Changing the risk
Changing
the risk
US economic growth has been stronger than expected. This good news means that the need for interest rates to fall is reduced, especially as inflation appears to be plateauing at around 3%, rather than the target of 2%.
Equity valuations remain elevated which reduces their attractiveness in the near-term. Likewise with non-government bonds, whose yield pick-up over government bonds is very low despite rising cases of corporate bankruptcies.
With interest rates remaining higher for longer, longer duration bonds have been weak and could fall further if inflation does rise further, especially with the higher oil prices seen over the past few weeks.
Following our recent Investment Committee meeting, longer duration bonds have been sold and the funds raised shifted to liquidity and hedge funds with the aim of continued diversification against equity risk without the risk of bond duration impacting portfolios.
Good news on growth
The US economic outlook continues to improve. The chances of a recession recede as leading indicators and economic data point to a surprising resilience. The clearest indicator is the troughing of the Institute of Supply Management (ISM) survey. The ISM Manufacturing survey reflects that, in the US, the weakness in growth in manufacturing sectors is coming to an end.
There are pockets of weakness but 2024 economic growth forecasts for the US have moved significantly higher over the past few months. Other economies remain relatively stagnant with very subdued economic forecasts.
The Institute of Supply Management (ISM) survey suggests that activity in the manufacturing sector is troughing
Source: Bloomberg, Artorius
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. With rising commodity prices, especially oil, there is less disinflation than was the case, so the pace and extent of inflation’s declines in coming months may stall. Alongside stronger economic growth, economists have been nudging up the expected inflation rate for 2024 in the US. Parochially, the UK inflation outlook has improved of late, which may tempt the Bank of England to cut rates in coming months.
Economist forecasts for 2024 inflation rate for various economies (measured by Consumer Price Index (CPI))
Source: Bloomberg, Artorius
Inflation rate in the US appears to have stopped falling, potentially at a rate that is too high for policymaker comfort
Source: Bloomberg, Artorius
Central Banker bind
Strong economic growth data and persistent inflation present the ultimate bind for the Federal Reserve: any premature celebrations of victory over inflation would damage their credibility and de-anchor expectations. Alternatively, further hikes may drive the economy into recession, albeit we suggest that the risks of a recession are much reduced.
The market has shifted its expectation of 7 interest rate cuts through 2024 at the start of the year to expecting only 2 interest cuts now. If inflation proves to be stickier and the economy more resilient, as it has been over the past year, then the Federal Reserve may feel comfortable in delaying any policy shift still further.
Selling bonds
With higher economic growth and rising inflation expectations, we have sold the long duration US Treasury Bond holding in the portfolio. This was bought in the expectation of a recession and would typically have provided resilient returns in a recessionary environment. As our view is that a recession is no longer likely then the long duration bond holding runs the risk of suffering losses if interest rates need to remain higher for longer.
Expensive risk assets
Despite seeing a better than expected economic environment, the pricing of risk appears to suggest that investors are complacent with high equity valuations. The price-to-earnings (PE) ratio of 21.4x forward earnings is elevated compared to long term history. The average PE ratio since 2005 has been 16.1x, indicating that the US equity market valuation is some 33% above its historic norm. Equities in other regions are also trading above their long-term averages, with World ex-US equities 10% above the 20 year valuation average, suggesting that despite a ‘normalisation’ in interest rates and bond yields, equities remain expensive.
Corporate bond (credit) spreads are also low relative to history. Spreads show how much more yield (return) investors have to be compensated with for investing into corporate bonds rather than ‘risk-free’ government bonds. Low credit spreads suggest that despite the pick-up in credit defaults, investors are willing to take on increased levels of credit risk for lower levels of potential additional return.
Despite a pickup in new Bankruptcy Chapter 11 filings, investment grade credit spreads over government bonds have been moving tighter
Source: Bloomberg, Artorius
The elevated equity valuation and reduced investment credit spreads suggest that markets are priced for positive news in both economics and profits.
