deVere Group: Investment Outlook Aug'24
Andrew.J. Barros ACSI
Area Manager at deVere Spain SL | Wealth Management Consultant for the Expats and International Investors
Investment Outlook
Tom Elliott
A fortnightly look at global financial markets
27th August 2024
Market sentiment: Calm, but wary. The MSCI ACWI index of global stocks is up a percentage point in local currency terms since the start of the month, and the S&P500 reached a new high last week. However, the MSCI ACWI index is down a little when expressed in sterling, this reflecting a strong pound and a weak dollar. Gold is at new highs, driven by several themes.
The Fed’s emphasis on being ‘data dependent’ almost guarantees unusual sensitivity on financial markets, to each economic data release. The VIX index of anticipated volatility on the S&P500 is at 16.2, well above the average of the year so far. Have bonds rallied too much? Is the U.S really heading for a soft landing? (this seems to be the scenario that investors once again favour).
In the U.K, better than expected economic data has led the Bank of England to warn that inflation has yet to be vanquished. Despite having begun the process of rate cutting last month, it was the bank’s governor Andrew Bailey who sounded cautious at last week’s Jackson Hole meeting. This contrasted with the Fed’s Jay Powell, who made clear that his focus is now on protecting the labour market, ie growth, rather than vanquishing inflation. The inflation problem – the implication seemed to be- is yesterday’s problem.
Have bonds rallied too far, too soon? The 2yr U.S Treasury yield is back to 3.9%, where it fell to on 2nd August as investors sought defensive assets amid the stock market sell-off. Some analysts caution that, if the risk of a U.S recession is not as great as was feared during the stock market sell-off (and how else to interpret the S&P500 reaching at new highs last week?), then surely bonds shouldn’t be priced at the same level as when that fear existed.
Some of the fall in yields that we saw last week reflects the confirmation by Powell, at Jakson Hole, that it is likely to cut rates next month. But that accounts for a small part of the overall fall in yields.
This is not to argue that Treasuries are overvalued. With real yields being positive (ie, after taking into account inflation), investors are being paid to take virtually no risk if they hold onto the bonds to maturity. What’s not to like about a 1% real yield on the 2yr Treasury? And 1.5% on the U.K’s 2yr gilt (3.7% yield minus July CPI inflation of 2.2%).
But any surprise uptick in U.S inflation, that causes the Fed to delay its first rate cut, could be badly received by the bond market. For investors intending to hold until maturity, this is not important. However, some investors will be using borrowed money, or have duration limits on the fixed income portfolios, and so may sell in order to crystalise gains or avoid losses. And what goes on in U.S Treasuries is often echoed on other G7 government bond markets, as higher Treasury yields then suck money away from other bond markets until yield differentiation is restored.
Equities – diversifying out of the U.S. The U.S stock market continues to be highly valued relative to its European and Asian peers. This reflects, in part, the large weighting of growth stocks (ie, tech), in the S&P 500 index, compared to, say, the FTSE100 index where more cheaply valued cyclicals and defensive stocks (together known as value stocks) dominate. Is the premium that is applied to U.S growth stocks justified?
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The rapid growth in earnings of the Magnificent Seven tech stocks in recent years suggests it is. And figures from Bloomberg support this; they estimate that the largest 3000 U.S quoted companies, as measured by the Rusell 3000 index, will grow their earnings per share (EPS) by around 11% this year. Almost triple the 4% expected EPS growth from non-U.S stocks, as measured by the MSCI ACWI ex-U.S index.
Nvidia, a particularly fast growing Magnificent Seven stock, is due to release its quarterly earnings numbers tomorrow (Wednesday).
And yet. Portfolio construction is about achieving the maximum reward for the lowest possible risk. This is achieved through diversification, and so avoiding the risk of large drawdowns in portfolios that can do so much damage to long-term investment returns. The sell-off in early August, led by U.S and Asian tech stocks, demonstrated the value of owing other sectors, and other region’s stock markets. Notably, the value-heavy FTSE100 was shaken, but only slightly, and when the U.S stock market recovery set in shortly after, its was led by defensive sectors.
Meanwhile, the rally in bonds during the early-August stock market sell-off reminds us of the usefulness of fixed income in a well-balanced portfolio. Alternative asset classes, such as gold, commodities, and structured products should also be considered.
Sterling strength/ dollar weakness. Stronger than expected economic growth in the U.K during the first half of the year, and a more cautious tone to rate cuts by the Bank of England compared to the Fed, have contributed to a stronger pound this month. Up five cents, to $1.32, since 1st August.
But there are two sides to most currency stories, and the dollar is down against a basket of major currencies. It has fallen over the last month in response to the stock market sell-off, and market calls for emergency Fed interest rate cuts. The Fed did not respond to those calls, but the dollar index continued to weaken as it became clear that imminent monetary easing is on the cards. This was confirmed last week in the release of the minutes of the last Fed policy meeting, and in Jay Powell’s Jackson Hole speech on Friday.
Gold has now passed the psychologically important $2,500 an ounce price level. It has also been a beneficiary of the weak dollar, and the prospect of reduced returns on cash and bonds as dollar interest rates start to fall. The worsening of tensions in the Middle East, as Israel squares up against Hezbollah and its backers, together with Ukraine’s unexpected incursion into Russian territory, has also prompted buying.
Meanwhile Russia and China’s central banks are buying the metal, as part of a long-run strategy of diversifying their reserves away from dollars U.S issued financial assets (such as Treasuries). BRIC central bank buying is likely to be a long running support to gold, enabling balance of payments deficits to be rectified through transfers of ownership of the yellow metal (which will still, ironically, be ultimately priced in dollars).
But the next phase of de-coupling from western financial systems, an electronic financial payments system equivalent to SWIFT, will be much harder to achieve. It requires mutual trust in the political neutrality of each other’s legal systems, and confidence that one particularly large member will not seek to dominate the system.
U.S politics and the Fed. Donald Trump does not want Powell to cut Fed interest rates before the November election. He has said that any cut prior to the election will be proof that the Fed is not impartial. Similarly, Democrats are hoping for rate cuts to start soon, so they can go to the election without the burden of the highest interest rates in decades still on their charge sheet. Powell will have to tread carefully, if he is to preserve the perceived political neutrality of the Fed. But this should not deter him from spelling out to the electorate the inflationary risks of what we know of Trump and Harris’ economic policy.
Both support expansion of the child tax credit, and Harris has proposed ending tax on tips. Both would constitute fiscal relaxation, and boost household disposable income, and probably prices. Trump also proposes higher import tariffs, which are a direct charge on the consumer. Sending home migrant workers will push up wages, fuelling inflation, while cutting back on output: a policy for stagflation. Neither side has announced plans for cuts elsewhere in government spending, to help balance the books and to help control the budget deficit.
Better for the Fed to tell voters the possible costs of politicians’ promises now, than for the bond market to enforce fiscal discipline on Washington with higher borrowing rates.
A curiosity of the election is what appears to be each candidates’ blind spot. While Trump might appeal to blue collar workers in the key swing states at a cultural level, his economics has always been against their interest. (Eg, opposing Obama’s health care program, unfunded tax cuts for the rich). Harris has the opposite problem: her economics appeals to those voters, but her ‘campus politics’ turns them off. The winner may be the one who can overcome their blind spots.