Cornelian Risk Managed Funds: Market Outlook

There are some mixed signals developing that concern the economic outlook for the US and globally. The beginning of the year saw optimism that even though economic growth was accelerating in the US, the Federal Reserve would be able to start cutting rates meaningfully as inflation was soon about to fall. However, inflation has proved to be stickier than anticipated and this has stayed the Federal Reserve’s hand from embarking on a sustained rate cutting cycle.

Nonetheless, US economic growth momentum is beginning to slacken and headwinds to economic growth are building. Interest rates adjusted for inflation are restrictive and quantitative tightening is ongoing. There are signs that retail demand may be starting to respond to the higher interest rates, whilst property market activity remains constrained by elevated financing costs.  Furthermore, the massive Biden fiscal stimulus starts to wane next year, although this headwind will be counteracted by the significant number of construction/infrastructure projects that have been given the green light which will take years to complete. It is interesting to note that some economically sensitive stocks have started to underperform and a survey of manufacturing companies noted that new order activity lacked lustre.

Looking forward, the key issue is whether, all else being equal, the Federal Reserve will be able to cut interest rates meaningfully on the back of slackening growth or whether service sector inflation (read wage growth) will remain stubbornly high and so prevent anything more than a token number of interest rate cuts.

If the latter, then the mega cap, quality growth style is likely to continue to outperform; if the former, then mid and small sized stocks have a chance to shine provided the prospects of a genuine hard landing remain low.

Overall, we believe that we are likely to see an extension of the quality growth theme until an economic data point surprises to the downside and a sustained rate cut narrative starts to build. Such a scenario should be positive for both bond and equity prices, provided central banks are not perceived to be hopelessly behind the curve (which we do not expect). Whilst we judge the outlook for risk assets to be attractive, we also anticipate an increase in volatility during this transition and the debt of riskier, more economically sensitive companies may underperform the bond market somewhat given current keen pricing. Following a period of disappointing performance, we are particularly excited about the prospects for mid-sized and smaller companies given attractive valuations as well as the returns on offer via less economically sensitive commercial property and infrastructure assets, which are likely to benefit materially from the perception of reduced financing costs to come.

Elsewhere, in Europe the consumer is beginning to perk up, but the Chinese economy remains moribund relative to its own history. Chinese consumer price inflation has been close to zero for over 12 months and the yield on long dated Chinese debt is plumbing new lows. The economy is sagging under the weight of the property market bust and the redirection of foreign direct investment away from China. The Chinese authorities appear either unwilling or unable to instigate the measures necessary to draw a line under the economy’s property problems and move the narrative on to recovery. Going forward, China’s contribution to global growth is likely to remain relatively subdued.

The two wild cards to the above are (i) the prospects for an Artificial Intelligence (AI) related productivity surge (which would, undoubtedly, drive asset prices forward) and (ii) further fiscal incontinence (which could have the power to derail markets).

Whilst the hype around AI enablers such as Nvidia may have got out of hand (after all, Nvidia’s market capitalisation is now greater than that of the UK stock market), we do believe that there are many companies which will benefit from the adoption of AI-related technologies, and this is not remotely priced into their valuations.

Concerning populism and fiscal incontinence, one has to suppose that leaders current and future will have learned the lessons from Liz Truss’s premiership and will conclude that the risks of introducing unconventional fiscal policies are not worth it, but we shall only know this in time. As a result, government bond investors may temper their enthusiasm for longer dated bonds until they can get a handle on revised fiscal policy frameworks, and this could act as a headwind.

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References

Source: https://www.brooksmacdonald.com/insights/cornelian-market-outlook

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