In summary
We are delighted to introduce The Quarterly Edit, our newly named and redesigned publication. This issue features insights and contributions from our team, reflecting on a quarter of significant market activity and change. In this issue, we explore the resilience of equity markets and our asset allocation choices which inform positioning across our portfolios.
Market Backdrop
Central banks have started cutting interest rates – but where will they stop?
The final level of interest rates will significantly affect markets. Many central banks in major Western economies have cut interest rates this year. The cuts began with Switzerland in March, followed by Sweden, Canada, the eurozone, the UK, and the US. This marks a shift from the ‘higher for longer’ approach to controlling inflation.
Despite previous interest rate rises, economies have shown resilience. Households have maintained spending through savings and borrowing, supporting economic activity and, in turn, a resilient jobs market. However, interest rates are still high enough to eventually impact consumer spending.
Central banks need to balance cutting interest rates to avoid slowing the economy while keeping inflation in check. The US Federal Reserve expects interest rates to be around 2.9% in just over two years, with inflation at 2% by then. However, if inflation stays high, it could impact the direction of interest rates and economic growth. There are worries that factors like the costs related to climate-change initiatives might also keep inflation above targets. That matters, as higher interest rates could make stocks less attractive compared to bonds.
While we expect inflation and interest rates to stabilise, we remain flexible and ready to adjust our strategies as needed.
What sent markets into a rollercoaster ride this summer?
Unexpected events have shaken investor confidence, but the markets have shown remarkable resilience. Summer is usually a quiet time for financial markets, but this year was different. The Bank of Japan surprised everyone by raising interest rates in late July. Then, US labour data showed fewer new jobs than expected, raising concerns about economic growth. Mixed results from big tech companies, added to the uncertainty, shaking market confidence.
On 5 August, the Japanese stock market saw a significant drop, with the main index falling by 12.4%, its worst performance since 1987. The broader Japanese market also experienced a record decline. The previous strength in Japanese stocks had been partly due to a weak yen currency, so when rising interest rates strengthened the yen, this negatively affected global investments. There was particular concern about investors borrowing in yen to invest in higher-yielding assets. This strategy becomes less profitable when the yen strengthens, causing investors to pull back. Despite the initial panic, markets quickly bounced back. By the end of August, major US stock indices were near their all-time highs, and market fluctuations had calmed down.
This episode highlights how fragile market expectations can be and the difficulty of timing short-term markets. Sticking o long-term investment goals remains crucial.
How should investors value megacap technology companies?
Valuing large technology companies, especially the ‘magnificent seven’ (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla), is vital for investors. Nvidia exemplifies this challenge. With a market cap exceeding US$3 trillion at one point in July, Nvidia’s valuation has skyrocketed since the launch of ChatGPT, a generative artificial intelligence (AI) chatbot, in November 2022. This surge impacts broader equity indices, with nearly 30% of their weight coming from these seven companies.
Nvidia’s role in generative AI, promising companies cost reductions, productivity gains, and a boost to profitability, is at the heart of this boom. However, valuing Nvidia is complex, requiring investors to both estimate the future market size for its chips as well as the share Nvidia might have of this market. With Nvidia’s CEO highlighting the need for a trillion US dollars of capital expenditure to be spent by companies and governments to upgrade global data centres, this emphasises the limitations of static valuations, like price-to-earnings ratios.
Assumptions in valuing fast-growing companies are often inaccurate, either too conservative or ambitious. This variability extends across the technology sector, leading to a wide range of potential market outcomes. Therefore, the focus should include asset allocation as a tool, rather than solely rely on precise valuation models or financial metrics.
Diversifying investments across the tech sector and beyond can mitigate risks and balance potential returns.
How do we position for changes in equity markets?
