Economic outlook

Globalisation has created commonalities across many developed economies. Ageing populations, immigration, populism, inflation and ballooning government deficits affect all developed countries to a greater or lesser extent. The need to combat climate change is universal. These macro trends however mask significant differences between the major global economies, and in this issue, we focus on where the pressure points lie at country level, and how this impacts our overall view on the investment outlook.

The US

The US economy survived Covid and the energy crises better than most. It shut down less in response to Covid than peers. And it is broadly self-sufficient in energy. However, the reaction by both the US administration and by the Fed in 2021 was to stimulate the economy by pumping money in and keeping interest rates down.

Through 2023 and 2024, economic growth has been higher than expected, particularly given the Fed’s efforts to apply the brakes. At the same time, inflation has fallen sharply. While markets had taken the view that cuts in interest rates were imminent, concern that inflation is not falling further has risen and it is not now clear that we will see any reduction in Fed rates in 2024.

The equity market continues to reach new highs despite the higher interest rates. On the face of it, this is surprising. It is worth noting that the market capitalisation of US stocks is now about 60% of the total world equity capitalisation. Within that, a few stocks in the tech sector have driven much of the rise. This feels unstable, but these are extraordinarily profitable businesses. We may be in for a major breakthrough in AI, and the US is uniquely strong in high-tech development.

As we move into the second half of 2024, there is likely to be increased emphasis on the possibility of a Trump presidency. In the short term, this is most likely to influence foreign policy, given the isolationism of the Trump wing of the Republican party. In the longer term, this could pose a very serious threat to the existing world order, particularly if it spills over into trade.

In a broad context, the US has some major problems which could have serious long-term effects. There is the dysfunctional political situation with the real prospect of a second term for Donald Trump. There is the two-year reduction in life expectation over the last few years, partly associated with the opioid epidemic and the inability of the US to deal with social problems. These are almost as worrying for the rest of the world as they are for the US itself.

The EU

The situation in the EU differs in two key respects. First, the European economy did not overheat, although it is in reasonable overall shape. Second, the effects of Covid and the Ukraine war were much more severe, not least because Europe is a big energy importer. While the situation has been reasonably managed, inflation has been more pronounced.

Inflation reduced quite sharply through the second half of 2023, in large part as energy prices have decreased enormously. Inflation in food prices and other areas (core inflation) remains too high, but the overall rate in the euro area is now similar to the US at around 2.5% (core inflation is nearer 4%.) Perhaps the biggest concern – and what may make the ECB hesitant to reduce rates by more than the recent 0.25% cut, is the high level of wage increases and continuing strength in the jobs market.

China

If anything, the short-term economic picture in China has brightened over the last few months. Covid lockdowns have finally ceased and the economy is beginning to pick up. A slowdown in real estate remains a concern, with new home prices in China falling 0.7% over the month of May alone, the strongest decline in a decade. Unlike many western countries, China has a surplus of unsold housing stock, which is denting confidence in the overall market.

More broadly, there are major issues in the Chinese economy: a declining and ageing population and a reliance on exports in an environment of intensified geopolitical tension.

It is interesting that the economic growth targets set by the authorities have reduced to around 5% – much less than achieved in recent years. China will likely now revert to much lower growth figures which, in turn, will expose underlying economic and social problems. Having appeared primarily focussed on demonstrating political power & promoting social coherence through 2021 & 2022 in the run up to the start of Xi Jinping’s third term as president in March 2023, the Chinese government appeared to become ever more concerned about the economic situation through 2023. However, they appear reluctant to intervene in any major way to resolve the serious property problems.

It is concerning that China sees economic growth through exports rather than through higher domestic demand. This makes higher tariffs much more likely, even in countries not tied to the US or Europe.

The biggest immediate problem in China is the possible territorial ambitions of President Xi. Any conflict involving China and the US would be disastrous. It is some encouragement that there have been serious efforts made in recent months to get dialogue going again between China and the US.

Elsewhere

Japan continues to be something of an outlier, with relatively low inflation and growth in a reasonably stable overall picture. This is reflected in the strength of the Japanese stock market through 2023 and 2024. It will probably not have a huge effect on the overall market situation.

The UK remains a laggard after a series of policy mistakes and the disruption of Brexit. It has the same problems as the rest of Europe, exacerbated by its particular problems which have led to higher inflation and poor growth prospects.

The large energy exporters are awash with money but cannot easily spend this bonanza in the short term at least. More likely there will be a lot of fairly unnecessary large capital projects in the Middle East in particular.

Overall economic situation

The current central bank position is that, while we may well be at the end of the period of interest rate rises, it is not yet clear that inflation is under control. Central banks have now moved closer to our position that it was not clear how quickly economies will slow and how rapidly inflation will stabilise at the magic 2% level.

