Feature Stories | Jul 04 2023
Analysts offer their views on global markets as we head into the second half of 2023.
-Central banks to keep hiking
-Wall Street driven by tech alone
-AI to change the world
-Recessions still on the cards
By Greg Peel
This time last year all talk was of a return to Living in the Seventies. Inflation was surging, impacting on economic growth, and leading to warnings of stagflation, as had been the case in the seventies – a decade of economic recession.
While the seventies brought about the first attempts by central banks to control inflation with monetary policy – not previously a mandate – the mistake made, in hindsight, was to hike rates rapidly but then to quickly reverse those hikes when recession hit. While central banks, most notably the Fed and RBA, were very slow to act on inflation amidst the economic drag of covid, they have since increased rates both dramatically in quantum and in speed.
To the extent that for most of this year, markets were expecting rate cuts to have followed swiftly – if not by now at least in the second half of 2023 – as economies entered recession. But that assumption has now waned, given (a) recession is yet to be seen (by backward-looking measures) and (b), central banks have insisted there will be no cuts for the foreseeable future, and likely more hikes instead.
Central Bankers such as Jerome Powell and Philip Lowe remember the seventies. Only when then Fed chair Paul Volker decided the only way to tame inflation was through hiking rates well into double digits and forcing a recession upon the US economy did inflation begin to recede. Powell and Lowe are not going to make the mistake of cutting rates and risking a second wave of inflation growth, no matter how unpopular that makes them.
Moreover, the seventies saw prolonged double-digit inflation that make numbers under 10% look tame. Inflation is now receding globally. Slowing growth and disinflation mean there will be no stagflation.
As long as there are no external shocks, such as a new pandemic or prolonged war.
And what’s more, talk of living in the seventies has now turned to living in the nineties. The seemingly sudden rise of AI and resultant tech stock surges is being compared to the advent of the internet, and the nineties culminated in the 2000 burst of the dotcom bubble.
But is it 1995, when the internet and dotcoms took off, or 1999, being the peak of the frenzy?
Narrow-Minded
The jury is out.
“Rarely (indeed perhaps never) are bubbles forecast by the majority of market participants – or indeed much discussed ahead of time,” notes Longview Economics. “In that sense, this one will be somewhat unique if it continues to behave like it’s 1999 (which is the current favoured analogy in many circles)”.
Longview points out the advent of the internet in the nineties was accompanied by an existential digital threat – what happens when the clock ticks Y2K? Fearing planes dropping out of the sky, then Fed chair Alan Greenspan flooded the market with liquidity, just as central banks did during covid. When planes landed safely, that liquidity was withdrawn.
By 1999 any company listing as X.com surged from day one irrespective of no earnings or even revenues – just a website and a dream. Cheap money fuelled risk-takers.
US tech companies similarly surged in 2021 on zero interest rates, but met their comeuppance in 2022 when rates surged. It was not a tech wreck, rather a bear market. Those same companies have been on the move again in 2023, because it wasn’t until this year that anyone paid attention to AI. Microsoft’s ChatGPT has changed the world for ever, so we’re told.
But this time it’s not about companies with no earnings or revenues to speak of, indeed quite the opposite. The so-called “Magnificent Seven” are the most highly capitalised stocks in the world, have more money on their balance sheets than they know what to do with, and continue to be earnings machines, AI or not.
Four of those seven – Microsoft, Apple, Amazon and Nvidia – are tech wreck survivors. Google, Meta (Facebook) and Tesla are twenty-first century listings. All are seen as AI beneficiaries (Nvidia actually makes the chips) and indeed had been working on AI adoption long before 2023.
E&P Research (Evans & Partners) notes recent strength on Wall Street has taken the S&P500 net forward price/earnings ratio to 20x, for the third time in history. The first was in the nineties dotcom bubble and the second in the covid bounce of 2021.
Much of the spike in valuations is due to the tech sector, particularly the Mega Tech companies. The Mega Tech companies are now trading at a combined PE well over 30x, notes E&P. The bulls say take out the Mega Techs and the remaining PE for the rest of the market is reasonable, although E&P warns still elevated – around 10% above long term average valuations.
Brandywine Global notes the ten largest stocks in the S&P500 have accounted for nearly 90% of the index’s year-to-date returns, the highest percentage in history.