Large-sized companies have been leading the markets, but this could be starting to change. The post-Covid pandemic economic environment has been challenging for smaller and midsized companies, but larger companies have tended to perform better. Smaller firms faced significant hurdles, with arguably bigger impacts from swings in consumption patterns and higher borrowing costs due to inflation. These financial burdens were tougher for smaller companies lacking access to stable funding.
However, the tide may now be turning in favour of smaller and mid-sized companies. Recent reports, like those from the US Federal Reserve, show a tentative improvement in financial conditions. With more interest rate cuts in the US and other developed countries likely, the financial burden on smaller companies is expected to ease, potentially boosting their performance.
Anticipating this shift, we increased our exposure to US small and mid-sized companies earlier this year. Further, despite the general industry trend of reducing UK equity allocations, we maintained our UK small and mid-sized company holdings. Encouragingly, these companies have outperformed large-sized ones globally since July. Looking ahead, smaller companies could benefit from falling financial costs and increasing valuations.
While we see opportunities in small and mid-sized companies, maintaining a diversified equity allocation remains crucial as larger companies will continue to be profitable and attractive investments.
Can investors defend against the changing nature of government borrowing?
A diversified asset allocation strategy can help to manage some of the risk. Government borrowing is a hot topic, both in terms of the amount of money borrowed and how it’s being raised. Recently, governments have been borrowing more money, seemingly regardless of economic conditions, especially during the pandemic’s rapid economic shifts.
Traditionally, governments increased spending during economic downturns but reduced it during growth periods. Many governments are running significant annual budget deficits, even in stable or growing economies. This shift might be driven by the need to finance large projects or political pressures to fulfil election promises.
However, this approach carries risks, potentially making economic cycles more extreme and creating vulnerabilities if investor sentiment shifts. The short-lived Truss UK government in late 2022 showed just how quickly borrowing costs can rise with adverse sentiment.
Excessive borrowing can also threaten the value of a country’s currency. To guard against such risk, investors should diversify geographically and across asset classes, including equities, bonds, and alternative assets.
Diversification helps mitigate single country risks and provides a balanced approach to investing. Despite the risks, staying in cash and not investing at all arguably poses a greater long-term risk, especially when considering inflation.
Is the traditional asset allocation mix of equity and bonds still suitable?
Despite the challenges of 2022 still fresh in the memory, we should keep it in perspective. Our investment strategy focuses on diversifying risk across different regions and asset classes. For bonds, we include both government and corporate debt, considering their maturity and mix. For equities, we look at regional bias, investment style, company size, and themes. We also add a third category, which includes alternative investments, which often don’t follow market trends and may include other income-generating assets.
Successful asset allocation is crucial, potentially determining over 80% of client returns over time. But there are three main challenges: tactical (short-term opportunities), dynamic (regular rebalancing), and structural (long-term suitability). The latter is arguably particularly relevant after 2022, when both equities and bonds failed to offset each other’s losses for the first time since 1988.
In 2022, markets faced a toxic combination of post-pandemic inflation combined with initially low bond yields. As Western central banks rapidly raised interest rates, both asset classes were negatively affected. While a similar situation could happen again with renewed inflation, the starting point now is different, with much higher bond yields. Most interest rate hikes are thankfully likely behind us. Higher yields now offer attractive returns for future bond investors and provide a cushion, as bond yields could decrease in a mild recession, restoring their traditional role of balancing portfolios.
In summary, while 2022 challenged the traditional model, current conditions suggest our existing asset allocation mix remains relevant.
Contact us
0203 418 0257
info@onekc.co.uk
References
Source: https://www.brooksmacdonald.com/individuals/resources/insights/quarterly-edit-q3-2024
The Quarterly Edit: Q3 2024
In summary
We are delighted to introduce The Quarterly Edit, our newly named and redesigned publication. This issue features insights and contributions from our team, reflecting on a quarter of significant market activity and change. In this issue, we explore the resilience of equity markets and our asset allocation choices which inform positioning across our portfolios.
Market Backdrop
Central banks have started cutting interest rates – but where will they stop?
