The big share market anomaly in a tough global economy

Despite any number of economists expecting downturns, major share markets have generally been up over the past six or so months
Dan Farmer

MLC Asset Management

The world would be an easier place for investment professionals, like my colleagues and I to navigate, if issues played out in simple straight lines.

Here’s a case in point: when inflation around the world is at higher levels than it has been for decades; official interest rates have climbed to combat inflation; and any number of economists expect downturns, perhaps even recessions across economies, it would be reasonable to assume that share markets would be flat.

Right? Actually no.

Rather than struggling, as the economic backdrop suggests they ought to, major share markets have generally been up over the past six or so months, at the time of writing.

Here’s another anomaly. A March 2023 Gallup poll showed that 83% of Americans described economic conditions as “only fair” or “poor.”(1)

Yet, US consumer spending in January 2023 posted its biggest gain in two years(2) and though more recent data point to overall spending growth slowing, consumers still intend to spend sizeably on select categories with about 40% saying they intend to “splurge in 2023,”(3) a percentage that has stayed fairly consistent since late 2021.(4)

The contradictions and complexities of US consumer sentiment and behaviour may be explained by the fact that while most people are pessimistic about the broad economy, a tight labour market and low unemployment support a sense of personal financial positivity.

It is possible that consumers in other advanced countries are thinking and behaving along the same lines – pessimistic about the economy, but more positive about their personal circumstances, especially in a context of low unemployment.

The most recent Organisation of Economic Cooperation and Development (OECD) countries’ unemployment data showed the rate to be at the lowest level since the start of the series in 2001.(5)

Maybe the takeaway from all this is that we should not be overly surprised by what has occurred in economies and markets in recent months.

Markets and economies consist of vast numbers of people driven by a host of emotions and impulses as much as by logic and data. It is too simplistic, even deterministic, to assume that people ought to behave like automatons.

Deglobalisation, economic decoupling ahead?

Investment professionals must keep our eyes on what’s right ahead, but equally, we need to be aware of what’s around the corner, because what’s around the corner may have even bigger implications for portfolios we manage for our clients than immediate issues.

One of those ‘around the corner’ issues is the possibility that global inflation will not settle back to central banks’ roughly 2% target figure, but perhaps settle at a higher number than has been the case over the past few decades.

Higher medium to longer-term inflation could stem from deglobalisation or at least selective economic decoupling between Western countries and China.

There is recognition that globalisation, which has placed China at the centre of so much manufacturing, has contributed to overall economic wellbeing by enabling consumers and businesses to source products and services from lowest-cost providers. However, the COVID-19 pandemic showed the vulnerability of global supply chains.

Countries, such as Australia, learned that many essential items, including pharmaceuticals, like paracetamols, are imported.(6)

In two recent speeches(7), US Treasury Secretary Janet Yellen, and European Commission President Ursula von der Leyen, spoke about the primacy of strategic security, even if it comes at costs to America’s and the European Union’s respective economic relationships with China.

Meanwhile, US National Security Adviser Jack Sullivan expressed his thinking more bluntly arguing that the relocation of industries and jobs to China has undermined domestic cohesion saying:

“The so-called ‘China shock’ that hit pockets of our domestic manufacturing industry especially hard, with large and long-lasting impacts, wasn’t adequately anticipated and wasn’t adequately addressed as it unfolded. And collectively, these forces have frayed the socioeconomic foundations on which any strong and resilient democracy rests now.”(8)

While other nations may not be so explicit about it, there are widespread expectations that we will gradually be moving from a world of ‘off-shoring’ to one where countries will increasingly emphasise supply-security by bringing production of essential goods and services closer to home.

The strategic reasons for doing so are understandable, but it does mean costs for a host of items will be higher than if they were sourced from the lowest-cost global supplier.

This transition from globalisation to ‘friend-shoring’ or ‘on-shoring’ are trends investors need to be on top of as it will have inflationary implications and potentially change the mix of industry and company winners and losers.

US banking industry troubles

A more immediate cloud is the troubled US banking industry, or more accurately the troubles of the country’s midsize-to-smaller banks. First Republic Bank was the most recent to fall into crisis and policymakers acted quickly and arranged for it to be taken over by JP Morgan Chase. It would be naïve to think that First Republic Bank will be the last to be in trouble.

The panic that hit First Republic, and before that Silvergate Capital, Signature Bank and Silicon Valley Bank were liquidity-driven crises, sparked by the impact of rising interest rates on balance sheets with large holdings of low-yielding bonds. As interest rates rose, so did unrealised losses on those assets, when valued on a marked-to-market basis.

Spooked depositors withdrew money from the banks, with the banks, in turn, forced to sell assets at ever-declining values to fund the withdrawals – a destructive chicken and egg spiral.

In a world where a social media post can set off a chain of events, other smaller US banks may find themselves under fire. Remember that the Global Financial Crisis was set off by the failure of financial institutions. The causes may be different this time, but we need to be prepared for a possible repeat of consequences.

Vigilance in portfolio positioning

The complexity of the investment climate calls for caution and vigilance in positioning across the portfolios we manage for our clients.

Our investment professionals have decades of experience running multi-manager, multi-asset portfolios and this know-how is being collectively applied across all strategies.

We are cautiously positioned in equities as we believe that current market valuations don’t appropriately capture risks to earnings. At the same time, our share market exposures have a ‘quality’ bias as measured by such things as return-on-equity, histories of solid profitability, and cash-flow resilience.

