Investment Market Update
As we leave summer behind and head into Autumn, markets have been broadly positive and reasonably calm over the last couple of months. There can never be an escape from the noise and threats that has become a constant feature of the current US administration. This continues unabated with India now under threat of 50% tariffs and, as the Financial Times headline stated, “Trump’s battle against the Fed heads for courtroom showdown”. It is hard to think of any other President who has come close to dominating the world financial and geo-political news the way Donald Trump has done. Unfortunately, though, the war in Ukraine continues and does not feel as though a solution is imminent. The Middle East continues to be gravely concerning and a humanitarian catastrophe. The jury is out on the impact of tariffs. Yet, the Dow joined the broader S&P 500 and Nasdaq in notching a record high this year.
In the UK, we are heading towards an Autumn budget which we are being told will make the horrors of Halloween seem like a walk in the park. It feels like Groundhog Day as, yet again, we read of threats to attack pensions, tax-free cash, ISAs, savings, property and almost anything you can think of. According to the rumour-mill, all of these are in the Chancellor’s crosshairs. Despite this, the FTSE 100 has had a strong summer and reached record levels. At the same time the cost of government borrowing is climbing steadily as long-dated gilt yields surge, reflecting global monetary shifts, weakening demand, and persistent inflation concerns.The cost of UK government borrowing has jumped in recent months to near a 27-year high.
Why Have Markets Remained Buoyant?
Most would agree that the world is far from being in a good place and the economic and political news flow is depressing and often hard to consume. It would seem however that markets are ignoring the world around us and remain buoyant. Inevitably, as records are reached, commentary focuses on valuation and questions are asked whether markets are blind and ignoring reality. Concocting a bearish view on US stocks based on valuations is relatively easy. It doesn’t mean the market is going to correct but with US stock market valuations hitting historic highs reminiscent of the Great Depression and dot-com bubble, some experts warn that a significant correction may be on the horizon. As we have discussed many times, it is impossible to time the market, and evidence suggests time in the market is a key plank for success.
A recent article produced by the Chief Market Strategist EMEA of JP Morgan looked at this issue with particular focus on the US markets. It is suggested that there are possibly four reasons why markets remain buoyant despite higher tariffs and a slowing US labour market. The reasons are broadly sound, but some must be viewed with caution and are less compelling. The article, whilst positive, was also deeply questioning.
The first reason offered is that private sector balance sheets remain healthy, so any severe slowdown looks unlikely. The second is that the worst of the US trade policy newsflow is now behind us. The third is the Federal Reserve is going to support the US economy and global markets by cutting interest rates. The final reason is the beneficial effects of AI will overwhelm any short-term economic or market weakness. There simply hasn’t been a worrying build-up in private leverage in this cycle. Busts are usually preceded by booms, most of which involve an excessive build-up of debt. Slowdowns get ugly when debt has risen significantly.
Then households, businesses and banks worry about their debt and therefore pull back spending and lending, which in turns deepens the downturn. US household debt as a share of GDP is 30 percentage points below its pre-financial crisis peak, and corporate balance sheets remain strong.
The same is broadly true across other developed economies. This lack of leverage suggests that any slowdown should be limited in both magnitude and length, providing investors – particularly those with a longer-term focus – with the confidence to look through any potential near-term volatility. This is an encouraging conclusion.
Tarrifs and Trade-Related Risks
The worst of the US trade policy newsflow is behind us. The JP Morgan article suggests that this reason is not a wholly convincing one. The US administration has certainly demonstrated a more pragmatic approach to trade policy following the upset of ‘Liberation Day’, and the US has agreed several framework deals with key trading partners.
However, trade-related risks to the global economy and markets remain.
