Economic Performance & Outlook
We must return to the period between 1950 and 1990 to find a time when the problem was to suppress inflation rather than to maintain it. When inflation took off in 2021/22, monetary authorities thought it was a temporary blip caused by Covid supply issues and energy shortages driven by the war in Ukraine. That is no longer the view, but inflation has come down steadily over the past year and is now not much above the magic two per cent in both Europe and the US.
It’s not just higher interest rates that have helped quell inflation. Oil and gas prices have returned, broadly, to the levels of three or four years ago, reversing the inflationary input which drove prices up. Food price increases look more permanent, but at least prices have stabilised.
We cannot, however, be sure that inflation is going to remain quietly around the two per cent level. Service inflation remains high, driven by higher wages and a general labour shortage. The jobs market generally remains tight, particularly in the US. While inflation looks likely to remain under control for the next year or two, there is at least a possibility of an upward break.
For the first time this century we are seeing positive real yields on government bonds – at first in the US and now in Europe. This may be a return to what economists would generally believe to be normal or it may be something related to falling inflation. If the latter, as interest rates fall, real yields might again turn negative.
This presents the investor’s dilemma. Are we returning to a world where inflation needs to be controlled and real interest rates are positive, or is this somewhere between the old and new worlds?
Our view remains that inflation will probably settle at a higher rate than the very low figures of 2000 – 2020. The factors which led to such low inflation, particularly the growth in global trade, are not likely to prevail for the next 20 years. We think it is more likely that central banks will be spending most of their effort on keeping inflation down rather than the opposite scenario. Given this scenario, it is likely that interest rates will settle at higher rates than we have experienced in the first part of this century.
One of the key questions this raises is the general level of asset prices. Asset price inflation has been considerable in the last 20 years, driven partly by low interest rates and easy monetary policies. If these are not present going forward, will we see a reversal of asset price inflation? And, if we do, what effect will that have on economic activity? We can’t answer these questions, but they would suggest that the next 20 years might be very different for markets than the last 20.
Fixed Income
Bond performance over past year
All bonds 10+ years, 22/03/2023 – 21/03/2024, local pricing
Interest rates are closely linked to inflation – we expect them to rise and fall with inflation, perhaps with a time lag. If we go back to the period prior to 1990, there was a strong link between smoothed inflation and smoothed long-term yields on government bonds. It was expected that there would be a real (or positive) yield of the order of two per cent a year. The first twenty years of this century have been anomalous both in the low level of absolute and of real interest rates. As mentioned earlier, for the first time in this century, we are seeing positive real yields on government bonds – at first in the US and now in Europe, which is a welcome reprieve for savers and investors with a preference for low levels of investment risk generally associated with this asset class.
With inflation levels now around or below current government bond yields, the prospect of further falling inflation – the most likely probability – means that a case can be made for investing in bonds with duration for the first time for many years.
Equities
Equity performance over past year
21/03/2023 – 20/03/2024, local pricing
Against this background of substantial rises in interest rates, the overall movement in equities has been surprisingly positive. The strongly negative returns seen in 2022 have been largely negated by the strength of the market recovery through 2023, which has continued in Q1 2024. One would have expected that the prospect of interest rates and inflation remaining higher for longer to have had more of a dampening effect. It is true that company profitability has been stronger than would have been expected – this has been particularly the case for some of the large technology stocks and some drug companies.
In particular, the extraordinary rise of US stock markets since the pandemic – up about 75 per cent since their trough and touching all-time highs – can be mainly laid at the door of a few very large technology companies which dominate indexes. And the rationale for why those stocks have increased so much in recent years is the benefit that analysts attribute will accrue to these companies on the back of artificial intelligence advances. There is no doubt that the market has swallowed this story hook, line and sinker – shares in Nvidia, a maker of computer chips used in artificial intelligence, have risen by close to 90 per cent over the first quarter of 2024 alone (on top of an increase of over 200% in 2023).
The highs in equity markets are against a background of much higher interest rates and inflation. Economic growth rates are being reduced as more money goes on buying energy and food. It is difficult to see much scope for serious growth in equity prices in the year ahead, particularly as markets begin to look beyond expected falls in central bank interest rates.
Euro cash
The ECB benchmark deposit rate has held at four per cent now since September last year.
With yields on short government bonds sitting at about three per cent upwards, and inflation also around three per cent, rates on cash have become much more attractive. With many banks slow to pass the benefit on to deposit holders, many savers and companies are investing in money market funds as a way of capturing these returns.
Property
Property in general has longer cycles than the equity market which can make it useful as a diversifier. Dealing with the changes we have seen since COVID on people’s working and spending patterns, and the impact this has on the demand for and usage of property, in addition to higher interest rates, has caused challenges for property investors. Nevertheless, we believe European property has a positive long-term outlook and is worthy of inclusion in portfolios of investors with medium to long investment time horizons, although there may be short-term declines as these issues are worked through asset pricing and while the prospect of a recession remains.
Commodities
Commodity performance over past year against equities
21/03/2023 – 20/03/2024, US dollars
The oil price as of late has been difficult to predict – fears about the war in Gaza initially led to concerns that that might put pressure on supply in the Middle East, however this failed to materialise and prices haven’t seen the gains predicted. That said, recent ructions over supply through the Red Sea may reawaken concerns about the ability to deliver oil from the Middle East to the rest of the world. However, the volatility of commodities in general means that for most it is best avoided, and left to serious risk takers.
Hedge funds
Hedge fund performance over past year against equities
01/03/2023 – 29/02/2024, US dollars, hedge funds priced monthly
Hedge funds can make an appropriate investment because of their defensive qualities in a market downturn but generally incur high management fees and tend to underperform during bull markets.
Currency funds
These funds have shown gains and losses recently. They are useful as a diversifier because of the relative independence from other securities but can experience significant volatility over the short term.
Multi-asset / Global Tactical Asset Allocation (GTAA) funds
There is little useful information with which to assess these funds for their performance, but many have struggled to deliver on their stated investment objectives (typically cash plus four to five per cent, or two thirds of equity performance). Because of the very wide range of investments they hold, they can provide useful diversification, and the ability to dynamically shift asset allocation can provide some protection in times of equity market corrections. The higher returns now available on cash and bonds, many of which can be accessed in a low cost manner means we are advising clients to reduce their exposure to multi-asset funds, many of which have high active manager fees, and would not be including them in new investment portfolios at this time.
Credit (Senior loans, High Yield & Emerging Market Debt)
We remain positive on credit as a diversifying strategic allocation within portfolios, and they are currently offering a relatively high and attractive premium over cash. Given the extent of the recent upward movements in bond yields and the current stage in the economic cycle, we would have a tactical preference for Emerging Market Debt over High Yield Debt or Senior Loans at this time.
