The big share market anomaly in a tough global economy
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.
Never miss an insight
Hit the follow button to stay up to date with all the key events that are driving markets