All Change?

TL;DR

1.      Markets should be thinking more about immigration, than tariffs.

2.      The playbook that has worked in the last twenty years, probably won’t work in the next twenty years.

Welcome. I lead the research effort for the Multi Asset Strategies UK team at Invesco. My colleagues and I are generalists who look at a wide range of asset classes and topics. The aim of this ~monthly piece is to highlight our thinking on key macroeconomic and market topics, and the debates we are having internally and with our clients. Sometimes that might focus on the very short-term, elections for example, sometimes we’ll consider the very long term, like demographic changes. And everything in between. Hopefully, this gives you something to think about and helps you navigate these challenging but fascinating markets.

I fully expect this piece to evolve over time as markets evolve. If you have comments or would like to discuss anything further, please contact your Invesco representative.

The short view: All change on the political front

2024 will go down as the year that incumbents were shown the door. All developed markets, and many emerging markets, that held national elections this year saw the vote share of incumbent parties fall. Populations today, it seems, really do not like inflation, and are showing their ire in the voting booths. But we should be careful of taking too simplistic a view of political change and imposing those views onto financial markets. Too often markets will humble us.

The core message that we have been trying to get across ahead of and around the election is that investors should be careful in thinking they know how an election result will play out in markets. Policy, and bluster around it, does not take place in a vacuum. When telling people to be wary of their gut feelings the best example we can show is that of the performance of oil & gas stocks, and clean energy companies during the Trump and Biden administrations. Most people would agree that President Biden favours a greener, more climate friendly agenda than Trump, while Trump supported deregulation and the granting of more drilling permits to the US shale industry during his first term. And yet Oil & Gas companies were one of the worst performing groups while Trump was in office, and the best while Biden was in the White House. The reverse is true for Clean Energy companies.

I am absolutely not saying you should ignore politics, and I’d encourage you to check out this recent webinar hosted by my colleagues Andy Blocker and Kristina Hooper for their thoughts. What I am saying is that there are other macro, micro, and fundamental factors that often matter more to markets than who is resident in the White House. When I talk to my colleagues that is unanimously the way they are thinking about investing today. Equally, we need to be wary of taking the headlines, tweets, or truths at face value. So, what should investors be thinking about or worried about as the political landscape shifts?

The US Election: Pay more attention to immigration, than tariffs

President Trump secured a strong victory including all three branches of US government. He and his team have a strong mandate for change, but what form that change will take is highly uncertain. Our view, and that of many people we speak to today, is that the range of outcomes on key policies are very wide, and very hard to predict. Google’s search trend data suggest that people are most worried about the impact of tariffs – that is at least the term they are searching for most. We get that, tariff is Trump’s favourite word.

Long ago, when I was a young Economics undergraduate, I was taught that tariffs were bad and inflationary, free trade was good. As is often the case with the economics we learnt in a stuffy lecture theatre, in the real world it is not quite that simple. We can look back at Trump 1.0 for evidence of the impact on prices we find that tariffs tend to raise the price level in a one-off fashion but don’t lead to sustained inflation. In January 2018 President Trump imposed a 20% tariff on imported laundry equipment. The chart below shows that prices of these goods rose by around 20% in a three-month period, and from April onwards the deflationary trend of these products returned at a similar level. By late 2019 prices had returned to their previous level.

This is important because it means the Fed is likely to ignore the price impact of tariffs, nay maybe even respond to them with cuts, as they will see the hit to demand as a greater risk than sticky inflation. In a 2018 paper that is largely the conclusion the Fed drew.

According to our chart of Google searches people seem less concerned about immigration. I think that is wrong. I am far more concerned about the immigration story which I think could have a more meaningful macro and market impact. It is highly unlikely that President Trump will be able to make good on his suggestions to deport 15-20 million undocumented individuals. The infrastructure is not there to do that. But by severely restricting the border and deporting some people, the impact could be meaningful.

