Cautious re-risking
Cautious
re-risking
US economic data has eased back in recent months, with more data coming in below forecasts. That does raise the question of whether data is the problem or the forecasters, but a softening backdrop is a change from the better-than-expected outcomes seen since mid-2023.
US inflation remains higher than had been anticipated, and the Federal Reserve is holding off from cutting interest rates for the time being.
Company profits are coming in better than expected and feeding through to analysts raising their profit forecasts for 2025. Despite equity valuations remaining elevated, rising profits should allow equity markets to weather higher-for-longer interest rates, until the point that the slowing economy morphs into a recessionary one, if it arrives.
The good news in the UK is that with wages climbing faster than inflation the ill-effects of the cost-of-living crisis may ease and result in better economic growth domestically. With inflation easing back in the UK, the Bank of England may choose to cut rates against a backdrop of an improving economy.
With better-than-expected profits, and investors' tolerance for higher interest rates, for clients’ portfolios we have recently added to equity-like risk via a fund of structured products. This historically has provided defensive equity exposure, with some of the equity upside captured whilst protecting against modest equity market weakness. A cautious re-risking that has been funded by the selling of short-dated government bonds.
Mixed news on economic growth and inflation
After an extensive period of better-than-expected economic growth in the US, recent data has been mixed. While there are pockets of weakness, 2024 economic growth forecasts for the US have moved significantly higher since last summer, so we will watch to see if the recent negative surprises in the data continue and result in downgrades to the economic growth forecasts.
US economic surprise index falls below zero, indicating that US economic activity has started to disappoint
Source: Bloomberg, Artorius
Of note is the weakness in the US consumer. Evidence is emerging that the US consumer, and especially those with low incomes, are spending less in real (inflation adjusted) terms. This may limit the overall health of the economy and may be the catalyst that prompts interest rate cuts in late 2024.
Economist forecasts for 2024 economic growth (measured by Gross Domestic Product (GDP)) for various economies
Source: Bloomberg, Artorius
Stubborn inflation
Alongside stronger US economic growth, inflation has also proved to be surprisingly stubborn. April’s inflation data points to prices rising at 3.4% year-on-year and it is proving hard to get back to the Federal Reserve’s target of 2%. This sticky inflation together with upbeat economic growth forecasts, means that interest rates may be held higher for longer. The CITI inflation surprise indicator has started to tickle up, which suggests that the decline in inflation seen since the beginning of 2022 may be slow to resume.
Inflation (shown on the right-hand side (RHS) by Consumer Price Index year-on-year (CPI yoy) in the US appears to have stopped falling, and is still too high for policymakers to implement interest rate reductions, yet.
Source: Bloomberg, Artorius
Earnings update
Just as the economic growth data is quite divergent: US good, everywhere else a bit stagnant, so it is with the profits backdrop.
US profits continue to climb higher, albeit the positive backdrop is dependent on the technology behemoths. What is striking, is that the forecast for company earnings in 2025 are being revised higher. This is a significantly different backdrop from that seen in previous years where earnings forecasts have generally been downgraded. Rising profits tend to generate a better backdrop for equities, even if equity valuations remain elevated.
US earnings (Earnings per Share (EPS)) have been revised higher for 2025, which is a change from the downgrades seen since mid-2022
Source: Bloomberg, Artorius
We note however that the near-term earnings backdrop may face headwinds implied by increasingly negative economic surprises. If economic data disappoints for an extended period, this tends to translate into weaker earnings, and a downward revision of the profits outlook. The good news is that a weaker economic backdrop will enable the Federal Reserve to begin to reduce interest rates, which would be taken positively by investors as long as economic weakness doesn’t roll-over into a recession.
Analysts' revisions to corporate earnings forecasts with a lag to the economic surprise index: worse than expected economic data tends to result in a poor backdrop for profits expectations
Source: Bloomberg, Artorius
In Europe, the stabilisation of the economic growth backdrop appears to be delivering more resilient expectations for 2024 profits, and hopes for 2025 and 2026 earnings remain upbeat.
European earnings have stabilised of late, but hopes remain of a strong recovery in 2025 and 2026
Source: Bloomberg, Artorius
UK: Getting better all the time
After a period of economic stagnation, it appears that the UK economy is moving back to some growth. 2024 has seen an easing of inflation, albeit it remains well above the Bank of England’s 2% inflation target. Average earnings growth (wage inflation) remains elevated at 6% and earnings are now growing faster than inflation.
After the sharp declines in wages in real terms, UK workers are seeing a recovery in their spending power. This is showing up in company updates, with the likes of Currys and Tesco reporting stronger sales growth and robust profits.
UK: earnings are growing more quickly than prices
Source: Bloomberg, Artorius
If inflation continues to ease, then the Bank of England may have the opportunity to cut interest rates. However if economic growth continues to recover in the meantime, the Bank may be able to delay any cuts until they need to stimulate the economy.
Cautious re-risking
With a better backdrop for earnings, we have increased equity-like exposure in our clients’ portfolios. Using a fund of structured products, the fund offers medium term equity upside exposure, but with some element of protection against equity markets falls. This has been funded out of short-term bonds (gilts) with the aim to bring enhanced returns for clients, but with a control over risk.
Resulting in a rise in real earnings
Source: Bloomberg, Artorius
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Conclusion
The economic backdrop in the US remains ok, but not quite as rosy as economists had expected in recent months. With inflation taking time to fall back towards the Federal Reserve target, interest rates appear to be on track for remaining higher for longer. Even against these headwinds of mixed economic data and interest rates, corporate profitability has improved resulting in upgrades to the profits outlook for 2025.
As a result investors appear willing to continue to invest into equities despite full valuations and political uncertainty.
Whilst US economic data has become more mixed, the delivery of profits has improved of late. In light of investor tolerance of interest rates remaining higher for longer, we have added some equity-like risk to portfolios funded by sales of short-dated bonds.
Domestic UK economic data appears to be getting better. Much of this could be down to the improvement in the index between wages and inflation. After 2 years of wage growth lagging inflation resulting in real incomes falling, the reverse is now true. Real wages have started to climb, and this is being seen in both economic data getting better but also in upbeat company statements by the likes of the retail and consumer facing companies.
Important Information
Artorius provides this document in good faith and for information purposes only. All expressions of opinion reflect the judgment of Artorius at 17th May 2024 and are subject to change, without notice. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete; we do not accept any liability for any errors or omissions, nor for any actions taken based on its content.
The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested. Past performance is not a reliable indicator of future results.
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