Log inMarket Update 23rd February 2024 – The year of the catchphrase; bumpy soft landings and the most important stock on earth – from Jilly Mann
As I write this update, I reflect on a period of weeks in 2024 that have seen Central Banks almost reach the point of cutting interest rates then pull back, heightened geopolitical tensions across the globe, pockets of optimism in unloved markets and the advent of the “world’s most important stock”.
What encourages us is that the need to cut interest rates becomes ever more compelling, the longer Central Banks hold out. This in turn perpetuates the coiled spring effect which we see in fixed income markets and offers us some tactical opportunities to take advantage of Central Bank dalliance, whilst boosting returns.
- Global tensions and the impact on investment markets
- The weight conundrum of the US market globally and domestically
- Global large caps vs small and mid cap stocks
- The Spring Budget opportunity in the UK
- Shifting sands in the emerging world
- The economic outlook for 2024
- Tapping in to the research expertise of Square Mile
Global tensions and the impact on investment markets
We will start with geopolitical tensions and the impact this is having on investment markets. However horrific the reports coming out of the Middle East and Ukraine are from a humanitarian perspective, the impact on financial markets has been largely nullified to date.
If we were to see a further escalation in Russia’s threat to broader Europe, then we could easily expect to see a further spike in energy prices, with defence stocks soaring as wider markets suffer. There isn’t much evidence to suggest at the moment that President Putin has any intention of expanding his sights beyond Ukraine. From a Ukrainian perspective, the next few months may well prove decisive, as they run short of ammunition, manpower and look across the Atlantic to see who the next President of the United States will likely be. If Donald Trump returns to power in the White House, then it would seem unlikely that he would support the Ukrainian war effort in the way in which President Biden has done, thus meaning that a deal between Ukraine and Russia would be the most likely outcome. Any ceasing of military action would provide quite a boost to wider Europe, assuming that President Putin stayed true to whatever negotiation was agreed.
Despite sometimes inflammatory interventions from countries across the Middle East, the conflict there has been largely contained and so the impact on investment markets hasn’t yet materialised. A greater consequence has undoubtedly been seen in terms of Red Sea shipping lanes, with the Yemeni Houthis attacking cargo ships traversing the passage, further destabilising the Middle Eastern region. Should the conflict in the Middle East continue, then it is feasible that it could prove inflationary for goods, as the costs of either taking an alternative shipping route or exporting by air force price hikes on to end consumers.
The chart below shows the performance of the Baltic Dry Index year to date. The Baltic Dry Index provides a benchmark for the movement of major raw materials by sea across a range of commodities, vessels and shipping lanes.
The chart shows the index tumbling around the 7th January 2024, hitting a low in mid-January, before creeping back upwards to its present levels. In essence, this implies that whilst the heightened Red Sea attacks resulted in a short sharp shock to the shipping index, indicative of reduced demand for shipped goods, much of that shock has fallen out of the system and normality is returning to shipping prices and demand. This trend is not indicative of a world at war, but if an abatement of Middle Eastern tensions isn’t reached soon, the world will be watching the US to see how they intend to bring about a resolution and prevent global trade disruption.
The world feels eerily like the Cold War era at the moment, with global leaders in either the US camp or not. The forthcoming US election adds jeopardy to this scenario, but in the short term, investment markets aren’t especially moved by an increased threat of global conflict.
The weight conundrum of the US market globally and domestically
Thinking of the US, they now represent 70% of developed markets in the MSCI World Index. By contrast, the UK represents less than 4%. 70% is huge share and it has been increased by the demise in recent times of China, who not so long ago were on course to challenge the USA’s place in the world order.
With the US forming such a large part of global markets, we simply cannot ignore it from an investment perspective, hence our equity allocation to the country. The US economy continues to confound economic theory and in our view is papering over the cracks of a creaking property market and employment data which is increasingly open to interpretation. We continue to be nervous about the over-valued S&P 500 and the influence of the Magnificent 7 technology stocks on market movements. As a reminder, the Magnificent 7 (more commonly known as a famous film from the 1960s) in stock market terms comprises of Apple, Amazon, Alphabet, Meta (Facebook), Microsoft, Nvidia and Tesla.
In 2023, the Magnificent 7 alone outperformed the MSCI All Countries World Index by 73%. That level of outperformance is simply unsustainable and so we expect some form of re-evaluation. Some component stocks may well continue to post strong results relative to the rest of the market, but we doubt that they all will do so.