Earnings growth has become scarcer, and the premiums investors are willing to pay for those companies with it have skyrocketed. Indeed, PE expansion as opposed to an improvement in earnings outlook has been the primary driver of market performance. Earnings estimates for the year have risen from the beginning of April but remain lower than consensus estimates at the beginning of the year.
Interestingly, the Fed hiked its funds rate from 0-0.25% to 4.25-4.50% over 2022, sparking the tech bear market (from lofty valuations). In 2023 the Fed has moved that rate up to 5.00-5.25% yet the Nasdaq has rallied 30% year to date, led by the Mega Techs.
The key difference between 2022 and 2023 is found in bond yields. The US 10-year Treasury peaked above 4% in October last year and is currently, despite ongoing Fed tightening, trading around 3.85%. Bond yields are the true masters of the universe. It is no coincidence this year's strong recovery in equities already started in October.
But does a mere pause in the bond yield uptrend warrant such a strong recovery for equities?
Today’s bears point to the 2023 rally for the S&P500 as lacking breadth (small group of stocks doing all the lifting). The bulls shrug this off, and point to AI as a game-changer that will override historical precedents.
If tech doesn’t lead the market higher, given it’s overextended, then cyclicals are the most likely candidate, suggests Longview Economics. Cyclicals, nevertheless, historically haven’t led the market higher into recessionary environments. As such, for cyclicals to take up leadership, then the worst of the economic slowdown needs to have passed.
Added to which, the S&P500’s cyclical sectors are already overbought on a short-term basis, Longview notes, and close to overbought in the medium term.
Headwinds
Brandywine Global sees a myriad of headwinds as the US enters the second half. Household excess savings have been worked down, and data suggest those for the lower-income quartile were exhausted by the end of the March quarter. Beginning in September, student loan repayments will resume, which some sources estimate will be a -US$128-148bn annualised headwind on consumer spending.
While prices for core goods, excluding used vehicles, were nearly flat in April, price inflation for services remained persistently strong. It will take a weaker labour market for services inflation to slow. The debt ceiling debacle has come to an end, but the Treasury needs to refill its coffers, which likely will create a drain on liquidity.
There have been twelve Fed tightening cycles since 1960, eight of which have resulted in hard landings and four of which have resulted in soft landings, observes Piper Sandler. The recipe for the former tends to be underscored by a sharp deterioration in unemployment while the latter experiences little to no downturn in employment.
Piper Sandler also writes precursors to a hard landing have been rapid Fed hikes coupled with tight bank lending standards and sticky inflation while precursors to a soft landing have typically consisted of modest Fed hikes, easing bank lending standards, and low inflation. Current conditions seem very similar to those that preceded hard landings in the past.
Brandywine believes it is prudent to be positioned more defensively at this time.
In the short term, liquidity is a key driver of equity markets, notes Longview Economics. In that vein, there’s been widespread discussion about the implications of the US treasury embarking on a major debt issuance program now the debt ceiling is resolved. Recent estimates of net debt issuance are over US$1trn for the remainder of 2023.
This will clearly be a drain on market liquidity, Longview warns. Added to that, the Fed’s quantitative tightening (QT) program is ongoing, with no hints from Powell it will finish anytime soon. Over most of the post GFC period, there’s been a reasonably good correlation between QE/QT and the S&P500’s PE ratio. It’s only in the past six months that that relationship has been suspended.
Close analysis of the liquidity environment, though, supports the view the running down of the Treasury account had offset the effect of the Fed’s QT liquidity drain. With that Treasury account dynamic now reversing, markets will once again have to absorb the Fed’s QT drain, notes Longview.
The Global Outlook
The global economy continues to show resilience, highlights Citi. Spending on services has remained strong, and core inflation is running stubbornly above targets. In response, central banks have signalled their intention to remain vigilant. Citi anticipates their efforts will ultimately be successful, but only after a period of further policy restraint.
Citi sees global growth running at 2.3% this year and 2.0% next year, slightly lower than previously due to downward revisions in China. Compared with 3% trend growth, the global economy’s performance will be notably soft. For example, Citi continues to expect recessions in the US and Europe.
Even so, the key message that emerges from the analysts’ forecasts is relatively constructive. Despite the numerous headwinds and challenges endured in recent years, the global economy is likely to keep powering ahead.
The resilience of many world economies is being tested, suggests T. Rowe Price, as the effects of a steep, global interest rate hiking cycle and a shift to quantitative tightening are still being felt. Labour markets remain strong and are an important signal for investors to watch as any softening could increase the risk of a recession.