Over the last five years the growth in the US labour force has solely been the result of increased foreign-born workers. The level of native-born workers in the US labour force has barely returned to where it was at the start of the pandemic. A growing workforce allowed the labour market to ease, wage pressures to ease, and therefore inflation to ease. Already in 2024, the number of immigrants entering the US has fallen, if that continues sectors such as health care, and leisure and hospitality where the labour market remains very tight could tighten further.

If the labour market tightens next year and wage pressures move higher, then it will be much harder for the Fed to justify further rate cuts. To my mind, higher inflation, and fewer rate cuts from the Fed in 2025 than is currently priced is looking more and more likely. That is not necessarily a problem if growth stays strong. At the start of 2024 Fed Funds futures were pricing around six rate cuts from the Fed. We’ve only had three so far in 2024 and yet the S&P500 has delivered one of its best years ever. That has been the case because growth has been more resilient than many expected. The risk for 2025 is that a labour market supply shock pushes inflation higher and growth lower.

Rates markets appear to be telling us that a soft-landing is more likely, and inflation is still a risk. That is best shown by the change in 10yr US Treasury yields since the Fed cut by 50bps in September. It is very unusual for yields to rise when the Fed is cutting rates, even during non-recessionary periods. It is also likely that we see a steeper curve and increased risk premium in 10y yields despite the Fed cutting rates. That can variously be attributed to the changing fiscal landscape, increased bond supply, and future expectations of policy led inflation risks.

The UK budget: Not great, but shouldn’t impact equities

Rachel Reeve’s first budget started off very well. “Invest, Invest, Invest” she said. I agree, the UK needs more investment. Unfortunately, it was downhill from there and Labour’s budget, according to most estimations, including those of the OBR, suggest that business investment will be lower because of this budget. My colleague Graham Hook covers UK politics far better than I ever could. His thoughts on the UK budget are well worth a read.

Does the budget change my view on the UK and UK assets? Not really. There is evidence that the increase in employers National Insurance contributions has caused companies to pause hiring, but we need to see more evidence that companies are laying off employees to become much more negative. We are watching that closely.

And there are reasons to think positively about the UK today. The UK consumer is in decent shape, still sitting as it does on a pile of excess savings from the pandemic period and much lower leverage than they had entering the Global Financial Crisis (GFC). Wealthier savers have been sitting pretty over the last couple of years as rates have been rising and interest on savings account has provided a solid income to many. Borrowers who have moved off fixed rate mortgages in the last two years have felt the impact of higher rates in a very different way.

But some of those mortgage holders should start to see a little relief in the coming months as the effective rate on new mortgages falls. Already that has fallen from over 5.3% in November 2023 to 4.6% in October. The refinancing pain has not gone away, but it is reducing. A little more stability alongside real income growth means the UK consumer can keep spending. That may offer support for some UK small caps.

More broadly UK equities remain deeply discounted against global equities and provide a shareholder yield that is much higher than many other markets today. Like UK households, many UK firms have much stronger balance sheets today than they did several years ago. Energy and Financials for example are comfortably able to return cash to shareholders without having to lever up their balance sheets today. While bond yields and discount rates have peaked, I do not think we are returning to the ZIRP era (more on that below). In an environment where rates are higher compared to the post GFC period a greater amount of the value in future cashflows comes from nearer term cashflows such as dividends. Value and high yield parts of the market are likely to perform better than Growth areas. Regionally, the UK looks very attractive on those measures.

The Long view: The next 20 years will be different from the last 20 years

The last four years have felt anything but normal. The first true pandemic in living memory, a conflict on the European border, and a surge in inflation. Many would like to think that inflation is now headed back to levels seen during the 2010s. That is normal after all. Isn’t it?

No. Taking a longer view it is clear the post-GFC, pre-pandemic period was the abnormal period whereby inflation was low and displayed low variance. Much of the last 100 years has been characterised by either much higher or much more variable inflation as shown in the chart below.

