Log inMarket Update – Waiting for our pitch? – 28th November 2023 from Jilly Mann
Legendary investment guru, Warren Buffet, is quoted as saying that “the stock market is a no-called-strike game. You don’t have to swing at everything, you can wait for your pitch”.
For those readers less familiar with the nuances of baseball, Buffett’s point was that it isn’t essential to invest in every opportunity that presents itself, regardless of the clamour from the outside to do so. Just as a batter in baseball waits for the right opportunity, so should investors. I use this quote, because in this market update, we highlight some of the opportunities, which are now presenting themselves in the US and comment again on the reasons as to why we haven’t sought to invest in every opportunity which the US stock market appears to present at face value.
- US interest rates and why we think they will fall sooner rather than later
- Won’t the Federal Reserve want to be sure before they cut interest rates?
- Falling yields and the impact on Fixed Income assets
- To be concentrated or not to be concentrated, that is the question
- Why the focus on the US?
- Conclusion
US interest rates and why we think they will fall sooner rather than later
The market consensus view for US interest rates is that they will remain unchanged until at least the second half of 2024. There is a school of thought out there, that they may even look to raise rates further from here if current measures appear unlikely to bring inflation data back within range of 2%.
We disagree with this view. We have referred in previous updates to the lag effect of fiscal and economic policy on economic data. Looking at unemployment, the housing market and mortgage approvals in the US, it is evident that the data is starting to present a less than rosy picture.
The graph below shows the US unemployment rate going back to the late 1940s through to today. The graph key is unfortunately rather small, but the horizontal axis shows dates, whilst the vertical axis shows percentage increase/decrease. The red circles indicate the low point of each economic cycle since then. The grey shaded bars show periods of recession.
There was a fairly tumultuous period throughout the 1950s as the world recovered from the Second World War and this saw a succession of short sharp economic cycles, but since then a more consistent pattern has emerged. If anything, the economic cycle which has lasted since the Global Financial Crisis (GFC) of 2008/09 has been sustained for far longer than history suggests that it should, especially if we discount the aberration of the Covid pandemic data spike in 2020. On average, recessions occur every 7 years, the GFC recession was 14 years ago.
A key point from this graph is that at no point during the best part of 80 years, has unemployment risen slowly after reaching the low point of an economic cycle. What typically happens is that unemployment shoots upwards rapidly from the low point. Unemployment typically shoots upwards at a rate of knots, compared to a slow descent as economic conditions improve.
We see no reason that we won’t see a similar spike in unemployment rates as this cycle grinds to a conclusion. The far right-hand side of the chart shows the current uptick in unemployment circled in red and you will notice how eerily similar it is to all the other previous economic cycles and the periods of recession that subsequently followed.
The US housing market is also showing weakness. The graph below shows US home sales on the top half, with the average 30 year fixed mortgage rate on the lower half. As fixed mortgage rates have reached a high point, US home sales have reached a 13 year low.
Corporations took the opportunity to refinance at lower rates a couple of years ago and so businesses haven’t yet been as affected as they will become in the next year or two if interest rates remain at their present level, but the consumer is absolutely starting to feel the impact of interest rate policy. These are but a few of the measures which we look at when considering the future direction of markets.
Optimists will say that the US can still avoid a recession and can cope with elevated interest rates for longer, we don’t believe this is the case. It is just a matter of time for the data to pull through the full extent of the measures which the Federal Reserve have already taken.
Won’t the Federal Reserve want to be sure before they cut interest rates?
Jerome Powell, Federal Reserve Chair was late to the party when raising interest rates in March 2022 and so there is an argument to say that he will be conservative when it comes to cutting rates in the future. Powell is firmly influenced by the 1970s experience, when the Federal Reserve cut interest rates before inflation was under control, leading to inflation taking off again and the Federal Reserve having to backtrack by raising interest rates rapidly in response. He doesn’t want to be the Chair who repeats that error.
Looking at recent data globally across a universe of 81 Central Banks, October 2023 heralded the first time since January 2021 when more Central Banks cut base rates, than hiked base rates.
Emerging Markets and Latin America have led the way on these cuts, but then they had hiked rates substantially before developed market Central Banks and so it is not surprising that they are in a position to cut rates sooner. Nonetheless, it does indicate that we are moving through an economic cycle, albeit at different paces across the globe.
More specific to the US, Jerome Powell will be highly cognisant of the upcoming US election. He doesn’t want to be a political pawn in the race for the White House. Realistically, he would probably much rather retain his job as Chair of the Federal Reserve under whichever political regime is elected.
