MARKET UPDATE 16/07/2024

Market sentiment: Optimistic. The S&P 500 and the NASDAQ 100 indices continue to make new all-time highs, helped by a surprisingly robust domestic economy and continuing optimism around AI. Political risk has eased in the U.K and France, which has helped local financial markets. The Fed is widely expected to make its first cut interest rates in September.

Barring any geopolitical shocks, second quarter corporate earnings announcements are likely to dominate investors thoughts over the coming weeks. U.S large cap stocks appear more vulnerable to any disappointments than European and Asian stocks, given their high valuations. Average Q2 earnings growth expectations for the S&P 500 is at 11% year-on-year.

U.S small cap, and non-U.S developed stock markets, may better placed to absorb any earnings disappointments or deteriorating outlook statements. As ever, investors are advised to diversify as much as possible in order to obtain the highest long-term risk-adjusted returns.

Central banks on hold. Investors are convinced that the Fed wants to cut to interest rates, and are looking for two cuts this year, starting in September. However, global inflation, and interest rates, have both been ‘higher for longer’ than were expected at the start of the year, and a cautious approach to financial markets by investors may be appropriate. On Thursday we have U.S retail sales data for June, analysts are looking for broadly flat numbers.  

In the U.K, there is hope a stable and avowedly pro-growth government will stimulate investment, and boost long-term GDP growth rates. The result has been a buoyant pound, reaching $1.30 last week, and strength on stock and gilt markets. The drawback is that improved optimism over long-term growth rates may slow down Bank of England rate cuts. Markets currently price in at 50% the first one being in August.

The ECB meets on Thursday, record low unemployment of 6.5% and 5% plus wage growth mean that the central bank will probably hold interest rates. However, markets are pricing in an 85% chance of a September rate cut, given that a recent pick up in growth appears to have lost momentum.

Politics, budget responsibility and fixed income investing. U.K financial assets may benefit over the coming years from relative political and fiscal stability amongst its G7 peers. So far, markets have given the new Labour government the benefit of the doubt. In part, this is because it has promised to stick to the previous government’s five-year fiscal plans, outlined in the spring, despite the independent Institute for Fiscal Spending describing them as unrealistic. The government is anxious to appear responsible with public money, to keep the bond market on side.

However, prime minister Kier Starmer will face immense pressure from within his Labour party to increase public spending. Whether to save industrial jobs, such as in the steel industry, reverse Conservative restrictions on welfare, rescue ailing public services, and commit more money to defence spending. We will soon see how he responds to these pressures, and whether his pledge to keep to the existing five year fiscal plans will be honoured.

In France, the fear of a right-wing government has receded, for now, allowing for a rally in French and European stocks and in French government bonds. However, there is considerable disagreement between the Macron-bloc in the legislative body, and the left-wing bloc, as to how France should be governed and on budget priorities. For instance, the left wingers want to reverse Macron’s reform to pension laws, bringing the state pension age back down to 62. Macron may struggle to govern.

The U.S is running the largest budget deficit amongst the G7 countries, at 6.3% of GDP. However, neither Republicans or Democrats show any interest in raising taxes or cutting public spending. Relatively strong economic growth can, in part, alleviate the problem over time. And some economists believe the U.S is uniquely able to issue large amounts of government debt, because global investors will always want to buy dollar assets backed by the U.S government.

But investors are becoming increasingly nervous that appetite for Treasuries may fade, if inflation remains stubborn as a result of government fiscal largess, and/or an over issuance of government debt crowds out private borrowing, and so restricts investment and economic growth. Furthermore, there is an adage in finance that is borne out by history: that long running, very high, deficits end with inflation and political instability. Is the U.S so very different from countless examples over the past couple of centuries?

Investors can respond to these risks by having a variety of government bonds (and of varying maturities) in their fixed income portfolios, together with an exposure to corporate investment grade and high yield.

Real assets. If inflation is to remain sticky, investors should have exposure to real assets. These are so-called because their value tends, over the long term, to keep abreast of inflation. They maintain a ‘real’ value. The term includes property and commodities. Real assets can be owned directly, or through funds.

Many investors would include equities in the category of real assets, given that many companies can pass on higher input prices to their clients. But some sectors offer more protection against inflation (eg, utilities and supermarkets) than others, particularly if inflation squeezes discretionary spending. And equity prices (should) reflect the discounted future income flows of the underlying assets, which is a very different concept from non-income producing real assets such as commodities and collectables.