Although equity markets have delivered gains in the first half of 2023, earnings estimates may still be too high for a weakening economy, putting further pressure on equity valuations, warns T. Rowe. Bonds, which suffered in 2022 alongside stocks, present potentially attractive opportunities in high yield, selective sovereign bonds.
It is oft noted the impact of monetary tightening is not felt until perhaps eighteen months after it begins. The Fed began tightening fourteen months ago, and the RBA eleven.
Most developed markets will feel the lag effect of monetary policy tightening during the second half of 2023, suggests Amundi. The corporate profit recession has not yet materialised and the outlook for consumers is worsening.
In Europe, Amundi expects inflation to stay significantly above target until mid-2024 but to remain on a downward trend, helped by below-potential growth in 2023 and 2024 as a result of policy tightening. Sticky core inflation, coupled with tight credit conditions, will cap spending by the private sector. Amundi forecasts anemic growth in the eurozone and the UK in 2023-2024.
In the US, the economy has been resilient so far but Amundi expects a mild recession to materialise from the December quarter 2023. Consumer resilience will be a key variable to watch amid tightening credit conditions and inflation above target throughout the year.
In Amundi’s view, Asia should take the lion’s share of growth in 2023 (around 70%) and foreign direct investment should also significantly contribute. The region has also emerged as more autonomous and less vulnerable. In China and India moderate growth may signal structural changes towards more sustainable long-term growth models. Amundi forecasts China GDP growth of 5.7% in 2023 and 4.3% in 2024, and India’s GDP to expand by 6.0% in 2023 and 5.5% in 2024.
Markets have not yet repriced for a worsening outlook. Generally expensive risky assets, with few exceptions, coupled with high uncertainty on growth and inflation, call for a cautious asset allocation entering the second half, Amundi warns. Adding risk will require some of the uncertainty to fade and market prices to adjust to reflect the economic and earnings outlook.
For equities, it’s quality first. The analysts remain cautious on equity overall. Investors should search for low leverage, protected dividends, and earnings resilience. In developed markets, the current risk-reward profile is seen as unattractive overall while concentration risk is high.
On top of US recession risk, the housing/construction/infrastructure side of the Chinese economy looks especially vulnerable, Longview Economics suggests, and it accounts, directly and indirectly, for approximately half of that country's GDP.
Germany is in recession, growth in the eurozone is flat, the UK economy is also flat over the past twelve months, while various other western economies are struggling, including Australia, New Zealand and Canada.
Overall, therefore, the global growth backdrop and outlook looks poor. Longview recommends moving to Underweight equities.
This strategy update has proven rather bearish. There are of course, conflicting views.
A common theme is, as noted, the impact AI is about to have on the global economy, on productivity, and on corporate valuations. Companies can be divided into three cohorts: those directly involved in AI development; those which will benefit from adopting AI in their services; and those which will be left out in the AI cold.
Few disagree that AI has the capacity to change our lives, just as the iPhone did early this century and the internet last century. However, the more circumspect point out AI transition is a five-ten year story. It is not a second half of 2023 story.
And it will require a great deal of fresh IT investment.
Otherwise, bulls scoff at reference to historical precedents. The pandemic up-ended the world, leading to impacts not before experienced in anyone’s lifetimes. One untypical factor is the stubborn strength of labour markets post-covid, and the support this provides to consumers even in the face of higher rates.
Inflation is coming down. While rates may stay higher for longer to get inflation back to 2-3% targets, consumers should be able to tough it out.
One undeniable factor is that the greater amount of shared bearishness, the greater the likelihood events will unfold to the positive. Recession bells have been ringing since last year. Recessions do not typically occur when everyone expects them – quite the opposite.
The bears are admitting they have been caught out in 2023. They remain bearish, but fewer now expect, for example, Wall Street will fall back to last year’s lows. There will likely still be a pullback, but only to higher levels than seen in October.
One T. Rowe price analyst noted in a recent report “I am bearish because the risks are substantial, but I am also reluctant because excessive pessimism can lead investors to overlook opportunities and miss potential market recoveries”.
There is a famous quote attributed to Great Depression-era economist John Maynard Keynes – “Markets can remain irrational longer than you can remain solvent”.
I say attributed, but there’s disagreement about who exactly said this first. It may have even been Warren Buffett.
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