreme in the US (see Chart 4). But there are a couple of important caveats here: first, valuations have almost zero correlation with your next 12 months returns so don’t help at all in the short term. And second, the market is doing better than you might think. Companies have done a good job of pushing their margins higher over the last decade and this has pushed up returns on equity. You should, of course, pay more for companies that have better returns on equity than ones that don’t. And this is what the market is doing. It just so happens that many of the best returning companies are in the US and the return on equity advantage for the US technology sector is high and continues to improve. Viewed through this lens current markets don’t seem as extreme or irrational to me (see Chart 5).
The risk is, of course, that the US technology sector starts to disappoint. My instincts are the impact of the AI revolution will – like many economic changes – be over-estimated in the short run but probably under-estimated in the long run. This leaves US technology, and the AI theme in particular, vulnerable given today’s lofty return expectations. This does not mean we are selling our core US holdings, but it does mean we are keen to pair them with investments that have less disappointment risk built in. The obvious candidates today (as you can see in Chart 4) are
Europe (and I am including the UK here) and Asia. Valuations are low and growth is, if anything, picking up. And I think there is plenty of upside in the Old World if it does. As an example, Chart 6 shows UK new car registrations. Though they have picked up recently they are still 20% below their pre-Covid levels and today’s car sales are not far off their post-financial crisis lows. We have therefore maintained our blend of a core US equity allocation balanced with pockets of much cheaper international exposure and we believe this approach broadly worked in the first half of the year.
Looking to the second half, politics remains the main risk on the horizon. But, that said, it may be that the UK starts to benefit (for a change) from a political dullness dividend. A Labour government with a large majority which is focused on not rocking the economic boat may provide the kind of stability that will see international investors re-engage with the UK
again. It is worth noting that the last time we saw a Labour landslide (1997) UK focused equities went on a strong run of out-performance even compared to the US (see Table 2). While France does look to be a potential longer term problem, the second round of the election has meant a coalition government with neither the left nor the right extremes being able to win an outright majority. Again, our instincts are this may be a short term tailwind rather than headwind for European markets.
This leaves Donald Trump. It is hard to imagine a Trump presidency being good for stable, cohesive international governance (or for Ukraine for that matter). But, for the US equity market at least a pro-business, pro-tax cut Trump is probably better than whatever the Democrat alternative turns out to be. That said, Trump tariffs will potentially hit European and Asian exporters. For valuation and AI disappointment reasons, it is tempting to rotate some of our US exposure back into Europe and Asia. But the rising likelihood of a Trump presidency means that that there might be better entry points for this ahead (should this still be the right strategy at the time of course).
Fixed Income and Alternatives
The fact that inflation is back on track to target means that central banks could start cutting interest rates if they had to (and indeed the European Central Bank has already begun). We started the year with markets expecting around 7 interest rates cuts in 2024 for the US and UK. But growth has stayed strong, inflation has come down only slowly and so far, we have had none. This has seen bond yields rise again and fixed income (and many interest rate sensitive equities) lose money.
The issue for central bankers is why cut if the economic cycle is picking up again? In many ways this environment is a return to the more normal relationships investment markets have. Strong growth has been good for equities and bad for fixed income. We still think that the major risk we face today is that growth (finally) starts to slow as the impact of interest rate rises hits home with a lag. If this happens, then bonds should prove to be a good investment as central banks look willing and able to cut interest rates in response. Until then, at least we are being paid something to wait for a capital return. Our (high quality) sterling fixed income book yields around 5% today, which is thankfully back above today’s inflation rates of 2%-3%.
The ability to beat inflation without having to reach for a large amount of risk is one reason we have a lower allocation to alternatives today than we have had in the past. That said, the alternatives we do have (typically in the renewable and infrastructure space) do look to be a very attractive opportunity today. Having been impacted by higher rates, many of our investment trusts trade at sizeable discounts. We don’t really need these discounts to close – today’s running yield on these trusts is in line with our return targets for them – but if they do then there is of course upside from there.
We are also thinking ahead to a world where interest rates start to fall again and the need for alternatives rises. Higher rates on cash is a boon for the absolute return sector and we may look to invest again there. For now, though, we are happy to keep it boring and wait.
Chris Brown
Chief Investment Officer
The value of investments may fall as well as rise and you may not get back all capital invested. Past Performance is not a guide to future performance and should not be relied upon. Nothing in this market commentary should be read as or constitutes investment advice.
