Multi asset perspectives: The unique challenge of divided markets

GAM Investments’ Julian Howard outlines his latest multi asset views, exploring how stock market progress during Q2 was dependent on an excessively optimistic view of the universal benefits of artificial intelligence.

28 July 2023

Review

Global equities as measured by the MSCI AC World Index rose 6.6% in local currency terms in the second quarter of the year. Stock markets – and specifically US stocks which account for around two thirds of the world index – surged ahead on the back of euphoria around the latest breakthrough in artificial intelligence (AI). Seven stocks accounted for most of the positive gains, namely Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla, revealing a distinct lack of breadth in the market. Whether AI will live up to its promise was highly contested but the stock market, at least until the final few days of the quarter, appeared to have made up its mind.

Similarly, market volatility as measured by the VIX index collapsed to just under 13 in June, a level last seen just before the Covid-19 pandemic. Despite this, reasons to be more generally concerned about the economy and markets were both more numerous and persuasive. The US debt ceiling deadline was only just met at the end of May as politics was set aside at the last minute to avoid the humiliation and chaos of a potential US default. More worryingly, inflation remains unvanquished across the major advanced economies. In the US, eurozone and UK, headline inflation was on a decelerating course but core inflation remained stubborn at 5.3%, 5.3% and 7.1%, respectively, by the end of the quarter. While the US Federal Reserve chose to ‘skip’ a hike in its June decision, there was little question of ending the current tightening cycle, while the European Central Bank (ECB) and Bank of England both hiked rates at their June meetings (the latter by 50bps) in a clear signal of intent. The uncertainty around the end-point of the inflation and interest rate saga that began in early 2022 shows no sign of lifting, a fact not lost on bond markets, whose own MOVE volatility index still remains elevated versus 2021.

Other potential risks included the continued travails of the US regional banking system which saw the failure of First Republic in early May and whose impact on lending into the real economy is just now starting to reveal itself. Geopolitics remained fraught too amid Ukraine’s counter-offensive, an attempted putsch by Russian mercenaries and simmering tensions between the US and China. The US Republican nomination process provided its own dramas as the leading candidate faced outright criminal charges. While the last few days of the quarter started to show a more consistent alignment as market volatility picked up amid all this, the review period as a whole was characterised by a marked divergence in markets.

Chart 1: Core of the problem – underlying inflation remains stubborn

Long-term portfolios face the perennial challenge of investing for the time horizon their description suggests while needing to provide a controlled journey through the short-term ups and downs that capital markets inevitably generate. It is important to focus on those areas which have a realistic possibility of generating growth in a low growth world of secular stagnation. In our view, this coalesces around (inevitably US) large cap technology stocks whose sizeable cashflows can finance their unrivalled innovation pipeline. We are also positive on emerging markets and China. While many analysts have lamented China’s slow recovery since its belated re-opening, we believe the country’s economic growth prospects remain far better than most advanced economies and its equity capital markets far more under-represented in world indices.

Away from equities, our focus is on consistency and reliability over outright growth. As such, we emphasise fixed income and credit strategies that are independent of the main bond markets. These include mortgage-backed securities, catastrophe bonds and subordinated financials. But we believe the best risk-reward (see chart 2) comes from short-dated fixed income in the form of ultrashort investment grade bonds and either treasury bills or money markets depending on reference currency. With discount rates across the key economies elevated and likely going even higher to deal with unvanquished inflation, we believe these instruments offer healthy yields with relatively little risk (US debt ceiling fiasco aside).

Chart 2: Why take on complexity and risk for the sake of it?

Outlook

Declaring the macroeconomic and investment outlook highly uncertain risks sounding trite but the reality is that markets are startlingly divided and at some point this will need to be reconciled. While we recognise the changes that AI is likely to bring to many workplaces, we believe that its paradigm-shifting qualities may have been overstated. The history of technology step-changes not universally characterised by huge leaps in growth and productivity. The academic literature for example is persuasive on the limited impact of the US railways in the 19th century while the modern concept of secular stagnation notably took hold in the years following the supposedly paradigm-shifting dot.com boom of the late 1990s. We still prefer large cap technology stocks for their qualities as ‘vendors’ of innovation into the broader economy over time but fail to share the breathless enthusiasm for AI’s purportedly transformational qualities.

In the meantime, the principal threat to the stock market, and indeed any series of cashflows that characterise a financial asset, is persistent inflation and the yet-higher rates that the major central banks will need to deploy to deal with it. Much has been written about lifting inflation targets as a means of side-stepping the ghastly spectre of tightening policy to the point of crushing demand and bringing spending almost to a stop in order to bring prices down to current targets. While this is intriguing it is probably also naïve: central bank credibility, already bruised after the belated start to policy tightening in 2022, rests on pursuing carefully thought through policies in a consistent manner. Our sense therefore is that discount rates in the US, eurozone and UK will continue to tighten, and therefore render most asset classes – equities included – even poorer value in the short term. While this has the potential for creating volatility in equities as high risk-free rates threaten to outright overshadow corporate earnings yields, the consolation is that short-dated fixed income offers a rare opportunity to potentially generate high risk-adjusted returns away from stocks. None of this renders a structural allocation to equities invalid. Indeed we believe they should be so for a reason – the ‘Siegel Constant’ of 6.5-7% observed real returns in equities over the last two centuries has been achieved net of periods just as disorientating as this one. The real risk is to believe something has profoundly changed.