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Overview
Introduction – Balancing the scales
The scales used by investors to balance the positive and negative influences on financial assets are often finely balanced, with just a small shift one way or the other capable of changing the course of markets. On occasion, there is a big imbalance, resulting in either a severe bear market, or, more happily, a raging bull market. But observation over long periods tells us that the scales are rigged in favour of more positive outcomes, and that should always be borne in mind when investing for the long term.
In this quarter’s commentary, we shall look at some of these ‘weights’ on both sides and how they are influencing performance. They are not necessarily the same in all regions, but global equity market performance continues to be dominated by the US and especially the indefatigable appetite of investors for exposure to the artificial intelligence (AI) theme. It is either impressive or depressing, depending upon your point of view, that both Nvidia and Microsoft, the companies currently vying for the title of the world’s largest company by market capitalisation, are both individually worth more than all the shares quoted on the London Stock Exchange!
What keeps investors up at night?
The thing that investors find most unsettling is uncertainty. In investment terms, ‘risk’ is quantifiable, but uncertainty is not. This leads to the slightly counterintuitive outcome that even when bad things happen, markets can go up if investors don’t think they are going to get worse.
The headlines have been full of tariff threats this year, and sentiment reached its nadir at the beginning of April when President Trump unveiled his ‘Liberation Day’ list of what he was going to impose on different countries. Remarkably, though, the MSCI World index of global equities is up more than 20% since it bottomed on April 8th and has been making new all-time highs. One by one, the US’s trading partners have reached deals. The UK was one of the first, submitting to a 10% tariff rate for most of its exports to the US. There was a flurry of activity as we approached the August 1st deadline for deals to be made, with Japan, South Korea, and the European Union the latest big blocs to agree to a 15% tariff rate. The main holdout countries remain (at the time of writing) India and China, although talks are continuing. With no agreements in place, higher tariffs have been imposed on some countries, including Taiwan (20%), Canada (35%) and Switzerland (39%). The general assumption is that these will be negotiated lower.
The average tariff rate appears to be settling somewhere in the high teens, which is multiples of the prevailing rate of 2.7% at the start of the year, but appreciably less than the potential high-twenties rate that was implied by the initial announcement. But at least we now know where we are. The next imponderable is who is going to end up paying. Despite President Trump’s apparent belief that it is foreign exporters who are on the hook, the reality is that the burden will fall largely on the US private sector, split between companies and consumers. For example, Procter & Gamble, the household goods company, projected that tariffs would cost it around $1bn over the next year, but it has also said that it intended to raise prices on around a quarter of its products in the US by 5% to compensate. Our opinion is that US companies and households will be able to absorb the higher prices, and that, from the perspective of the economy in aggregate, there will be some compensation from the fact that the tariff income is being recycled into tax cuts (although these favour higher income households who tend to have less propensity to spend).
A final concern is that what we are seeing now might be the thin end of the wedge. The rates of income tax, capital gains tax and VAT, for example, have all risen meaningfully from the levels at which they were first introduced.
The next worry on our list also features the US President as the principal protagonist, and that is the threat to central bank independence. Mr Trump has regularly threatened to sack Jerome Powell, the chair of the Federal Reserve, and to replace him with a ‘stooge’ who will cut interest rates more aggressively. The market reaction to such suggestions is universally negative, and we have seen US equities, bonds and the dollar simultaneously sell off in response, the sort of reaction that is usually associated with troubled emerging market economies.
“What’s the problem?”, you might ask. Surely lower interest rates are a good thing. Not if they are inappropriately low for the economy and lead to higher inflation, a risk that is being reflected in an increase in US breakeven inflation rates (the forward inflation rate derived from the price differential between conventional and index-linked government bonds).
Related to the topic of central bank independence, we saw on August 1st an extraordinary announcement from President Trump that he was going to fire the head of the Bureau of Labor Statistics because he didn’t like the (weak) employment report it had just produced. This undermines the credibility of supposedly independent US institutions and potentially attracts a greater risk premium for US assets, especially ones that are issued by the government itself. Although the dollar did rally in that day’s risk-off phase, actions such as this would add to potential structural selling or rebalancing pressure on the greenback.
The next worry is equity valuations, especially those in the US. The Price/Earnings ratio (PE) for US equities (S&P 500) is around 27x, which is historically high and potentially unsustainable. Even so, there a couple of factors that might help to calm nerves on this front. The first is that valuation is a dreadful market timing tool. Equities can remain either over or undervalued for long periods of time. The second is that investors have become more sophisticated in how they value companies, with much greater emphasis put on the underlying economic profitability and cash-generating abilities of companies as well as the longevity of those profits. It is also apparent that as economies and technologies have evolved, profits can be generated on a much smaller asset base than in the past – think robots and intellectual property as opposed to smokestack industries, allowing what appear to be sustainably higher returns on capital.