This may seem a contrary view to take given Nvidia’s Q4 results were released this week with no little expectation and fanfare. Stock markets seemed to stop as the clock ticked round to results hour. Goldman Sachs’ strategist, Scott Rubner, called Nvidia the “most important stock on earth” ahead of the announcements. Rubner has been vocal in recent weeks in his view that if the US stock market starts to drop a little, it could then go down a lot.
Whilst we have selective exposure to the US market, we are predominantly in areas which are less exposed to this sort of conjecture. It feels unsettling to be too heavily exposed to a market that even seasoned strategists see teetering on a precipice. If it goes up, then the winners will be many. If it goes down, the reverse is equally true. Until the S&P 500 becomes less dominated by so few stocks, this roulette on a handful of stock results will continue.
If we take Nvidia as an example, the chart below from Bloomberg demonstrates the extreme trading of the stock in the run up to the results being published. The day prior to the results coming out, 20th February, saw a sharp mark down in the stock price, only for the price to bounce back to even greater levels on the 21st February post results. Nvidia beat its targets, but if that were one of the other Magnificent 7 stocks which so influence the S&P 500 index missing their targets, then one can imagine the knock on consequence for broader US valuations and in turn, global markets. With the index so heavily weighted to 7 specific stocks, the market will continue to depend on narrow margins.
The chart below explains why we don’t believe that all component parts of the Magnificent 7 will beat their targets in the year ahead. The chart shows four members of the Magnificent 7 US stocks. The black line represents Nvidia, the green line is Meta, the orange line is Apple and the blue line is Tesla. The chart is run over the last 12 months. Whilst Nvidia is up 265%, Tesla is down 4%. In contrast to Nvidia, Tesla’s earnings were well below market expectations and so far this year the stock is down 22%.
Based on recent reports for each of the Magnificent 7, only Nvidia, Amazon and Meta could be deemed winners. Alphabet and Tesla have both missed their earnings targets, whilst reports for Apple and Microsoft were mixed. As we have said before, our concerns for US technology stocks are not that they will all sink unremittingly, it is that the overweight in the S&P 500 index of these stocks collectively, means that if even half of them disappoint Wall Street, the inflated reaction will easily bring down much of the rest of the US stock market. In turn, that typically leads to sentiment following suit in other parts of the globe.
If we look at a heat map of current US sector valuations vs their 15 year median which Schroders put together, the redder the number, the more expensive it is. Without becoming too technical on the various statistics shown, only energy, real estate and utilities are cheaper than their 15 year median, all other sectors are more expensive today, with consumer discretionary and IT significantly more expensive.
Global large caps vs small and mid cap stocks
We continue to favour small and mid cap stocks globally. The charts below help to demonstrate why.
The graph on the left from Bloomberg shows the performance of global large cap stocks since the start of 2023. On both an earnings and price basis, the pattern was consistently upward, until the Autumn of 2023 when large cap pricing started to turn downwards, as Central Banks indicated that interest rate hikes were over.
The graph on the right shows the performance of global small-mid cap stocks since the start of 2023. It is almost the polar opposite of the pattern on the left hand side. Small-mid cap stocks trailed large caps for much of 2023, until the recovery started as Central Banks ceased raising interest rates. This story won’t be linear from here. It won’t simply be the case that all large caps will drop, whilst all small-mid cap stocks will rise. We are definitely in a stockpickers market, but we see small-mid caps being a beneficiary of falling interest rates and are positioning ourselves to take advantage of that through 2024.
The Spring Budget opportunity in the UK
We see an opportunity in UK small and mid cap equities in the coming weeks and have taken up a small position in the Gresham House UK Multi Cap Income fund. The Spring Budget will take place in the UK on the 6th March, just under 2 weeks from now. If the Tories are to try and wrestle any momentum going into a much mooted General Election, then the Budget would seem their prime opportunity to do so.
The UK technically entered recession in Q4 2023, but there are signs that things are actually improving economically in the UK. Consumer spending is tipped to recover through 2024 and Sterling should benefit if the US and and Eurozone cut interest rates before the UK. A stronger Sterling wouldn’t be particularly good news for the FTSE100 given it’s overseas exposure, but small and mid cap stocks will likely benefit on a domestic level. Data out this week has also shown that the UK is running its largest monthly budget surplus since records began in 1993. In summary, this means that UK tax receipts were higher than state spending. Whilst politicians will argue over the interpretation of the data, in essence, it provides some scope for the Treasury to cut taxes and offer some growth incentives.
The Bank of England seem most likely to delay cutting interest rates until after the US and Eurozone as things stand, even though there is arguably a greater need to cut rates sooner in the UK. With a 9.8% minimum wage rise impacting inflation numbers from April 2024, it is likely that the Bank of England will not want to be seen to act too hastily, although interest rate cuts of at least 1% are still factored in for 2024. We think it should still be more than that.