President Biden could do with a positive economic story to campaign on. Falling interest rates would be very timely for him and the Democrat Party. If the US falls into a deep recession or indeed any recession which stymies growth and impacts the voting masses, he is highly unlikely to be re-elected.
Donald Trump, who may yet be the Republican candidate, has already expressed his dislike of Jerome Powell and so it is unlikely that Powell would continue in post in the event of a Trump presidency.
The Federal Reserve are keen to remain neutral when it comes to politics and so if the economy can be stabilised and if inflation comes down towards the 2% target, we would expect Jerome Powell to seize the opportunity to bring down interest rates by the end of Spring 2024 and thus avoid becoming a political scapegoat.
To the outside world, Powell maintains a steadfast view that he is prepared to do whatever it takes, including raising interest rates, in order to bring inflation down and keep it down. He maintains that he sees little changing in interest rates cuts until late 2024. That may sound sensible and act as a warning to markets to not get carried away, but it would be a far bolder move from a Federal Reserve Chair to instigate a major interest rate policy shift in the throes of a presidential campaign than it would be to take the sting out of the tail before the campaigning kicks into gear.
Falling yields and the impact on Fixed Income assets
Recent weeks have seen the 10 year US Treasury yield and the 10 year UK Gilt yield fall from their 2023 highs. Our view has been that as Government Bond yields fall, fixed income values will rise.
The graph above charts some of our core fixed income holdings and their returns from a low of the 19th October through to the 22nd November 2023, a period of just over a month. It is a short period, but that is the point. During that time, our Liontrust funds were up over 6%, our Janus Henderson funds were up over 5.6% and our UK Gilt fund was up over 5%. This contrasted with the UK 10 year gilt yield falling by 10.70%.
A 10.70% drop sounds significant, but we believe that there is much further for the gilt yield to fall in the coming weeks and months.
The graph above shows the UK 10 year Gilt yield since it’s low point on the 29th June 2020, a time when the yield was 0.144%. At its peak in August 2023, the 10 year Gilt yield reached 4.519%. As I write, the 10 year Gilt yield sits at 4.2% and one could see it comfortably return to a level of around 2.5% ongoing. We have already seen falling Government bond yields in the wake of weakening economic data and the expectation that interest rates have stabilised. If markets start to believe that interest rates are likely to be cut sooner than expected, which is our belief, then one could expect to see the value of fixed income funds rally even more strongly, and more quickly.
The key message is that one needs to be invested in fixed income assets in order to benefit from the uptick. Being a week or two late into these funds, will result in missing out on some significant returns.
We have started to rotate our fixed income position as Dollar movement has impacted some returns generated by the US 10 year Treasury yield falling. We have maintained some exposure to the US 10 year Treasury via some of the funds charted above and a new addition to portfolios in the M&G Optimal Income fund, but we have reduced exposure to funds where currency movements are offsetting some of the return.
To be concentrated or not to be concentrated, that is the question
Our answer is to not be concentrated. In hindsight at the start of the year, it would have been easy to just buy the S&P 500, the US index representing the 500 largest companies by market capitalisation, but this would have gone against our investment thesis and would have resulted in us swinging at the things that simply weren’t our ideal pitch, to coin the Warren Buffet analogy.
The S&P 500 has never been more concentrated than it is today. As at the 30th September 2023, the top 7 companies in the S&P 500 represented 28.4% of the index. That means, that 493 companies comprise the remaining 71.6% of the index. That is hugely disproportionate and given that the US market makes up the majority of global equity fund allocation as well as US equity fund allocation, anyone owning an equity tracker fund in either sector would have ended up with 28.4% of their portfolio invested in just 7 stocks. Those stocks are Apple, Microsoft, Alphabet, Amazon, NVIDIA, Tesla and Meta. Notable for all being technology stocks.
The last time that the S&P 500 was so top heavy towards 7 stocks was in late 1999, just before the technology bubble burst in the early 2000s. Back then, the top 7 stocks comprised 21.8% of the index and were Microsoft, Cisco, GE, Intel, Exxon, Walmart and Oracle. Of those, only Microsoft has survived intact today.
We are not predicting the demise of all of the current top 7 stocks, we think this market cycle will be more focused on removing the froth from the market rather than individual stock destruction. Companies that struggle to justify their valuation, that are ‘nice to haves’ rather than essentials as the cost of living remains high and who are facing a refinancing challenge in the near future will be judged harshly in our view. Those companies that can demonstrate pricing power, have strong balance sheets and products or services which can thrive in a tighter economic climate, will be rewarded.
That means that we are looking at an environment where in our view, we will see increased diversification in market returns. We will be rewarded for owning the right investments rather than following the herd and hoping that a recession never happens. I’ve never thought that hope alone was a good underpin for an investment strategy.