And whilst there is seemingly a danger of the US stock market turning into a ‘one-trick pony’, with that trick being AI, there is some evidence of a welcome broadening out of returns. For the year to date, the total return of the Bloomberg Magnificent 7 index has been roughly matched by the return from the other 493 stocks in the index and it has also been encouraging to see the equal-weighted S&P 500 index making new all-time highs too. While it would not be unhealthy to see some of the froth being blown off more speculative plays, and with the caveat that we entering what has historically been a seasonally weaker period for markets, there seems to be no cause for alarm.
We can also point out that historically high valuations are largely a US phenomenon, certainly at the aggregate index level, and that other regions’ markets offer better potential value, even if we allow for the mix of industry exposure – no other market offers quite the same exposure to technology and innovation as the US, after all. Bearing this in mind, we spread our net globally in terms of investment opportunities.
By this token it is important to highlight the domestic FTSE 100 index which made new all-time highs in July, finally breaking through the 9000 barrier. Considering it reached almost 7000 as long ago as 2000, this has been a slow journey. It might surprise readers to know that since the end of 2021 (which coincided with the end of the post-pandemic boom), the UK’s flagship index has barely lagged the S&P 500 index, delivering a total return in dollars of 37.5% vs 39.5% (to end August) and it has outstripped the Magnificent 7 stocks, which could only muster 19%, over the period. Obviously, a lot changes depending on what starting point one uses, and this was a particularly auspicious one for this exercise. Even so, it demonstrates that there is relative value to be found in even the less vaunted markets.
The final thing to mention is geopolitics. Sadly, this has become an ever-present on the worry list and seems set to remain there. Obviously, it carries a wide range of threats, both in nature and geographically, with the latest being the US’s deployment of two nuclear submarines in response to aggressive statements from Russia with respect to the situation in Ukraine. And yet, markets have shown a consistent ability to bounce back from several escalations in recent years. We recognise that it is impractical to construct portfolios based a singular potential event and so we address the risk through our quality-biased stock selection and our exposure to diversifying assets.
Sleeping more soundly
It’s clear that, despite the preceding list of concerns, there is much to be optimistic about, given that many equity indices around the world are at or close to all-time highs. We often emphasise the fact that equities are a solid long-term investment by showing a chart labelled with all the crises that have occurred over the decades. Yes, there are dips along the way, but the trend is higher.
Right now, the thing that investors are most optimistic about must be the adoption of AI. A study from Empirical Research, in which it measured the performance of companies that it considered to have spent the most time discussing AI in a substantive way on earnings calls, concluded that, since the beginning of 2023, more than half of the returns of the S&P 500 have been derived from companies exposed to the AI theme. Is this sustainable? And is this healthy? One concern amongst investors is that the vast amount of capital expenditure being committed to AI, especially by the Hyperscalers, will not generate sufficient economic profit to have been justified, but there was certainly no sign of a slowdown in spending in the most recent quarterly earnings.
We have highlighted in the past that both the internet and the smartphone enabled applications and even whole industries to evolve that might not otherwise have been possible or even imaginable. It is not a stretch to say that the benefits of AI might accrue from uses that most of us have not even thought about yet. The wider adoption of AI, such that it becomes ‘business as usual’, should allow increases in productivity to flow through the economy.
Another supportive factor for financial assets now is loose financial conditions. Goldman Sachs’s index of US financial conditions sits close to the low end of the range established following the sharp repricing of money that occurred in 2022.
The key risks are a return to higher inflation (leading to higher interest rates and bond yields), a lack of confidence by global investors in the US administration (which would be reflected in higher bond yields) and a recession (which would lower earnings and trigger a rise in credit spreads).
Regarding interest rates, the good news is that there is broad scope for most central banks to reduce them if required. The European Central Bank is the most advanced in its loosening, having cut its deposit rate from 4% to 2% over the last year. The Federal Reserve and the Bank of England have been more reticent owing to concerns over inflation. The Fed Funds rate has dropped from a range of 5.25% – 5.5% down to its current 4.25% – 4.5%, but the Fed’s ‘Dot Plot’ of members’ rate expectations is falling consistently towards 3% in the years ahead. In the UK, the Bank of England was stuck at 4.25% since May (to the end of Q2), having also reduced the base rate by 1% from a peak of 5.25%. Sticky services inflation has kept it from cutting more aggressively, but the futures market sees a very high probability of rates falling to 3.5% by next summer however, despite this tailwind, softening economic data saw the All UK Conventional Gilts index broadly flat over the last quarter, delivering a total return of -0.06% over the three months to end August and –0.4% over the last year.
Conclusion and Outlook
The message this year has been consistent: be braced for increased volatility but stick to your guns in terms of investment, whether that be retaining existing portfolio exposure or adding to investments as planned. So far that has played out reasonably well despite a few setbacks along the way. As can be seen from the preceding commentary, we are far from complacent about the outlook and continually scanning the horizon for icebergs, sometimes, it feels, in thick fog! If a ship’s captain is equipped with maps, a compass and radar, we remain committed to our quality-biased equity investment process and to a longer-term approach to wealth accumulation through compounding returns.