To understand where inflation might settle in the coming years, we should try to understand why inflation was so low and so stable in recent years. There are myriad reasons, but one key reason is the change in private sector behaviour before and following the Global Financial Crisis. The GFC was caused by huge excess leverage in the private sector. The clearest example was in the housing market, where individuals were encouraged to take on large or multiple mortgages as they chased the American dream. In the five years headed into 2008, debts for middle income households rose by more than 80% while the assets they held only grew by 37%.

Looked at another way, in the chart below, gross domestic investment in the US was at or above savings for a sustained period. Something that had not really been seen in the prior 100 years. The GFC destroyed a lot of private wealth very quickly and the reaction among households and corporates in the subsequent years was to over-correct. Households and corporates saved more, paid down debt, and cut back on investment. In the UK for example in 2008 around 50% of households held an interest only mortgage, today 84% or mortgages outstanding are on a repayment basis. A story for another day is China, where over investment and leverage has persisted in recent years. China today looks a lot like the west in 2008.

This lack of investment in the west means fixed assets have aged significantly in recent years. The average age of farm equipment in the US is 24 years today. There have been some incredible advances in technology in this space in recent years and many manufacturers are now taking advantage of AI techniques to make their equipment more efficient. There is a good chance that encourages an increase in traditional fixed asset investment over the coming years.

I think lower savings rates and higher investment rates are likely to prevail over the coming years and companies could be encouraged to invest more as their equipment ages and tight labour markets force them to try to boost productivity. If I am correct and investment increases and savings fall, then the natural rate of interest should be higher in the coming years than we have been used to in recent decades.

There are other reasons to think that inflation and interest rates will be higher over the coming years compared to what we had become used to in the past two decades. Topics to explore in more detail in the coming months.

1.      Demographic changes, for example, which we discuss in detail here, will be incredibly important as an aging population means fewer workers and greater demands on health care.

2.      In recent decades a peace dividend has allowed countries to reduce their spending on defence as a proportion of GDP and support social security programs. But now the world is experiencing more kinetic conflicts than has been seen since the end of the cold war. This is a topic we’ll explore in more detail in the future but in simple terms wars tend to be inflationary.

3.      High government debts are a clear worry for some today and the picture is likely to get worse before it gets better as entitlement spending and interest costs rise. I’m generally not of the view there is a crisis here today, but governments clearly have an incentive now to run the economy hotter and with higher inflation which would go some way to erode the real value of their debts.

4.      The fractious nature of geopolitics and the experience of the pandemic means many companies are rethinking their supply chains. This might be in part to avoid possible tariffs, but it is also in part to move to something that is more akin to just in case production methods, as opposed to just in time. Just in time methods mean high efficiency, lower costs, until the chain breaks. Greater investment and reorganising of supply chains is likely to be inflationary, at least in the short-term.

5.      The pre-pandemic era was characterised by an abundance of cheap energy. In the US the shale gas revolution allowed cheap oil and gas for the US. In Europe cheap imported oil and gas from Russia was the order of the day. Now nations are focusing on energy security as well as greener energy sources. As this transition takes place energy prices are likely to be higher and more volatile, especially in Europe. That is inflationary. Something we’ll explore in the future is the nascent revival in the nuclear energy space which could herald a new era of cheap and abundant energy. But that transition will take time and be costly.

6.      Artificial Intelligence might solve all these problems and provide the world with a huge productivity boost. I am somewhat hopeful on this topic. But in the immediate term the energy demands of the AI and cloud computing space could be inflationary rather than deflationary.

The conclusion I draw is that we must think differently and more carefully about inflation than we have in recent decades. If inflation and rates are higher than we have been used to in prior decades, that will have profound implications for investing. Some of the themes and trends that have been so strong over prior years – US outperformance of, well, almost all other markets, and Value underperforming Growth could be on track to turn. Some trends already are turning. The chart below shows how unusual a period the post-GFC period was as Growth outperformed Value for more than a decade. That has not happened before. Since rates have risen a nascent return to trend with Value performing better appears to have returned.

