Don’t assume it’s all doom and gloom – the market hasn’t

Going into this year there was a common narrative amongst economists, financial commentators and investors – the big spike in inflation was going to lead to a recession, which many expected to happen in the first six months of 2023. The gloomy commentary has been particularly prevalent in the UK, due to high inflation and a post-COVID recovery in GDP that has lagged other countries¹. 

The gloomy narrative has been wrong so far. There wasn’t a global recession and some equity and bond markets have done well.  While inflation has been slower to fall in the UK, it’s come down quickly in the US. Inflation remains low in Japan and China. It’s fallen back below target levels in much of Asia and Latin America. Last week the IMF revised its 2023 GDP forecasts upwards for all regions (compared to April forecasts) and no longer thinks a recession in the UK is likely².

Why the gloomy feeling? 

In 2022, equities and bonds both fell. That’s an unusual sight. Even more uncommon, bonds fell by more than equities, making the supposedly less risky portfolios worse off. This made people worry about ‘tail risks’ - the events could cause investments to move by more than is ‘normally’ expected. The cautious outlook has been reflected in investor allocations. Bank of America Merrill Lynch regularly publishes a survey of fund managers on what investments they hold. The most recent survey showed managers are holding more in cash and less in equities than has been ‘typical’ over the past 25 years. 

As the year has progressed investors have gradually removed or become more comfortable with various ‘tail’ risks such as a recession in Europe or a banking crisis in the US. Stronger than expected economic data has also defied the recession narrative. This has left a broad portfolio of stocks and bonds positive for the year and with a better return than having held cash. 

Why has a recession not happened? 

Put simply, it’s because consumption has remained steady. 

The original narrative—inflation shock => interest rates shock => recession—is based on the fact inflation has risen because there is too much demand in the system and interest rates are the main tool to slow this demand. The expectation is that with higher rates households have higher mortgage payments and less money to spend, while businesses find it more difficult to borrow. The debt held by households and companies becomes more expensive and makes it harder to finance more spending.  

However, the economy of today is not as sensitive to interest rates as theory suggests. This is because over recent years households and corporates have been borrowing at fixed rates rather than adjustable rates and the tenure of the borrowing has increased, meaning there is little need to borrow at higher rates yet.

One of the other reasons is jobs. There remains a shortage of workers in developed countries— the  US and the UK particularly—which has prevented unemployment rising. Without a rise in unemployment the economy won’t fall into a deep recession. A shortage of workers keeps people in jobs and creates wage growth. This puts a floor under consumption. In the United States annual inflation has fallen to 3% as of June 2023. In contrast, wage growth was 4.2% over the same period³. This means there is 'real' wage growth, adjusting for inflation, for the first time in two years.

Is it time for us to cheer up? 

Humans are often reluctant to change their mind and there is still a widely held view that inflation is too high and we need a proper recession to bring it back to target. Stocks are priced expensively and hence the cautious outlook. Let’s look at these two points:

Inflation is coming down. If you take out the drop in energy and food costs, core inflation is still too high but inflation is heading in the right direction. We think inflation will stay higher than central bank targets but this will be tolerated without trying to bring it lower and creating higher borrowing costs in the process. At the same time, economic growth is decent in the US, a deep recession doesn’t appear likely in the UK and Europe, consumers continue to spend and unemployment is low. On this basis, we don’t think the outlook is that gloomy. 

Investors went into the year ‘light’ on stocks. This year key stock markets have gone up; US + 12.8%, Europe +11.4%, Japan +8.5%, and United Kingdom +5.3%⁴. Investors have favoured defensive parts of the market with earnings that are less sensitive to economic downturns and bought into stocks related to the Artificial Intelligence theme. Technology stocks, perceived to be defensive in a recession, fall into both of these areas. The tech-dominated NASDAQ index has returned +32% to end July in GBP terms. These stocks are no longer cheap and certainly aren’t pricing a gloomy outlook. 

Where we see opportunities 

The divergence in performance across regions and stocks has created opportunities for the months ahead. We think markets such as mid and smaller companies in the US as well as Europe and Emerging Market stocks can catch-up as the global economic expansion is sustained. We recently added an allocation to property shares as stock prices in the sector are priced for a very gloomy outlook. We also think the future returns on bonds will be good. Developed market government bond yields are around 4% pa and high quality corporate bonds yield 5.5% pa. With inflation now at 3% in the US, this provides investors with a return after inflation when held to maturity. 

For the first time in a while investors are being paid to wait. Getting a return on cash means there is an alternative to investing in the market. A gloomy narrative supports this approach. We continue to hold a more positive view and expect returns on stocks and bonds to continue to outperform cash rates over the longer-term. 

 

¹ World Bank GDP growth data 
² International Monetary Fund, World Economic Outlook Update, July 2023
³ U.S. Bureau of Labor Statistics, July 17 2023
⁴ Data sourced from FactSet, figures are total returns in GBP and to the end of July 2023