This month we focus on the usual short-term challenges that markets are encountering as central banks wrestle with when to stop raising interest rates. But we also take a step back and look out at the long-term to examine how the artificial intelligence revolution could drive portfolio returns over the next decade.
The key, we are told, to learning to ride a bike is to stare into the distance and not down at the wobbly wheel in front of us. However, this is a hard thing to do on those early, frightening journeys.
Today, if we stare down at the markets right in front of us, we see a wobbly wheel. Central banks are seeking to navigate the peak in interest rates. Whilst there is evidence inflation is falling, which enables them to lower rates again, they cannot take this action until they are sure the inflationary enemy is driven away. They are, after all, seeking the most elusive of economic phenomenon, a ‘soft landing’. This is a situation where rates rise enough to bring down inflation without causing a recession.
The US Federal Reserve and the Bank of England decided to take a ‘wait and see’ approach in September. Both central banks highlighted continued vigilance as they kept policy rates unchanged. However, the Federal Reserve went further and hinted at another rate increase by year end. This took investors by surprise and bonds sold off in recognition.
The US economy has shown remarkable resilience in the face of tighter monetary policy, with strong job creation and consumer spending keeping GDP growth positive even as inflation remains high.
This stands in contrast to Europe and the UK, where growth has slowed more noticeably due to spillovers from the Russia-Ukraine war and energy cost pressures. This has led investors to believe that US rates will stay higher for longer than the rest of the world. This is now being priced into currency markets and the US dollar has risen significantly against the euro and sterling. While the US is better positioned for now, its consumer and labour markets will be tested against a backdrop of global slowdown.
Oil prices climbed in September on tight supply worries, benefiting the energy sector. Higher crude adds inflation pressures, complicating central banks' aim to cool prices. Lower OPEC output and uncertainty over a proposed Western price cap on Russian oil have fuelled supply constraints. Meanwhile, demand remains solid despite economic headwinds. The increase in oil prices seen over the past few months highlights the complex interplay between geopolitics, supply dynamics, and market forces that impact commodity prices.
Equities declined in September, led by large technology shares, capping a painful third quarter. However, stocks could rebound if upcoming third quarter earnings confirm stability in corporate margins amid weak but still positive earnings growth. Valuations have moderated and improving trends in key sectors could lift sentiment while waiting for a rebound in cyclicals. Investors will be watching earnings closely to gauge the resilience of corporate profits in the face of rising risks.
Government and corporate bonds declined as rising yields hurt bond prices. Yields are unlikely to fall substantially until core-inflation (inflation ex-food and energy) declines meaningfully. While rate cuts may still be a way off, policy actions mitigate inflation risks and support bond prices. For multi-asset investors bonds can play an important role in portfolios, offering returns and diversification.
Navigating markets remains challenging as central banks combat high inflation, but risks of a severe global downturn have diminished. Equity markets have repriced significantly, reducing overvaluation. We are concerned about China's slowdown, but global growth should find a floor eventually. Our equity allocation emphasises quality companies with pricing power and stable margins. In fixed income, neutral duration provides stability amid rising recession worries. Portfolios are diversified across assets and geographies to withstand volatility. We are monitoring risks closely and can get more defensive if conditions deteriorate materially. Overall, staying invested in a balanced, diversified portfolio gives investors the best chance of participating when the clouds clear.
The Long-term view
The past few years, beset as they have been with crises, have led many people to question whether markets will ever return to winning ways.
But despite pandemics, wars and inflationary surges the long-term case for making strong returns over the next decade remains intact. It is built on one central thing; the capacity of humans to build an ever more productive economy. This is because it is improving productivity that powers economic growth. In the words of economist Paul Krugman it isn’t everything but ‘it is almost everything.’
So, to believe that equities will trend upwards over the long-term we must believe that our economy will carry on becoming more productive. Crucially, after major crises there will always be powerful voices who will argue that the productivity gains of the past cannot be repeated. It is after all far easier to look backwards at the productivity gains of the computer or the motor car and see how it has transformed the economy, than it is to look ahead at an only just emerging technology like artificial intelligence and believe that its impact could be as large.
The same problem of failing to really believe that each new wave of technological innovation can be as great as the past wave has plagued economists for generations. In the words of Bank of Italy economist Patrizio Pagana ‘in retrospect it emerges that pessimistic predictions were wrong neither because they were built on erroneous theories or data, nor because they failed to predict new technologies, but because they underestimated the potential of the technologies that already existed.’
Technology is a powerful driver of productivity because it increases what economists call ‘total factor productivity’ that typically delivers around half of all productivity growth. This is, in essence, a measure of how much more valuable the things coming out of the end of an economy are than the things going in the front. For example, a man attempting to build a rabbit hutch with a perfectly good pile of wood and failing, leaving only a pile of broken and butchered wood on the floor, would have a negative total factor productivity. A skilled carpenter who turned the wood into a beautiful rabbit hutch would have positive. Technology improves the ability for ordinary people to take the inputs of an economy and make them more valuable.
The next decade could be the period of the most rapid productivity growth since the early 1990s when the personal computer arrived. Goldman Sachs estimates that by 2030 global productivity will be improving by 1.5% a year due to artificial intelligence. This is massive by economic standards and offers compelling long-term opportunities for investors.
So how do we make sure your portfolio is exposed to these long-term trends? One first step is keeping a good allocation to the United States. Those companies at the front of the AI revolution are found in the United States – led by Nvidia. This technology giant makes world-leading AI chips and has gained an almost unfathomable lead in specific areas of the AI ecosystem. But the challenge for investors is to understand the risks as well as the opportunities in this innovation. There are enormous opportunities to harness, but not every company claiming to be an AI leader will deliver, and many will fail. Vigilant active management will be crucial as we make sure that the long-term transformation of the world drives portfolio returns.
Global equities have struggled in recent weeks as central banks have reaffirmed a tighter monetary stance. World stocks dropped 0.7% in September but remain up 9.5% in 2023.
US equities lost 1.2% last month as the technology sector fell.
UK large caps bucked the trend with a 2.4% gain in September.
Japanese shares climbed 1.5% last month, benefiting from loose monetary policy, a weak yen, and attractive valuations.
Earnings for US Large Cap companies are expected to be flat for the third quarter. This would mark and improvement in trends as corporate margins have stabilised.
8 of the 11 sectors are predicted to see earnings growth, with Communications and Consumer Discretionary leading.
Source: ASP and Bloomberg, 30.09.23
Government bond yields have jumped sharply in recent months, extending losses from last year.
The yield on the 10-year UK Government debt has climbed to around 4.5%, its highest level in 15 years.
UK inflation-linked debt declined sharply due to its high duration of 14 years, which made it more sensitive to rising yields.
Investors have scaled back expectations of rate cuts by the Federal Reserve in 2024.
Currencies have also been impacted, with the dollar rallying strongly in recent weeks.
The expected returns from bonds are the highest they have been in over a decade.
Forward looking inflation indicators continue to show falling prices.
Source: ASP and Bloomberg, 30.09.23