Active Thinking

GAM Investments’ David Dowsett shares his views on the most significant developments during a far-from-typical holiday season and considers the main factors for investors to focus on as Q4 fast approaches.

06 September 2023

David Dowsett, Global Head of Investments

While many of us have been away on holiday in August, I think it is worth summarising what has been happening on the economic front over the last four to six weeks across the main regions.

In Europe, news on the growth front has been disappointing and the outlook remains fairly weak but relatively predictable. But, to make sure that inflation is declining, we should still expect more tightening from the European Central Bank.

On the other hand, as expected Japanese economic growth has been very strong in nominal terms, with second quarter growth of 12%. While that is unlikely to be a level that is sustained, the growth outlook is healthy, a step change from the weak prospects we have seen in Japan for a very long period. Elsewhere, excluding China, the growth picture across emerging markets has been fairly mixed but largely stable, with the growth baton passed from China to other markets.

Focusing on US and China

I think it appropriate to focus on first the US and then China as those are the most important regions for global economic growth and the financial market outlook.

The US, from a growth and inflation perspective, has done much better than expected over the summer period. In fact, the US economy is now 40% larger in nominal terms compared to 2020, the third largest expansion in nominal terms since the end of World War II. In contrast, during the decade from 2009, the US economy grew by just 13%. So the increase over the last three and a half years is a huge step change, one that is largely due to fiscal policy but to some degree inflation too.

We are talking nominal terms, but that is important to companies’ bottom line in terms of how they measure their profits. It is also a key reason why US equities are performing as well as they are. In my view, the fiscal expansion we have seen is not sustainable but nevertheless it has been a huge supporting factor as the market has recovered from post-Covid lows.

US in the driving seat – the economy is motoring

Looking at the more immediate picture, US third-quarter growth is tracking around a very healthy 3.5% in real terms. We have seen important improvements in the supply side data over the past few weeks. The labour force is growing, hence the news that unemployment is going up slightly. Wage pressure seems to be moderating so the inflation picture is getting better, markedly better in the US than elsewhere, something that Federal Reserve (Fed) Chair Jerome Powell referred to in his Jackson Hole speech. Understandably, he did not want to say he had defeated inflation but there has been meaningful progress in the US policy transition. I think markets are recognising that the Fed is likely to be on pause at September’s meeting, and we are probably at the end of the hiking cycle.

Beyond the better-than-expected growth outturn and a better-than-expected inflation environment over the summer in the US, importantly – and intriguingly – there has been a measurable productivity improvement – so much so that this week’s statistics should show something like a 3.5% productivity increase. And we should get something similar in the third quarter too, so perhaps some of the artificial intelligence (AI) and IT investment benefits that investors have been talking about have already begun to appear in the statistics. Even at the start of 2023 nobody was really talking about AI benefits and even six months ago few had even heard of Chat-GPT – but if the effect can be sustained then that is a huge positive for the US economy, opening up a sustainable ‘soft landing’ scenario into 2024. This is definitely something to monitor, including how it might be reflected in earnings reports a few weeks from now.

What all this could mean for next year – productivity will be key

Looking into 2024, all this probably means that interest rates are going to be close to present levels for most of next year. I think the inflation backdrop gives us comfort that rates will not need to go meaningfully higher. Equally, given the growth backdrop and ‘soft landing’ scenario, my view is that markets could be overestimating the potential for interest rate cuts next year.

Of course, the ‘higher for longer’ interest rate view could highlight an ultimate pressure point for refinancing high yield debt. In fact, in areas like private credit, I think everyone has been surprised that we have not seen more blow ups so far this year. In my view, the key determinant as to whether we will see a traditional cycle slowdown or a soft landing lies in those productivity stats, and whether there really is any meaningful improvement in productivity across the services sector from IT and AI in particular.

Fragile China is a worry

Turning to China, there is no doubt that signs on a data and payments level over the last six or so weeks have been very worrying. The potential Country Garden bond default is probably not a huge surprise but brings it back into the market. We have also had some shadow banking weakness through Zhongrong. As always there is the worry that one shadow banking blow up could impact on the broader banking sector. More broadly, fixed asset investment was weak and economic growth outturns were generally lower than expected.

China’s policy response so far: no bazooka

So far, policy response has been piecemeal – by no means insignificant having pulled virtually every policy lever to some degree. Although there has been no ‘big bazooka’, my view is that it has done enough to stabilise the economy for the rest of 2023, so we are not looking at a dramatic collapse in Chinese growth; we should see perhaps 4% to 4.5%, possibly a 5% growth outturn.

With China’s economic ship stable, geopolitics come into play

Individually, there is nothing that grabs the attention but collectively, there is enough to stabilise the outlook. With people worrying about the financing picture, in the first half of August things were heading towards more of a hard landing scenario, although we have seen a tentative recovery in Chinese equities for the last fortnight. I am reasonably optimistic that this could continue, avoiding a complete freefall in Chinese asset markets. Ultimately, I think China will eventually have to implement a much more active fiscal policy to escape its real estate debt overhang problem, but for the moment it has done just about enough.

While there are lots of questions currently associated with the China story, I think it is significant that President Xi is going to the BRIC summit in South Africa but is not going to the G20. I see this as a sign that China is re-profiling its leadership role to exert influence with so-called middle powers. In Asia, despite China’s economy underperforming against consensus expectations in the post-lockdown environment of 2023, the perception is that President Xi is not operating from a position of weakness.

Given the stable outlook, investors are taking a patient approach

Against this backdrop, investors are remaining patient. Bank of America flow data for 2023-to-date shows around USD 230 billion has gone into bond funds but money market funds have seen around USD 1 trillion of inflows, meaning 10 times as much money has gone into money market funds compared to equities, with actively managed equities actually seeing outflows. With the growth drivers for equities relatively narrow, the 5-6% yield from money market or short duration funds is now a very viable alternative for investors. With the ‘staying higher for longer’ interest rate outlook, they could remain that way for some time.