Investment Institute
Viewpoint CIO

Sober September

  • 08 September 2023 (5 min read)

With the summer holidays behind us, speculation about where markets go from here is ramping up once again. But the truth is, not much has changed. There is not much new to cheapen risk assets or to embolden a fight against residual central bank hawkishness. Growth data is soft but not frightening. Inflation is falling but still high. The something new might need to be a shock. Will it be a deterioration of the US-China technology war following this week’s move by China to ban purchases of selected iPhone models? Or will Chinese deflation infect global trade and growth? Or will an El Niño-generated frosty winter in the northern hemisphere push natural gas prices back to 2022 levels? Unless such events materialise enough to shift the consensual acceptance that a soft landing is the regime we are in for now, the focus will remain on the trajectory for rates and the monthly ups and downs of the economic data. Not a trending market, nor a market where is it clear how to make returns.

Now it gets tough

The past month has been difficult for markets with negative returns across equities and fixed income. Yet nothing has really changed in terms of drivers of sentiment and market positioning. Interest rate futures are consistent with the view that the US Federal Reserve (Fed) has reached the peak of the rate cycle with the Fed Funds Rate at 5.25%-5.5%. The same goes for the European Central Bank (ECB) with the market not pricing any further increases in the deposit rate beyond the current 3.75%. In the UK, there is still another hike priced in, but peak rate expectations are lower today than they were at the start of the summer. On the growth side not much has changed either. It is now common to see forecasts for the US economy avoiding an outright recession and the data has continued to be consistent with a soft landing. The August employment report showed positive but slower jobs growth. The ISM reports showed modest increases in activity in both the manufacturing and services sectors. There are even commentators suggesting that instead of thinking about recession, investors should be prepared for re-acceleration.

Are rates high enough, or too high?

Markets are pricing interest rates at their peak. There is a risk that this is wrong and rates need to go higher. The Fed would be uncomfortable with the idea of growth picking up again because it would make it difficult to bring inflation back to target. Further rate hikes by the Fed and other central banks might occur if global disinflation trends stall. Few economists are certain that November will not bring an additional hike. There are also discussions about what the appropriate equilibrium neutral interest rate should be (the famously unobservable r*). A recent blog by economists at the New York Federal Reserve suggested it might be higher than Fed officials think, given the apparent limited response from much of the economy to the five hundred basis points (bp) of tightening so far.

In a complex system it is hard to model the impact of changing variables – like interest rates – over time and across all economic activity. The lags between changes in interest rates and movements in inflation, growth and unemployment are not stable, nor do they happen in real time. Companies with cash balances, built up during the pandemic either through retained profits or borrowing when coupons were super low, can benefit from high short-term interest payments on those balances. There is a view that excess consumer savings have run down, but household cash balances are still high. Total commercial bank deposits in the US have fallen modestly in 2023 but remain 30% higher than they were on the eve of the pandemic. Cash in money market funds is also still close to a record high.

Little conviction

As yet we do not have a classic monetary tightening-led squeeze on activity. Speculative arguments that this is still to come – just look at the performance of the retail sector – or that the Fed may have to keep interest rates at a high, or at an even higher level to eventually get that squeeze, are equally valid. Investors are not really coming down on one side or the other. There are a range of scenarios for investors to consider over the next year.

More of the same 

The consensus one, which might just be the default in the absence of either any strong signals of a recession or re-acceleration, and in the absence of shocks, is the soft landing. Moderating growth and a gradual further decline in inflation with no recession or jump in the unemployment rate will eventually call for lower real interest rates and monetary easing. The rate cuts priced in for 2024 are modest but consistent with this scenario. It means there is little incentive to get out of cash right now. Credit can continue to deliver a decent income return even if outright yields, in investment grade at least, are barely above short-term interest rates. For equities, I would suggest quality growth stocks perform the best. In a soft landing, parts of the economy will be growing while others will be flat and the growth will reflect structural factors – infrastructure spending, decarbonisation, and technology. Thus, equity markets can still provide good return opportunities.

What is important to think about in this soft landing is that it necessarily means modest overall growth until inflation returns to target and it necessarily means higher interest rates on average than in the past. There will be no repeat of free money and bond investors will be lucky to get any significant total return from the impact of lower yields.

Recession means cheaper risk, lower rates

The alternative scenarios are clearer in terms of their asset allocation implications. Interest rate hikes already in the pipeline could push economies into recession. That should mean a more apparent disinflation and accelerate interest rate cuts. Recessions typically lead to equity underperformance. If equities underperform, so will credit and high yield. Government bonds would be the beneficiary. Growing below trend, as many G7 economies are, makes them vulnerable to shocks. A China-led decline in global trade growth, another energy shock or a negative investor response to geopolitical events are all potential shocks that could tip growth over.

The worst scenario is stagflation with inflation remaining sticky or going up again and rates increasing further. Nothing does well in this scenario apart from cash and, potentially, real assets (land, gold and commodities). Such an outcome seems very unlikely as global economies are more flexible and globalised than they were when these outcomes occurred in the past.

Plan for the short and long term

Investors need to plan for the evolution of the business cycle and what that means for markets. When it is uncertain, the tendency is to not take too much risk. It does not feel right to be adding risk in equities or credit right now, and the buy on dips approach in stocks that has served investors well so far this year looks to be a challenged strategy now. That does not mean go fully risk-off, but parts of the equity market and parts of credit are at risk from a re-pricing if the macro environment does deteriorate.

Investors also need to plan for the long term and try to identify where the growth opportunities will be. That is difficult. I would suggest that variations of responsible investing strategies (net zero, ESG integrated, Sustainable Development Goals-aligned equity strategies, those focused on natural capital and biodiversity) will continue to grow in terms of assets under management and in terms of the diversification of potential returns. Beyond that it is interesting to think about emerging markets. China is potentially ex-growth while new opportunities will arise in big population growth countries like India, Indonesia and Nigeria. It might always be challenging to invest directly in these markets, but as their share of global GDP growth increases there will be growth opportunities for companies that form part of the supply chain to meet demand in those countries. If the world is serious about investing heavily in renewable energy and other net zero assets, it is these and other countries in the global south that stand to benefit the most.

Performance data/data sources: Refinitiv Datastream, Bloomberg). Past performance should not be seen as a guide to future returns.

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