Market Commentary from George Square Financial Management in conjunction with Albemarle Street Partners
Short-term problems and long-term transformation
This month focuses on the usual short-term challenges that markets are encountering as central banks wrestle with when to stop raising interest rates. But we also take a step back and look out to the long-term to examine how the artificial intelligence revolution could drive portfolio returns over the next decade.
The key, we are told, to learning to ride a bike is to stare into the distance and not down at the wobbly wheel in front of us. However, this is a hard thing to do on those early, frightening journeys.
Today, if we stare down at the markets right in front of us, we see a wobbly wheel. Central banks are seeking to navigate the peak in interest rates. Whilst there is evidence inflation is falling, which enables them to lower rates again, they cannot take this action until they are sure the inflationary enemy is driven away. They are, after all, seeking the most elusive of economic phenomenon, a ‘soft landing’. This is a situation where rates rise enough to bring down inflation without causing a recession.
The US Federal Reserve and the Bank of England decided to take a ‘wait and see’ approach in September. Both central banks highlighted continued vigilance as they kept policy rates unchanged.
However, the Federal Reserve went further and hinted at another rate increase by year end. This took investors by surprise and bonds sold off in recognition.
The US economy has shown remarkable resilience in the face of tighter monetary policy, with strong job creation and consumer spending keeping GDP growth positive even as inflation remains high.
This stands in contrast to Europe and the UK, where growth has slowed more noticeably due to spillovers from the Russia-Ukraine war and energy cost pressures. This has led investors to believe that US rates will stay higher for longer than the rest of the world. This is now being priced into currency markets and the US dollar has risen significantly against the euro and sterling. While the US is better positioned for now, its consumer and labour markets will be tested against a backdrop of global slowdown.
Oil prices climbed in September on tight supply worries, benefiting the energy sector. Higher crude adds inflation pressures, complicating central banks' aim to cool prices. Lower OPEC output and uncertainty over a proposed Western price cap on Russian oil have fuelled supply constraints. Meanwhile, demand remains solid despite economic headwinds. The increase in oil prices seen over the past few months highlights the complex interplay between geopolitics, supply dynamics, and market forces that impact commodity prices.
Equities declined in September, led by large technology shares, capping a painful third quarter. However, stocks could rebound if upcoming third quarter earnings confirm stability in corporate margins amid weak but still positive earnings growth. Valuations have moderated and improving trends in key sectors could lift sentiment while waiting for a rebound in cyclicals. Investors will be watching earnings closely to gauge the resilience of corporate profits in the face of rising risks.
Government and corporate bonds declined as rising yields hurt bond prices. Yields are unlikely to fall substantially until core-inflation (inflation ex-food and energy) declines meaningfully. While rate cuts may still be a way off, policy actions mitigate inflation risks and support bond prices. For multi-asset investors bonds can play an important role in portfolios, offering returns and diversification.
Navigating markets remains challenging as central banks combat high inflation, but risks of a severe global downturn have diminished. Equity markets have repriced significantly, reducing overvaluation. We are concerned about China's slowdown, but global growth should find a floor eventually. Our equity allocation emphasises quality companies with pricing power and stable margins. In fixed income, neutral duration provides stability amid rising recession worries. Portfolios are diversified across assets and geographies to withstand volatility. We are monitoring risks closely and can get more defensive if conditions deteriorate materially. Overall, staying invested in a balanced, diversified portfolio gives investors the best chance of participating when the clouds clear.
The Long-term view
The past few years, beset as they have been with crises, have led many people to question whether markets will ever return to winning ways.
But despite pandemics, wars and inflationary surges the long-term case for making strong returns over the next decade remains intact. It is built on one central thing; the capacity of humans to build an ever more productive economy. This is because it is improving productivity that powers economic growth. In the words of economist Paul Krugman it isn’t everything but ‘it is almost everything.’
So, to believe that equities will trend upwards over the long-term we must believe that our economy will carry on becoming more productive. Crucially, after major crises there will always be powerful voices who will argue that the productivity gains of the past cannot be repeated. It is after all far easier to look backwards at the productivity gains of the computer or the motor car and see how it has transformed the economy, than it is to look ahead at an only just emerging technology like artificial intelligence and believe that its impact could be as large.
The same problem of failing to really believe that each new wave of technological innovation can be as great as the past wave has plagued economists for generations. In the words of Bank of Italy economist Patrizio Pagana ‘in retrospect it emerges that pessimistic predictions were wrong neither because they were built on erroneous theories or data, nor because they failed to predict new technologies, but because they underestimated the potential of the technologies that already existed.’
Technology is a powerful driver of productivity because it increases what economists call ‘total factor productivity’ that typically delivers around half of all productivity growth. This is, in essence, a measure of how much more valuable the things coming out of the end of an economy are than the things going in the front. For example, a man attempting to build a rabbit hutch with a perfectly good pile of wood and failing, leaving only a pile of broken and butchered wood on the floor, would have a negative total factor productivity. A skilled carpenter who turned the wood into a beautiful rabbit hutch would have positive. Technology improves the ability for ordinary people to take the inputs of an economy and make them more valuable.
The next decade could be the period of the most rapid productivity growth since the early 1990s when the personal computer arrived. Goldman Sachs estimates that by 2030 global productivity will be improving by 1.5% a year due to artificial intelligence. This is massive by economic standards and offers compelling long-term opportunities for investors.
We of course continue to monitorglobal economies and financial markets.
You will be aware that the last years have been challenging but we remain optimistic that is light at the end of a very long tunnel.
As always please let me know if there are any queries or comments.
Parry Leggett Dip PFS EFA
