A pause in momentum
A pause in momentum
Economic growth continues to disappoint in the UK, Europe and China. Even in the US, the outlook has become more nuanced over the past month with further signs of a slowdown. Inflation remains too high for comfort, but Central Banks appear willing to pause before deciding to shift interest rates further.
Oil prices have risen sharply in the past 3 months as Russian and Saudi Arabian cutbacks take effect. This may prolong the inflationary pressure on the real economy and/or result in weaker real economic growth as consumers struggle to cope with higher costs.
Downward pressure on Sterling could be expected to continue in the face of weakness in the economy and the Bank of England holding off from pushing interest rates higher despite inflation remaining above their inflation target.
Expectations around corporate profits growth have stabilised over the past month. This is a stark change of momentum compared to the end of 2022. This change in earnings momentum has been driven by the large technology companies.
Scenario review
The use of scenarios allows investors to think about the future in a more flexible manner, taking into account conflicting data, without being wedded to one particular view or forecast. Through much of 2023, the market has appeared to move towards a Goldilocks outcome, but there is some evidence that growth may disappoint in 2024. Whether this migrates into a full blown recession will be key.
| Scenario | Economy | Investment consequences |
|---|---|---|
| Inflation peaks and economic growth recovers (Goldilocks) | Inflation peaked in late 2022 even though the US economy remains resilient. The Federal Reserve (Fed) eases back on the pace of interest rate tightening. |
Normalisation of market sentiment with earnings remaining linked to revenue growth of the overall economy. |
| Sticky inflation prevents Fed easing in 2023. | Inflation proves sticky with better economic growth (services and jobs). Fed moves to tighten aggressively and shifts the pivot from 2023 expectations to cut rates. |
Derating of equities continue. Earnings Per Share cuts accelerate. Bonds struggle as rates remain higher for longer. Risk-off i.e. a sell off of equities (a repeat of early 2022). |
| Recession | The current slowdown in economic growth escalates and, led by the US housing market, the US enters a recession in late 2023 early 2024.
Inflation eases back but unemployment increases in the US, resulting in a drop in aggregate demand in the economy. |
Earnings downgrades outweigh any decline in bond yields.
Risk appetite falls back towards lows. Equity markets fall and bonds rise. |
Oil: poses a risk of higher inflation or lower growth… or both
Oddly, against a backdrop of slowing economic growth in China and Europe, oil prices have risen sharply (by around 25%) in the past few months. Saudi Arabia and Russia prolonged their oil supply curbs by another three months, a more aggressive move than traders had been expecting as the OPEC+ members seek to support a fragile global market. Saudi Arabia will continue its production cutback of 1 million barrels a day and hold output at about 9 million barrels a day — the lowest level in several years. Russia’s export reduction of 300,000 barrels a day will be extended for the same duration. These reductions, which amount to around 1% of global production may not seem much, but against the expected growth in demand of 2.3 million barrels a day in 2023 (OPEC August 2023 report) marginal shifts in supply are meaningful for prices.
Oil prices have climbed over recent weeks to year highs, resulting in a less deflationary backdrop from commodity prices.
Source: Bloomberg, Artorius
One of the reasons for lower oil prices through 2022 and the start of 2023 has been the willingness of the US government to release oil into the market from its Strategic Petroleum Reserve. Historically oil from the reserve has been released into the economy in the face of challenges, such as hurricanes, to quell market instability. The 300,000 barrels of oil released since mid-2021 is likely to have contributed to the falling oil price. The US government has pledged to rebuild the stockpile and this additional demand may result in higher oil prices especially against the back-drop of supply cuts from Saudi Arabia and Russia.
The US Strategic Petroleum Reserve stocks have been run down over the past three years to multi-decade lows, which limits the ability of the US government to keep oil prices lower.
Source: Bloomberg, Artorius
Higher oil prices mean that the falling prices of the first half of 2023 are over and instead are rising once again. This could dent consumer confidence and sap spending power. As inflation has fallen over recent months, incomes faced the prospect of recovering in real terms going into 2024, but high oil prices may delay that upside surprise. Whilst oil related inflation may not prompt further monetary tightening from Central Banks, higher oil prices tend to act as a drag on economic growth.
The recent oil price surge takes place against a different backdrop from 2021-22, as economies are no longer in receipt of the government support that had been the case immediately post-Covid.
The test of the economy in coming months may be whether the higher prices are felt through higher inflationary pressures and consumers are able to bear the higher costs, or lower economic growth if consumers cut back on other spending to cope with the impact of higher oil prices.