The first risk is that the tariffs themselves haven’t really worked through the US economy yet. Although trade deals have been struck, the effective tariff rate today sits at a level that we haven’t seen for almost 100 years. The economic effects of tariffs have so far been muted by corporates stock-piling inventory early in the year, ahead of anticipated higher import prices. But as those stocks are depleted, businesses will face higher import prices. There is very little evidence that overseas companies are ‘paying for the tariffs’ by lowering their prices. Higher import prices could feed through to consumer prices, leading to a less accommodative Fed. It is also possible that a new wave of tariff announcements could be delivered. This could be prompted by countries not living up to the promises made in their trade deals with the US (such as billions of dollars of purchases of US goods), or because the US administration is seeking more revenue in order to cut taxes ahead of the US midterm elections next November.
The Fed is going to support the US economy and global markets by cutting interest rates. The market is currently expecting the Fed to lower the federal funds rate back down to 3% by this time next year, from today’s 4.25%-4.5%. This should simultaneously help cushion any economic downturn whilst making cash savings less enticing, forcing investors into risk markets in search of income. Although Chairman Powell indicated that a September cut looks likely, whether or not the Fed can deliver a whole series of rate cuts depends on how recent changes to tariffs, migration policy and tax rates start to affect growth and inflation. If the labour market continues to weaken and any rise in inflation is moderate, then the Fed will be able to look through short-term price acceleration and meet market cut expectations. If, however, inflation rises and becomes more broad-based, and/or there are signs that wage growth is once again picking up as migration curbs create worker shortages, then the Fed may not be able to meet market expectations for rate cuts. This would not please the President, and some might argue that political pressure will lead the Fed to cut regardless of the inflation backdrop. If the Fed chose to cut without this being warranted by the inflation backdrop, the long end of the US yield curve would likely rise – which could itself challenge risk asset performance. A risk of political interreference with the Fed is likely to have a negative impact on the dollar.
The final reason offered is that the beneficial effects of AI will outweigh any short-term economic and equity market weakness. Once again, this reason faces risks. The recent recovery in US stocks has in large part been driven by a recovery in tech stocks, following weakness earlier in the year. This tech recovery was, in turn, broadly driven by a very solid Q2 earnings season, which restored investors’ faith in the valuations they are paying for the MegaCap tech companies. While AI is likely to be transformative for certain sectors of the economy, structural questions remain as to how broad AI’s appeal will be. That is, how many companies find AI genuinely labour-saving and/or productivity-enhancing and thus are willing to pay high prices to adopt and implement AI technologies. Such broad enterprise adoption is likely necessary for the MegaCap tech firms to justify the hundreds of billions of dollars they have invested in AI. In the nearer term, economic and policy uncertainty could lead to slower capex, hindering the speed of corporate AI adoption. Historically, slowing capex has coincided with falling tech earnings. This time could be different, although it rarely is, but investors should always be wary of relying on this.
Conclusion
Overall, Western economies are structurally healthy, which should support risk asset returns. That’s not to say there won’t be bumpy periods in markets in the remaining months of the year. The article concludes that investors would do well to think about diversification, “Don’t put your eggs in one basket” which also is our mantra and a fundamental plank of portfolio construction.
In the next Investment View, we hope to explore some of the famous sayings that have made their way into investors vocabulary such as the above “eggs”. A major fund house has looked at twelve familiar sayings and ranked them on three metrics. We will seek permission to give more detail from this fun research. As a teaser, the top three and bottom ranked sayings are “Don’t put all your eggs in one basket”, “Time in the market beats timing the market”, “Cash is King” and “Be fearful when others are greedy”. The last saying is attributed to Warren Buffett, who will retire as CEO of Berkshire Hathaway after 55 years at the helm. The ‘Sage of Omaha’ is renowned for stellar investment returns and a pithy turn of phrase. Was his saying in gold position? Can you get them in the right order?
Douglas Kearney C.A. Investment Director
The above article is intended to be a topical commentary and should not be construed as financial advice. Past performance is not an indicator of future returns. Any news and/or views expressed within this document are intended as general information only and should not be viewed as a form of personal recommendation.