We are maintaining our defensive positioning overall, but we are rotating our equity exposure to those assets which we think have positioned themselves over the last year to thrive in conditions which will be relatively insulated from wider market concerns. Our focus is on US mid to smaller cap assets.
At present, the top 7 companies in the Russell Midcap index represent 3.6% of the index, a far cry from the S&P 500’s 28.4% top 7 weighting. It isn’t just about the top 7 companies though, it is about why stocks in the mid cap space are likely to withstand the potential economic downturn more strongly than their large cap peers.
In the US, $302 billion of fiscal stimulus has been invested into public infrastructure and clean energy investments, this is part of an overall $550 billion package which has been authorised for infrastructure spending under the Infrastructure Investment and Jobs Act. It takes time for money authorised through Government bills to make its way to end users, but this is now actively happening in the US and the firms who are benefitting the most, are in the mid cap space.
Whereas earnings reports for large cap US companies are still resulting in price markdowns should they underperform estimates, mid cap companies are being judged far less arbitrarily. Mid cap companies have moved through the cycle to a point where they are less likely to simply move up and down in line with the wider market. In essence, they are providing diversification to investors.
Looking at the funds which we have purchased, the Schroder US Mid Cap and the Premier Miton US Opportunities funds, the funds are heavily weighted towards industrial, healthcare, utilities and basic materials. Technology is there in small doses, but only in the sense of medical technology rather than frothy Artificial Intelligence, for example. These funds are investing in businesses which are aimed at property renovation and upkeep as another example, rather than new home construction. Thinking back to the earlier point about the US housing market, if new home sales are grinding to a halt, then investing in businesses which are directly linked to that sector wouldn’t be sensible, but investing in businesses that people will need if they are to stay put and renovate, does make more sense.
Schroders published the chart below to demonstrate where the Infrastructure Investment and Jobs Act funding was being spent and it is in precisely those areas which our chosen funds are focused on. Equipment, chemicals, machinery and fabrications to name but a few.
Perhaps we could have scored a ‘home run’ by buying the S&P 500 this year on hope, but logically that didn’t feel right at the start of the year and it feels even less right as we sit here today. I would much rather be striking for the sort of businesses in the months ahead, who I think will be rewarded for strong management and sustainable business flows than the flavour of the month index where the returns of 493 businesses are at the mercy of 7 stocks, some of whom no longer hold pricing power in the way they once did.
Why the focus on the US?
Baseball analogies aside, this update has spent time focusing on the forthcoming US presidential election, US economic data and US equity markets, but many of the same themes are playing out across Europe and the wider world. We aren’t simply ignoring those areas. In many respects, the US typically leads the rest of the world when it comes to cutting interest rates, irrespective of what is happening in individual economies, so what the US does next matters in that regard.
Europe showed some promising signs early on, but seems to have slipped back into more of a disparate economic climate where a recession is already fully underway. The Ukraine/Russia war hasn’t gone away, despite the media focus on the Middle East and the harsh winter weather forecast for Ukraine could again see a rise in commodity prices, something we are positioned for with our weighting to Natural Resources. Unrest in the Middle East also played its part in our decision to add a resources ballast to portfolios.
Politically, the last week has seen the Dutch elect a Far Right populist leader in the form of Geert Wilders and Argentina elect their own right-wing populist in the form of Javier Milei. The UK will face election fever next year, albeit with candidates on either side being far less extreme in their views than we are seeing globally.
Jeremy Hunt’s Autumn Statement delivered some respite for business in the main and a National Insurance cut for workers, but whether it went far enough or was bold enough to stimulate growth remains to be seen. I suspect, he may top it up with additional, more radical measures in the Spring Budget itself having tested the waters last week. With UK inflation remaining stubbornly high, we would be surprised to see the Bank of England cut interest rates ahead of the US.
To reassure investors, we don’t just watch US data, but right now, the US seems to hold the key to much of what is to come both economically and politically in the US, the Middle East and globally.
Conclusion
The rebound of fixed income assets in October bore out why we believe that fixed income is the place to be invested, with the promise of much more to come. We have to believe in what we invest in, hindsight is a wonderful thing, but we must only invest in those areas which we believe are right for our investors. We could follow the herd and worry more about our benchmark, or we can take a view that is based on solid data and which we think protects investors in the short, medium and long term. We will always try to do the latter and so we are enthused about the months ahead. We do think that we will see positive changes in interest rates sooner rather than later and we remain convinced that fixed income and selective equity exposure is the place to be to benefit from the best of the upside, whilst avoiding the worst of the downside.