Investment Outlook - Market Update
The first six months of 2023 saw strong returns for global equity markets with the third quarter ultimately proving to be trickier. For much of the quarter the consensus narrative, despite aggressive interest rate rises was to next anticipate a benign economic outlook of no recession, softer inflation ahead and central banks globally beginning to cut interest rates again during H1 2024. As the quarter proceeded, surprising resilience in US economic data in particular, led to a new narrative of ‘higher for longer’ interest rates which was reflected in US bond yields for example, reaching 15-year highs.
At KBI, the ‘higher for longer’ macro scenario remains an entirely consistent thesis of ours since Autumn 2021. Our view has been that a material ‘regime change’ of higher and more normalised global interest rates and bond yields lay ahead for global investors that may last years. We still believe the economy will deteriorate and slow down more than the consensus expects and that a mild recession is to be expected during the first half of 2024.The recent resurgence in oil prices and current geopolitical risk in the Middle East further complicates the task of central banks. We also note that much of the government fiscal spending packages of recent years that helped boost economic growth, will likely not recur and result in a fiscal drag as distinct to a fiscal boost into 2024. So, we remain relatively cautious believing asset markets could struggle.
From a macro perspective we believe we are undoubtedly late cycle. When considering asset class outlooks, we note that since the global financial crisis and an era of historically low interest rates the narrative ‘there is no alternative’ or TINA was used to champion equities as the asset class of choice. With interest rates and bond yields having ‘normalised’ this has changed and there now is an alternative to consider. Against this background, equity and bond markets will we believe, struggle to make progress. For the coming quarter, fundamentals will matter more than ever. Company earnings have remained very resilient, consistent with resilient economic growth so far during 2023. This may well remain for another quarter or two, but ultimately, we believe there will be a challenging period for company earnings into 2024 that will lead to downgrading of aggregate expectations.
While expecting more modest returns against the painted environment, we do expect this to be a rich environment for active stock picking. Portfolio wise, building balanced portfolios with a mindset towards downside protection should be rewarded.
Asset class outlook:
The somewhat bizarre and very narrowly driven equity market during the first half, rolled over during Q3 but did not reverse in any material way. Having noted that interest rates and bond yields have normalised, we continue to expect equity markets will also normalise and that they should also rotate and be once again driven by fundamentals rather than hype or sentiment over coming quarters.
At aggregate valuation equity markets aren’t cheap, having re-rated YTD. Market multiples have expanded in excess of earnings growth and are now at an aggregate level trading greater than historic averages, while within equity markets there are large valuation disparities with overhyped valuations in growthier sectors such as the artificial intelligence names that dominated YTD, compared to attractive entry points for value or higher yielding sectors, for example. There are also large areas of more secular than cyclical growth that we also find attractively valued
At a regional level we continue to note that the North American equity market in aggregate looks the most expensive compared to history. In contrast, European and Emerging Market equity markets look much more attractively valued having not been caught up in as much momentum and lacking most of the hype of artificial intelligence.
Bonds as an asset class having experienced their worst year since 2008 during 2022, have struggled heavily again during 2023. A combination of extreme over-valuation, the reality of ‘higher for longer’ narrative, the reality of increased supply from growing fiscal deficits have all weighed on global bond markets.
Having been consistently negative since 2021, we now acknowledge that government bond yields having risen substantially are now approaching what appears to be a more appropriate valuation level. We are not however, expecting that bond yields should dramatically fall again, rather that the bulk of the yield rises are likely behind us.
Risk wise, we are increasingly monitoring corporate bond markets for any signs of distress at a company or indeed sectoral level. We note that they could be vulnerable as both the cost of funding has increased sharply and our expectation of a less positive growth outlook ahead. At this stage corporate bond spreads are not indicating any material signs of stress.
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