Buying alternative diversification
Given the risks, either of higher inflation (more likely than it was) or a recession (less likely but still a possibility) we have allocated the funds raised from the bond sale into a mix of hedge funds and liquidity funds. They should provide continued returns (of around 4%) with limited volatility in either of the downside scenarios of higher inflation or recession.
Equity allocations remain in-line with long term plans, albeit preferring quality compared to more volatile value or small-cap exposure until greater economic certainty can be relied upon.
UK matters
Despite US inflation remaining stickier and slower to fall in recent months, UK inflation is expected to fall further. UK economic growth remains weak and rising unemployment threatens the nascent green shoots of an economic recovery in 2024. The Bank of England probably has an easier path to tread than the Federal Reserve to cut interest rates. If the Bank of England does reduce interest rates, then Sterling should weaken further.
One bright spot in the UK, has been the recovery in the UK housing market.
The Royal Institution of Chartered Surveyors (RICS) issue a monthly survey which takes the temperature of the housing market. The April 2024 RICS UK Residential Survey results continue to depict a turnup in housing market activity. This is in sharp contrast with the collapse in activity through much of 2023, post the Conservative Budget of Autumn 2022 when interest rates rose sharply.
The New Buyers Enquiries indicators point to a recovery, with households searching for homes to buy. Whilst interest rates are much higher than they were post-Covid, with longer mortgage terms (i.e. shifting from 25 years to 35) and a stabilisation of the interest rate cycle, buyers are buying again.
A recovery in the housing market maybe on the cards for 2024, as indicated by the pick-up in New Buyers Enquiries in the Royal Institute of Chartered Surveyors (RICS) report
Source: Bloomberg, Artorius
Equity valuation and earnings update
Just like 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. In Europe, the weak economic growth backdrop continues to result in cuts to earnings expectations. This is a pattern seen over the past decade in that US companies have delivered robust earnings growth and the companies elsewhere have collectively delivered very poor profits growth.
US earnings growth has been stellar over the past decade in contrast with the stagnant earnings backdrop in other regions (measured by Earnings per Share (EPS))
Source: Bloomberg, Artorius
In the US, companies have started their quarterly reporting cycle. Expectations for a resilient set of reports appear to be justified in the US. Analysts appear to be quite upbeat about the outlook, which may reflect the better-than-expected economic backdrop. In Europe and the UK, analysts are reducing their profit forecasts, again perhaps as a consequence of the weak economic backdrop.
Analysts appear to be cutting expectations to profits in Europe and the UK, whilst being slightly more upbeat about profit expectations in the US
Source: Bloomberg, Artorius
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Conclusion
Equites performed robustly in Quarter 1, up 9.5% (Sterling terms). Unlike in 2023, when the market was led by relatively few US technology giants, many areas of the equity market performed well.
In the US, economic growth appears to be more resilient (good news) but inflation appears not to be falling as quickly as expected (bad news). Combined higher growth and inflation has delayed the start of the interest rate cutting cycle in the US, as markets now only expect 2 rate cuts through 2024 rather than the 7 priced-in at the start of the year.
Elevated equity valuations (shown by price-earnings ratio >20 in the US) and investment grade and high yield bond spreads being very narrow indicates that investors are complacent about potential risks (especially as corporate bankruptcies filings are rising).
Higher for longer interest rates continue to push bond yields higher. Longer duration bond allocation in portfolios have been sold, and whilst valuations of risk assets remain high, we have reinvested into defensive assets that offer diversification from equity risk. We remain fully invested into equities but would prefer to see lower valuations before adding allocations to equities.
Important Information
Artorius provides this document in good faith and for information purposes only. All expressions of opinion reflect the judgment of Artorius at 19th April 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.
Nothing in this document is intended to be, or should be construed as, regulated advice. Reliance should not be placed on the information contained within this document when taking individual investment or strategic decisions.
Any advisory services we provide will be subject to a formal Engagement Letter signed by both parties. Any Investment Management services we provide will be subject to a formal Investment Management Agreement, which will include an agreed mandate.
Artorius Wealth Management Limited is authorised and regulated by the Financial Conduct Authority. Artorius is a trading name of Artorius Wealth Management Limited.
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