GAM Investments’ Julian Howard outlines his latest multi asset views, exploring how committed investors face the challenge of stretched valuations, China’s economic slowdown and rising geopolitical risks.
17 October 2023
Review
Global equities, as measured by the MSCI AC World Index, fell -2.5% in local currency terms in the third quarter of the year. While the number itself will be poor enough to disappoint some investors, the fact that markets did not hit a truly sustained air pocket over this period was noteworthy given the growing list of headwinds faced by equity investors. On fundamental metrics, the US equity market is now very expensive both on its own terms as well as relative to the available risk-free rates.
Starting with valuations, the Shiller Cyclically-Adjusted Price Earnings (CAPE) ratio now stands at over 30x for the S&P 500 index, meaningfully above its 40-year average of 24x. Comparisons with risk-free rates of return are even less encouraging. The forward earnings yield for the S&P 500 now stands at just 5.1%. While this is a touch more than the 4.6% offered by the 10-year US Treasury note, it is still less than the 5.5% offered by the 6-month US Treasury bill at the end of the review period. This startling fact, that parking cash at virtually no risk now offers investors more yield than that from riskier equities, seemed to have only a limited impact on equity markets during the review period. At the same time, the prospects for any improvement in these fundamentals – deep market falls notwithstanding – appear uncertain.
For one thing, the inflation picture in the US at least is not clear-cut enough to give the Federal Reserve (Fed) a reason to declare definitively the end of the current monetary policy cycle and thus start to lower the risk-free rate. While the Fed’s rate-setting meeting of 20-21 September saw a ‘skip’, the uncomfortable fact remains that the easing of inflation since October last year has not proved to be a linear process. Headline CPI had fallen from its June 2022 peak of 9% to 3% a year later but ticked up since then to 3.7% amid rising oil prices. In the meantime, news from the world’s second largest economy provided a different kind of uncertainty.
Indebtedness in China’s property sector has dampened consumer confidence and dragged on economic growth some nine months after the sudden abandonment of Covid-zero as a national policy goal. Geopolitically too, tensions with the US remained elevated amid a war of words and creeping protectionism, both formal and informal. In early September for example, China was reported to have banned the use of Apple iPhones in several government ministries and state-owned firms amid ‘national security’ fears. And in the background the brutal war in Ukraine ground on seemingly without end, while former US President Trump was officially charged for election subversion even as his divisive campaign gathered pace.
Chart 1: Paid not to invest – US equity market offers less yield than cash
Source: Bloomberg.
Past performance is not an indicator of future performance and current or future trends. Data from 27 Dec 2002 to 30 Sep 2023. For illustrative purposes only.
Positioning
Markets are presenting a classic challenge to investors – stick to the mantra of staying invested for the long term or make changes to defend capital now amid the unappetising backdrop described above? We believe that the long-term case for equities is too profound to be materially affected by even the most adverse near-term conditions. The Siegel Constant’s observed 7% real return from US equities over a multi-decade timeframe includes several such periods already and is therefore net of several stages like today’s. For this reason, our broad preference in favour of equities is likely to remain.
However, much can be done to mitigate some of the volatility that could potentially arise from the conditions outlined above. Our relatively positive view on US equities, for example, provides increased stability given that market’s deeper liquidity and safe haven status, even if it is itself relatively overvalued. The other pillar of our equity view, our liking of emerging markets and China, is harder to frame as a diversifier against near-term volatility, particularly if US rates remain elevated and the Chinese economy stagnates. But these regions do offer attractive valuations compared to the US, which should bode well from the medium term onwards - the MSCI China index is today trading at almost half the valuation of the MSCI USA index in forward price/earnings terms. Over the last 20 years, China has only been this cheap monetarily in 2020 and 2021.
Away from equities, we continue to see the value of effective and reliable diversifiers. In fixed income and credit, we like insurance-linked bonds, mortgage-backed securities, subordinated financials and some traditional sovereign exposure, particularly short-dated securities offering competitive yields for little risk ‘spend’. These include ultrashort investment grade paper but our preference is primarily for short-dated treasury issuance depending on reference currency. Given the supremely favourable risk-reward environment we see in fixed income, we envisage less of a role at present for alternative investments, albeit that the convertible arbitrage approach offers diversification of return. Finally, in terms of more tactical thinking, we would be prepared to take advantage of any market drops should they prove excessive with the use of simple index futures. That opportunity did not present itself during the third quarter but we ensured that we were paid to wait in the meantime by favouring short-dated US Treasury bills yielding over 5%.
Chart 2: China equities trading at nearly half the price of US counterparts
Source: Bloomberg.
Past performance is not an indicator of future performance and current or future trends. Data from 31 May 2006 to 30 Sep 2023. For illustrative purposes only. Indices cannot be purchased directly.
Outlook
To describe the outlook as uncertain risks sounding trite and yet it seems to be the most apt description for the investment landscape heading into the final quarter of 2023. A major difficulty is that risk assets have very little wriggle room to absorb anything significant going wrong after the multi-month ‘megarally’ that began in October last year and which appears to have finally peaked at the end of July this year. Valuations are stretched on most standard measures while potential catalysts for correction abound. This is an uncomfortable combination which investors need to be prepared for.
While US economic growth may well continue to defy expectations given the robust state of the consumer - theoretically boding well for earnings - this would also keep up the pressure on inflation and therefore the rates picture. Faced by a newly activist OPEC+, the Fed could end up forced to maintain a tighter policy stance than the market anticipates, and certainly tighter than the fully 75bps of rate easing the swaps market predicts by this time next year. Furthermore, the Fed will be acutely aware of its own credibility gap, with serious debate around the issue of whether the Fed’s rate rises have played any role in the easing of inflation at all given that the latter has occurred without any corresponding loosening of the labour market. A Fed that belatedly seeks to re-affirm its role while there is still some inflation left could see continued US dollar strength, creating headwinds for ex-US markets, especially emerging ones. Higher US rates would also suck more capital out of risk assets into areas such as money markets which themselves have been significant recipients of capital in recent months.
Within US stocks, wobbles in the technology narrative that have driven the market higher were seen during the third quarter and the enthusiasm for artificial intelligence (AI) may be tempered by further protectionism or the slightest disappointment in earnings, such is the peak pricing seen in the sector. Geopolitics also offers risks aplenty, from Ukraine to the US election and perhaps even Taiwan. All this and more could be a potential catalyst for a more profound correction. In such circumstances, the role of the investment manager becomes one of responsibly maintaining the structural allocation to stocks that will surely bring growth in the long term while managing near-term volatility sufficiently well to smooth the journey in the meantime.
As such, short-dated fixed income is likely to continue to play a major part in diversified strategies, while an enhancement to the existing equity ‘texture’ could include quality stocks focused on stable earnings with low debt levels which can better withstand drawdowns. Getting the balance right between long-term participation and near-term diversification will be crucial as the coming months potentially test all but the most committed of investors.
Important disclosures and information
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