Active Thinking

At GAM Investments’ latest Active Thinking forum, David Dowsett reviews some of the key events in the first quarter and considers what to look out for in Q2.

19 April 2023

2022 saw the worst year for US bonds since 1870 and was a bad year for equity markets across the board. We entered 2023 assuming it would be better than 2022, but what has characterised the year so far?

Better than expected growth

In the first quarter of the year, most major financial assets performed positively. This is notable given event risks, particularly with regards to banks, namely the collapse of Silicon Valley Bank and the takeover of Credit Suisse by UBS. Yet despite causing volatility in March, these events did not derail performance. As a whole, the first quarter was positive, particularly for risk assets, with both bonds and equities performing well.

This more positive first quarter follows better performance in the fourth quarter of last year. One of the main drivers has been a continued stabilisation of growth expectations in Europe. There was a lot of uncertainty about energy prices leading to projections of recession in Europe, which have simply not come to pass. Indeed, the growth outlook has been much better than expected.

Particularly notable in the first quarter of the year was the decisive exit from zero Covid policy in China. We saw this take effect in January but it had strong consequences for markets as we proceeded throughout the first six weeks. Overall, we saw better than expected growth expectations and a less immediate prospect of recession on a global basis. The consensus expectation at the beginning of this year was for a recession in the US in 2023, but Q1 growth was better than expected.

Declining headline Inflation, but core inflation remains sticky

In the first quarter, there was a marked decline in headline inflation but there are still concerns about core inflation which has proved stickier than expected. As a result, we are seeing central banks continue to raise interest rates.

Transfer away from US assets

Another important trend in Q1, which we signalled at the beginning of this year, is better performance of non-US assets and, associated with that, a firming expectation of a growth transfer from the US to the rest of the world as 2023 proceeds. It was particularly notable that in March, when we saw concerns about banks, the dollar underperformed. Typically in a risk event, we would see a flight to quality and therefore a stronger US dollar yet this was not the case. We have seen better performance from non-US assets. For example, the Dow Jones Euro STOXX 50 Index is reapproaching 2007 highs.

Episodic events

We highlighted at the beginning of the year that we might see some episodic events associated with monetary policy tightening. We saw the cumulative effect of that on SVB as 400 bps of interest rate hikes last year led to an asset liability mismatch for the bank. Very importantly, while that was a worrying couple of weeks, it has not decisively changed the growth or liquidity outlook for any economy thus far and has not created a more generalised banking crisis.

Stemming from that event, we saw that central banks were able to separate liquidity support for banks from interest rate policy. The most notable example of this was 10 days after the Credit Suisse/UBS merger, the Swiss National Bank (SNB) raised interest rates by 50 bps. This was a very notable move considering one of the country’s two large banking institutions had effectively failed. However, the central bank was able to do this successfully without any further spill over effects.

Where are the potential risks?

Going forward, there are two episodic events that I think represent potential risks. The first relates to government debt. The biggest bubble from 2008 to the end of 2021 was that created by USD 18 trillion of debt with a negative yield. A move to more normalised interest rates will not likely occur without any pressure on sovereign debt dynamics, particularly given the cavalier approach to indebtedness currently popular among the governing classes.

The second relates to private equity and the private credit sector. I do not believe that the transmission mechanism has played out; private assets have not repriced in the way that public assets have. For example, private equity firms have been taking public equity out of the market in the UK at a much higher multiple and paying a huge premium to the public equity price. This works as long as private equity firms have a long time period to realise their investment and providing they have liquidity. Eventually the investments that they are making will need to raise more capital and that has to come at a certain price in the market, either in the debt market or in the equity market. Therefore public and private markets will likely not remain misaligned forever.

This is all taking place in the context of a global economy that is deglobalising with greater emphasis from governments on resilience rather than efficiency; more emphasis on protecting domestic labour markets than cost effective global production; and more emphasis on security, given ongoing uncertainties about Ukraine and even Taiwan. As a result, labour markets at a national level remain tighter than they would have done in previous environments because every element of production is no longer being offshored and so the importance of the domestic labour force counts for more. This, in itself, raises the risk of boom/bust policy cycles as central banks employ counter cyclical monetary policies.

Outlook

The latest IMF projections show a gradually declining growth projection for the US. The developed world overall looks weak, although Europe is recovering. The emerging world looks more resilient, particularly emerging and developing Asia, showing the growth rebalancing away from the US. A lot of European equities are highly correlated to the Asian growth story, so as we see more recovery there, it should be more supportive for European assets as well. Our expectation for a US/non-US growth transfer and asset valuation transfer holds true for the second quarter of the year as a lot of the key uncertainties that will affect the outlook during Q2 reside within the US.

While the non-US outlook looks relatively healthy, what happens in the world’s largest economy is important. The primary concern about the US is the more medium term economic effects of the regional banking crisis. In the US, commercial bank lending has declined significantly since the SVB episode. It is entirely logical that banks are pulling back on their liquidity and credit provision and preserving more capital for themselves. It is also logical to expect this to percolate throughout the US domestic economy in the second quarter of this year. Growth in the US looked quite healthy, nonetheless, the more immediate indicators (eg jobless claims) are beginning to show a slowing growth impulse. The growth impetus in the US over the summer look less supportive than the growth impetus throughout the rest of the world and that is likely to have an immediate knock on effect on earnings provisions. If investors look at markets globally, they can make sense of valuations in emerging equities, particularly driven by China and emerging markets more broadly. Looking at mainstream US equities, it is harder to claim that there is a lot of value attached at current price-to-earnings ratios. I think that is the area of the market than may come under more pressure, at least on a relative basis, as we proceed throughout the summer. The case for non-US assets outperforming US assets is evident from the different growth profiles that they have. The lack of earnings momentum may not be evident in the data published this week, as a lot of S&P 500 Index companies report, but I expect this to be a key source of uncertainty for markets going forward. Investors want to see more evidence that the earnings projections that are priced into the market can indeed come to fruition against the headwinds that are occurring within the domestic economy in the US.

In Q2, we will also be closely watching the debt ceiling debate in the US. This week, Kevin McCarthy will give a speech to the New York Stock Exchange outlining the Republican approach to the debt ceiling. The Republican party is going to demand more spending cuts for an extension of the debt ceiling but President Biden has categorically ruled that out and is taking a confrontational approach. We have a situation where both sides think that the approach that they are taking is working politically for them. A resolution without a default would be a logical conclusion but I would be surprised if we reach that without more uncertainty. Again, this is a US centric concern and reinforces the view that investors will look to invest outside of the US.

Another aspect to focus on in the US, both politically and economically, is the Inflation Reduction Act and the CHIPS and Science Act which are interventionist industrial policies. It could be the case that we have not fully understood the effect of these policies on the US labour market. It is reported that some European countries are moving more production to the US to benefit from the subsidies associated with the Inflation Reduction Act. There is a case for saying these policies are important in continuing to support US growth and perhaps explains the strong outturn in the first quarter of this year and could continue to feed through to the labour market as well.

To summarise, we are in a better environment than last year and overall we expect markets to perform relatively well. Yields are attractive in fixed income markets and we see valuation opportunities in markets outside of the US. We will continue to invest against the backdrop of cumulative monetary tightening that has persisted for the past 18 months, with those who have not properly provisioned themselves or are running too much leverage likely to face the consequences. As a result, we expect positive markets from here but not without volatility.