If we were to compare the UK heat map to the US one shown earlier, the contrast is clear. Whilst the US had only three sectors cheaper than their 15 year median, the UK has only three sectors which are more expensive. The UK has long been undervalued relative to the rest of the globe and we aren’t suggesting that this is suddenly about to change, but if Jeremy Hunt does announce an accommodative Budget with tax cuts and incentives for UK domestic businesses, then we would expect to see a bounce in small and mid-cap UK stocks.
How long such a bounce may last, we aren’t sure and so at the moment we view this as a tactical position to hopefully take advantage of a specific set of circumstances in the UK.
Shifting sands in the emerging world
We have identified a similar opportunity in emerging markets. The ishares Emerging Markets Equity Index fund used to contain nearly 40% in China, but today the China allocation has reduced to around 27%, with India also around 22%. This matters because the Emerging Market index is no longer a play on China. Latin America remains a key, growing contributor as the dynamics of the index geographical weightings continue to shift. Some of the statistics coming out of India are staggering. I’m not sure if anyone watched the recent BBC programme focusing on Mumbai, but the speed at which the Indian economy can develop relative to the speed at which the UK or US developed is something to behold.
Undoubtedly there remain extremes of wealth within the country, but in 2007 only 4% of India’s population had internet access. By 2022, that figure was 48.7%. When one considers the scale of the country, that is phenomenal. Other advances in technology have led India to become an economy that has leapt straight to e-commerce, skipping traditional banking and payment methods so imbedded in the West. This has created an entrepreneurial drive for small and medium sized companies to grow online. We aren’t currently directly investing in small cap Indian equities within our portfolios, but emerging markets have been in the shadows of the Western world for so long, that it feels like momentum is building towards a recovery. When we look at stock market valuations globally and the risk of assets falling, we would argue that there is much further for some US stocks to fall than many emerging market stocks.
The emerging world is also an area that is likely to benefit as interest rates come down and if anything, emerging market Central Banks have been more on the front foot with raising rates early, bringing inflation under control and then being in a position to sustainably cut interest rates in turn. In contrast, emerging markets presently have lower levels of debt to GDP than their developed market peers, particularly the US. We expect to see a strong recovery in emerging market economic data through 2024 and it is no surprise that the IMF predict that India will be the 3rd largest economy in the world by 2027, surpassing Japan and Germany.
From an overall strategy perspective, we are at a point where our base case remains that fixed interest is the optimum asset class to be exposed to. We see no reason in the data to flip our defensive stance when it comes to our asset allocation, but where we see pockets of opportunity in equity markets, then we want to take advantage of those, particularly during periods of Central Bank hiatus.
I expect us to increase our fixed interest weighting again over the coming months and we are planning on redeploying some of our property exposure into fixed interest assets to further bolster liquidity within the portfolios over the coming months.
The economic outlook for 2024
It is important to explain that these tactical positions in the UK and emerging markets don’t represent a sea change to our strategy. Jerome Powell, Chairman of the US Federal Reserve, is under increasing pressure to cut rates in 2024. His nervousness to do so stems from his fears of cutting too soon and reigniting inflation, but increasingly the worry in the market is about cutting too late. If anything, we expect Europe to be the first of the three major Western powers to cut, as European data looks increasingly bearish economically with inflation having fallen. Our fixed interest positions have already reaped rewards before Central Banks have taken action, and we expect that to repeat in the near future, when they finally make the first cut and commence a swift cutting cycle thereafter.
The concept of higher for longer in terms of interest rates just does not add up to us. It is another catchy phrase, but how long is longer could be debated interminably. Longer than the last 25 years isn’t a tough target to beat and they have already achieved that by some margin.
Talks of a soft landing, no landing or a hard landing are increasingly caveated with phrases such as a bumpy soft landing if they delay cutting rates too long. Economists are running out of aviation terminology to position what is happening with Central Banks at the moment, but we believe in our thesis that in a world afflicted by so much uncertainty, assets combining the least amount of uncertainty yet with potential for upside, are the ones we need to be owning.
Tapping in to the research expertise of Square Mile
Square Mile is one on the UK’s foremost Investment Consulting and Research firms. As their name suggests, they are based in the City of London and like Telford Mann, they are now part of the Titan Wealth group of companies.
Square Mile produce detailed research on funds and investment strategies and as a member of the Titan group we are now able to benefit from their research facilities. Over the coming weeks and months we will be seeking to further enhance our existing investment research by tapping into their resources.