UK Blues: Sterling risk
The outlook for the UK economy has continued to be underwhelming relative to the resilience of the US economy. Economic growth has waned over the summer months. On the back of better-than-expected inflation data the Bank of England decided to hold-off from increasing interest rates further on the 21st September 2023.
Without higher interest rates, Sterling will lose the investor support that it had garnered post the Truss Premiership.
The chart below shows the futures positioning of so-called Non-commercial investors (CME) in Sterling (vs. the US Dollar). When investors go long (or overweight) Sterling then they hold a positive balance, as is currently the case.
In mid-2022, as Johnson struggled to hold onto power as Prime Minister, investors were ‘short’ or underweight Sterling. Thankfully the political confusion is much reduced by having a Sunak government showing higher levels of competence than in the previous decade. This may have justified the sharp reversal of investor positioning and the rally in Sterling since Autumn 2022. However, as we peer into the future, the relative economic outlook is weakening, and with a risk of investors seeking to move from overweight, we suggest that Sterling could be due a period of weakness.
Investor positioning which was extremely negative last year is hovering around highs, suggesting that Sterling may continue to weaken if the UK economy slows further.
Source: Bloomberg, Artorius
Longer term valuation models suggest that Sterling is modestly overvalued against the US Dollar, and about 15% overvalued against the Euro. The UK economy continues to run a current account deficit which suggests that it remains uncompetitive at present currency levels.
China continues to disappoint
““I cannot forecast to you the action of Russia. It is a riddle wrapped in a mystery inside an enigma: but perhaps there is a key. That key is Russian national interests.” ”
Whilst Churchill may have been describing Soviet Russia as it launched a joint invasion of Poland with Nazi Germany in 1939, the ‘riddle wrapped in a mystery inside an enigma’ may also be applied to China.
Although avowing to communism, the economic growth of China since the late 1970s has been one relying on modern-day capitalism of debt fuelled growth.
The Chinese economy shows limited signs of returning to the rate of economic growth seen before Covid. With elevated levels of corporate and local government debt resulting in some financial distress and a lack of meaningful policy response to stimulate a recovery, we no longer see Asian Emerging Markets (largely China) generating outperformance in the near-term.
Economic growth has slowed to a paltry 0.8% in the second quarter and youth unemployment data is so high that the government has stopped publishing it. Indebted companies (mainly in the property sector) are withholding interest, which results in the lenders (typically Chinese Trust companies akin to the UK’s Insurance companies) being unable to pay out to their investors. The financial consequences of over indebted companies is being felt by the household sector, which will dampen consumer confidence and weaken economic growth.
The weakness in the Chinese economy is hurting corporate profitability as analysts continue to cut their forecasts for profits for 2023 and 2024. Despite valuations being low, there is no obvious catalyst to generate strong outperformance from the region.
Valuation risk and waiting for earnings
After the strong rally in markets in the first half of the year, equities have struggled for direction over recent weeks. We suspect that the higher oil price is starting to weigh on investors’ minds.
Expectations around earnings (companies’ profits) appear to have troughed. This is despite questions around the resilience of economic growth, especially outside of the US.
Earnings may have troughed, which is unusual given uncertainty over economic growth.
Source: Bloomberg, Artorius
The chart above shows the difference in profits generated over the past 18 years between the US stock-market and the rest of the world. Post-the Financial Crises in 2008-09, US companies have seen their earnings grow by nearly 300%, whilst elsewhere profits have delivered less than 50% growth. Most (if not all) of this difference has been generated by the monopolistic technology giants in the US.
The difference in historic growth may explain why investors remain willing to place a higher valuation on US equities compared to those elsewhere. That said the US equity valuations remain elevated against other assets, especially when US interest rates of 5.5% may tempt investors to a safety-first approach.
Valuations remain elevated in US equities both against other global markets and historic norms.
Source: Bloomberg, Artorius
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A pause in momentum
Inflation remains too high for comfort but Central Banks appear willing to pause before deciding to shift interest rates further given the weakness in economic growth in the UK and Europe and mixed signals in the US economy.
Oil prices have risen sharply in the past 3 months as Russian and Saudi Arabian cutbacks take effect. This may prolong the inflationary pressure on the real economy or result in weaker real economic growth as consumers struggle to cope with higher costs. This may determine direction of both interest rates and markets in coming months.
Expectations around corporate profits growth have stabilised over the past month. This is a stark change of momentum compared to the end of 2022. This change in earnings momentum has been driven by the large technology companies.
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