George Square Financial Management Ltd Monthly Market Commentary

In Conjunction with Albemarle Street Partners

Pragmatism prevails:

While central banks were initially behind the curve in fighting inflation, they raised policy rates faster than any cycle since the 1990s. This unambiguous stance caused businesses and households to prepare for the economic winter we're now experiencing. Though it may not feel like it, the battle against inflation is over and the next hurdle is avoiding past policy errors.

The good news is that the pause in rate hikes we are now seeing in the US, Europe, and the UK, marks a step change in traditional central banking. Policy makers are exercising pragmatic restraint and utilizing real-time price data as they try to avoid undue damage to the real economy.

While this subtle shift may not seem like much, it moves central banking into the 21st century and away from static models of inflation and unemployment. Add to this the enhanced communication, which the Fed has perfected, and you have the wherewithal for businesses and consumers to make better decisions around savings and capital expenditures.

Silver linings:

It is hard to take positives from lacklustre economic growth, stock and bond market volatility and record high financing costs, but there are plenty that we see on the horizon. Monetary policy works because high interest rates attract capital. This capital flows from risky investments to safer ones and in so doing curtails economic activity. Prices are just an offshoot of this activity and as sure as night follows day, prices start to fall.

The flight of capital to safe assets and the curtailment of economic activity is temporary. As pools of ultra safe savings swell, they cause anxiety to dissipate and animal spirits in the real and financial economy to reignite. We have just endured a two-year period of lower economic activity and higher savings. This is not the normal situation and when interest rates are loosened, the excess savings that people and businesses have accumulated will find their way back into other assets and the real economy.

Portfolios:

Portfolios fell over October as equity markets reacted to higher yields in longer dated bonds. While the selloff in bonds has reversed in recent days, the year-to-date rally in stocks, particularly large cap technology companies, has reversed in the last three months.

Third quarter earnings season has often marked a change in tone for markets as companies talk about the coming year. The good news is at the halfway point, US Q3 earnings are up 2% year on year. Expectation for the near term remains muted but earnings are finally growing, and margins have stabilised for a large section of the equity market. While cyclical sectors are likely to see some further pain from a slowing economy, their impact on the portfolios is limited at this stage.

Bonds, despite some near-term pain, offer outstanding return potential and we are looking to take advantage of this by increasing allocations to active corporate and high yield bond managers.

We are also allocating to more active managers, where mandates allow, in Asia and Japan. The Bank of Japan has not tightened monetary policy and post-pandemic inflation could allow the domestic economy to shake off two decades of deflationary malaise. The change in domestic growth and inflation could be a watershed moment for Japanese equities and we would like exposure to businesses most likely to benefit.

Conclusion:

The pause in monetary tightening improves the odds of a soft landing in the US and allows monetary policy in other parts of the world to be loosened in the coming months. This creates a favourable backdrop for bonds and may allow equity markets, particularly those on depressed multiples, to recover in the coming year. As always, we are mindful of the challenges higher rates present and will adjust based on incoming data.

Parry Leggett Dip PFS EFA