In a stable world of low rates there is no need to pay up for stability and as such factors such as earnings quality or stable margins weren’t in vogue. Growth and duration were in greater scarcity and therefore commanded a higher premium. It was equally true that stock dispersion – the cross-sectional variation in stock returns was comparatively low for a long period of time. It is reasonable to think that as macro and micro volatility increases stock dispersion might increase too affording stock pickers greater opportunities to differentiate themselves.

Another abnormality that we have seen since the GFC that could be turning around is the strong outperformance of the largest cap stocks, and cap weighted indices over equally weighted indices. The strong performance of the largest companies means that today the US equity market on most measures is more concentrated than it has ever been. While historical earnings growth can justify much of that performance history shows that we should expect some mean reversion over time. If history is any guide the scatter plot below suggests we should expect something quite different over the coming five years.

Greater investment in physical capex and higher rates make regions outside of the US start to look more attractive too. While the picture I have painted might sound like one in which we should avoid fixed income, I don’t think that’s the case. As yields have risen fixed income can once again offer some protection against growth shocks, if they don’t come with inflation shocks. While in the normal course of events the coupons and yields on fixed income are more attractive. It is the income component of fixed income and equity dividends that I think will provide more value to total returns in the coming years than they have done in recent decades. Once again, that is a return to normality, we need to unlearn that returns only come from capital gains.

Today’s financial landscape is changing faster and more dramatically than in many investors’ careers. Most of us grew up in a world of low interest rates, low volatility, where central banks always had our back and Growth investors were heroes. While for many it is hard to imagine anything different, it should be noted that, compared to financial history, the last couple of decades have been quite unusual and were supported by some very favourable tailwinds that are now turning. Ergo, we are swiftly moving to a new investing landscape and must rethink our playbooks.

Recommended Reading & Listening

Think before you speak. Read before you think

Fran Lebowitz

Whenever I interview someone, I always ask them what they are reading. Partly because I like book recommendations but mostly because the answer tells me a lot about that person’s approach to learning. The worst answer I have received, on too many occasions from students, is; “I don’t have time to read”, the best is when I get a recommendation on a very esoteric subject completely outside finance.

I’ll drop a few book and podcast recommendations here each month. They might be especially useful this month if you are looking for a gift for the bookworm in your family.

It has been quite easy of late to get drawn into a state of depression about the state of the world. My favourite book of the year so far however is an uplifting treatise on climate change. In Not the End of the World Hannah Ritchie details the huge progress we have made on many climate and pollution issues. Hannah is the Lead Researcher at Our World in Data so her work is based firmly in data. She is far from a climate change denier but rather challenged some of my preconceptions around what actions we can take to improve the climate situation, and she proves that progress can be made. Nay, it has been made.

I’ve thought a lot about commodities this year and found Material World fascinating. The book investigates six materials Ed Conway thinks are the most important today – oil, copper, iron, lithium, sand, and salt - showing how and where those materials are mined and refined. A narrative that covers the dirtiest depths of mines in Chile to the cleanest factories on the planet in Taiwan.

I have a fantastic colleague in my team, Caroline Whittam, who constantly berates me for not reading enough fiction. So I took her suggestion to read, well listen to in this case, I am Pilgrim recently. Crime thriller and spy novel wrapped into one. It is stretches believability at times, although not as much as the reality of 2024 at times. This book offered some much-needed escapism in 2024. As does the Slow Horses series, the books that the TV series is based on. The plot lines follow very closely the TV series so choose carefully which you read or watch first.

If you prefer to consume your media through your headphones then you can hear more from me and Ben Gutteridge, CFA on our short weekly Podcast, Ben Squared and Ben’s longer form Time in the Market. And if you want to know what I am listening to podcast wise you might like to check out my Spotify Podcast Playlist – it’s an eclectic mix of material.

Remember, if you have any questions or suggestions on the content above, please contact your Invesco Representative and I’d be happy to talk further.

Best wishes for the holiday season!

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