What we can say is that everything to date has taken longer than expected, suggesting we could be in for a period of stagflation. We have expected for some time that the rapid rise in interest rates heightened the risk of ‘events’ such as the bank problems seen in 2023.

The period between about 1990 to 2015 was one in which a coincidence of events created a world where economic growth was very healthy. Important elements were the success of China – and other Asian countries – as a cheap manufacturer, the availability of both food and energy and the generally benevolent political situation. As perhaps was inevitable, these factors created their own tensions – notably the rise of populism and nationalism. These were driven by those who felt they had lost out, be they Russian empire builders, US manufacturing workers, Brexiteers in the UK or the far right in countries like France.

It does seem that we are entering a different era from that of the last 30 or more years. What we don’t know is how different. For instance, will China turn into an aggressive, nationalistic country or realise that its economy is inextricably tied to the rest of the world, accepting the constraints that entails?

The outcome of the war in Ukraine is difficult to predict. We can imagine various scenarios from a negotiated peace to one where the frustrated Russians use chemical weapons or even nuclear bombs. It is very important that the Russians are not seen to ‘win’, for the simple reason that their winning would encourage other nationalist empire builders to try something similar. The likelihood is a war that drags on for a considerable time with neither side ‘winning’.

We will be left with a world which will have suffered another blow to globalisation, following the effects of the Trump presidency and Covid. This is a world of warring camps, not one of general cooperation to make the world a better place to live in.

Which brings us back to inflation, the major topic of concern over recent years. We were concerned before the war that we were entering a period of severe inflation. The question was how long the heightened level would last, and to what level inflation would ultimately fall back. The biggest risk now is that we may be entering a period of stagflation in economies which are not major commodity producers. The US is better placed than the EU, UK, China or Japan, being more self-sufficient in basic commodities such as food and energy.

Until very recently, the language of central banks has been one of a determination to get on top of inflation, even if that meant inducing a recession. In theory, this should be easier in the EU – with limited wage inflation – than the US, where the economy needs slowing. We needed an economic slowdown to reduce short-term energy demand while we built up more reliable sources in the longer term. The current broad market view – shared by central banks – is that enough has been done to get inflation back to reasonable levels. The step beyond this must be concern as to how far interest rates can be reduced while keeping inflation under control. This is likely to become more of an issue as 2024 progresses.

Fixed income

Bond performance over past year
All bonds 10+ years, 28/06/2023 – 28/06/2024, 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 2% p.a. The first twenty years of this century have been anomalous both in the low level of absolute and of real interest rates. Over the medium term, interest rates are likely to remain at higher levels than was the case in the first twenty years of this century.

Where bonds are being used for matching it now makes sense to move towards a matched position, after a long period of this not being sensible.

Equities

 Equity performance over the past year
26/06/2023 – 28/06/2024, local pricing

It is hard to explain the comparative strength of equity markets since mid-year 2022. While inflation has fallen, interest rates are higher than they have been for many years. The better-than-expected economic picture has been a major factor but, as we look into the second half of 2024, it is hard to see where the good news necessary to push markets further will come from.

The relationship of the dollar to the euro, sterling and yen has tended to fluctuate between bands of about 20%. Most recently, the dollar has been very strong and at one point was above parity with the euro. This suggests that there may be opportunities for the euro investor in hedging. Any position taken needs to be monitored carefully.

What will be fascinating is the long-term effect of the heightened intervention by governments and central banks. It does seem likely that we have seen the end of the 2010-2021 period of benign markets driven by accommodating central banks. At the same time, democratic governments are under extra pressure to spend. Markets are likely to have a much bumpier ride in the next 10 years than in the last.

Euro cash

This month saw the first reduction in interest rates in five years.

With yields on short government bonds sitting around 3%, and inflation now slightly lower, deposit rates have become much more attractive.

Property

Property in general has longer cycles than the equity market which can make it useful as diversifier. Many property markets are still adjusting to the changes in people’s working and spending patterns that we have seen since COVID, and as part of longer term trends, and the impact these are having on the demand for and usage of property. Higher interest rates have also caused challenges for property investors and generally lead to a fall in property values. We do, however, believe that 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
28/06/2023 – 28/06/2024, US dollars

The oil price as of late has been difficult to predict – fears about the war in Gaza initially led to concerns that might put pressure on supply in the Middle East, however this failed to materialise and prices haven’t seen the gains predicted.

Most developed economies are driving to ensure access to secure energy supplies and improve energy self-sufficiency. There is no guarantee however that this will dampen oil price volatility, and the volatility of commodities in general means that investment is best left to serious risk-takers.

Hedge funds

Hedge fund performance over past year against equities
01/07/2023 – 28/06/2023, 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 funds / 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 4% to 5%, or two thirds of equity performance). Because of the very wide range of investments they hold, they 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 many credit investments 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 slight preference for Emerging Market Debt over High Yield Debt or Senior Loans at this time.