We think companies with these characteristics will fare better in the challenging business conditions we are anticipating.

Our fixed income positioning is also cautious reflecting the view that now is not a time to take aggressive interest rate risks.

Complementing our traditional fixed income and share markets investments are our investments in ‘esoteric private credit.’ These include catastrophe insurance-related investments, and government and legal receivables with cash-flows and return patterns that differ from those associated with shares or conventional fixed income.

Consistent with the principle of true diversification across many dimensions, many of our portfolios also invest in unlisted infrastructure and real estate, and private equity.

By doing so, we provide those portfolios with:

  • lower correlations with equities and fixed income
  • the potential for far higher active management than usually associated with public markets to influence operational and financial uplift
  • inflation protection as many property and infrastructure assets have implicit or explicit inflation linkages
  • long investment time horizons as owners and operators of unlisted assets are free from the quarterly earnings cycle and can execute business plans measured in years
  • lower volatility of returns, in part owing to periodic cashflow-based valuations rather than the daily gyrations of sentiment-driven public market valuations.

Ours is an investment team of great experience and skill that has steered client portfolios through many market stresses, including the GFC and the pandemic.

I am confident that our investment team’s collective knowledge, along with sticking by time-tested values can enable us to pilot clients’ portfolios through what may lie ahead.

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(1) Economic pessimism persists, with inflation still key concern, Lydia Saad, 31 March 2023, https://news.gallup.com/poll/473132/economic-pessimism-persists-inflation-key-concern.aspx (2) U.S. consumer spending posts biggest gain in nearly two years; inflation picks up, Lucia Mutikani, 25 February 2023, https://www.reuters.com/markets/us/us-consumer-spending-surges-january-inflation-accelerates-2023-02-24/ (3) A monthly update on the state of the US consumer: April 2023, Christina Adams, Kari Alldredge and Andrew Pitakos, https://www.mckinsey.com/industries/consumer-packaged-goods/our-insights/a-monthly-update-on-the-state-of-the-us-consumer-april-2023 (4) Ibid (5) OECD: unemployment rates updated in March 2023, 14 March 2023, https://www.miragenews.com/oecd-unemployment-rates-updated-in-march-2023-966178/ (6) Australia’s reliance on medications and other goods from overseas leaves it open to serious risks, Charis Chang, 30 April 2020, https://www.news.com.au/finance/business/australias-reliance-on-medications-and-other-goods-from-overseas-leaves-it-open-to-serious-risks/news-story/0cef696662002d0da66a44c1b043e62a (7) Remarks by Secretary of the Treasury Janet L. Yellen on the U.S. - China Economic Relationship at Johns Hopkins School of Advanced International Studies, 20 April 2023, https://home.treasury.gov/news/press-releases/jy1425; Speech by President von der Leyen on EU-China relations to the Mercator Institute for China Studies and the European Policy Centre, 30 March 2023, https://ec.europa.eu/commission/presscorner/detail/en/speech_23_2063 (8) Eyeing China, Biden official floats a new ‘Washington consensus’, Ishaan Tharoor, 1 May 2023, https://www.washingtonpost.com/world/2023/05/01/washington-consensus-china-trade-sullivan-protectionism/ This communication is issued by MLC Investments Limited ABN 30 002 641 661 AFSL 230705, IOOF Investment Services Ltd ABN 80 007 350 405 AFSL 230703 and OnePath Funds Management Limited ABN 21 003 002 800 AFSL 238342 each in their capacity as responsible entity and trustee of the various funds issued by them. These entities are part of the Insignia Financial group of companies comprising Insignia Financial Ltd ABN 49 100 103 722 and its related bodies corporate (Insignia Financial Group). The information provided is of a general nature only and does not take into account any particular investor’s personal circumstances. Accordingly, reliance should not be placed by anyone on the information in this communication as the basis for making any investment decision. Before acting on the information, you should consider the appropriateness of it having regard to your personal objectives, financial situation and needs. You should also consider the relevant Product Disclosure Statement (PDS) and Target Market Determination (TMD) before deciding to acquire or hold an interest in a financial product issued by an entity within the Insignia Financial Group. Past performance is not a reliable indicator of future performance. The value of an investment may rise or fall with the changes in the market. Actual returns may vary from any target return described and there is a risk that the investment may achieve lower than expected returns. No company in the Insignia Financial Group guarantees the repayment of capital, the performance of, or any rate of return of an investment. Any investment is subject to investment risk, including possibly delays in repayment and loss of income and principal invested. Any opinions expressed constitute our judgement at the time of issue and are subject to change. We believe that the information contained in this communication is correct and that any estimates, opinions, conclusions or recommendations are reasonably held or made at the time of compilation. However, no warranty is made as to their accuracy or reliability (which may change without notice) or other information contained in this communication. Any projection or forward-looking statement (Projection) in this communication is provided for information purposes only. No representation is made as to the accuracy or reasonableness of any such Projection or that it will be met. Actual events may vary materially. This communication is directed to and prepared for Australian residents only.

Dan Farmer
Chief Investment Officer
MLC Asset Management

Dan was appointed to the role of Chief Investment Officer (CIO) in July 2022, a position that brought together MLC AM and IOOF investment teams under his leadership. In this role, Dan is focussed on the group’s multi-asset strategies and he is...

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