The final level of interest rates will significantly affect markets. Many central banks in major Western economies have cut interest rates this year. The cuts began with Switzerland in March, followed by Sweden, Canada, the eurozone, the UK, and the US. This marks a shift from the ‘higher for longer’ approach to controlling inflation.
Despite previous interest rate rises, economies have shown resilience. Households have maintained spending through savings and borrowing, supporting economic activity and, in turn, a resilient jobs market. However, interest rates are still high enough to eventually impact consumer spending.
Central banks need to balance cutting interest rates to avoid slowing the economy while keeping inflation in check. The US Federal Reserve expects interest rates to be around 2.9% in just over two years, with inflation at 2% by then. However, if inflation stays high, it could impact the direction of interest rates and economic growth. There are worries that factors like the costs related to climate-change initiatives might also keep inflation above targets. That matters, as higher interest rates could make stocks less attractive compared to bonds.
While we expect inflation and interest rates to stabilise, we remain flexible and ready to adjust our strategies as needed.
What sent markets into a rollercoaster ride this summer?
Unexpected events have shaken investor confidence, but the markets have shown remarkable resilience. Summer is usually a quiet time for financial markets, but this year was different. The Bank of Japan surprised everyone by raising interest rates in late July. Then, US labour data showed fewer new jobs than expected, raising concerns about economic growth. Mixed results from big tech companies, added to the uncertainty, shaking market confidence.
On 5 August, the Japanese stock market saw a significant drop, with the main index falling by 12.4%, its worst performance since 1987. The broader Japanese market also experienced a record decline. The previous strength in Japanese stocks had been partly due to a weak yen currency, so when rising interest rates strengthened the yen, this negatively affected global investments. There was particular concern about investors borrowing in yen to invest in higher-yielding assets. This strategy becomes less profitable when the yen strengthens, causing investors to pull back. Despite the initial panic, markets quickly bounced back. By the end of August, major US stock indices were near their all-time highs, and market fluctuations had calmed down.
This episode highlights how fragile market expectations can be and the difficulty of timing short-term markets. Sticking o long-term investment goals remains crucial.
How should investors value megacap technology companies?
Valuing large technology companies, especially the ‘magnificent seven’ (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla), is vital for investors. Nvidia exemplifies this challenge. With a market cap exceeding US$3 trillion at one point in July, Nvidia’s valuation has skyrocketed since the launch of ChatGPT, a generative artificial intelligence (AI) chatbot, in November 2022. This surge impacts broader equity indices, with nearly 30% of their weight coming from these seven companies.
Nvidia’s role in generative AI, promising companies cost reductions, productivity gains, and a boost to profitability, is at the heart of this boom. However, valuing Nvidia is complex, requiring investors to both estimate the future market size for its chips as well as the share Nvidia might have of this market. With Nvidia’s CEO highlighting the need for a trillion US dollars of capital expenditure to be spent by companies and governments to upgrade global data centres, this emphasises the limitations of static valuations, like price-to-earnings ratios.
Assumptions in valuing fast-growing companies are often inaccurate, either too conservative or ambitious. This variability extends across the technology sector, leading to a wide range of potential market outcomes. Therefore, the focus should include asset allocation as a tool, rather than solely rely on precise valuation models or financial metrics.
Diversifying investments across the tech sector and beyond can mitigate risks and balance potential returns.
How do we position for changes in equity markets?
Large-sized companies have been leading the markets, but this could be starting to change. The post-Covid pandemic economic environment has been challenging for smaller and midsized companies, but larger companies have tended to perform better. Smaller firms faced significant hurdles, with arguably bigger impacts from swings in consumption patterns and higher borrowing costs due to inflation. These financial burdens were tougher for smaller companies lacking access to stable funding.
However, the tide may now be turning in favour of smaller and mid-sized companies. Recent reports, like those from the US Federal Reserve, show a tentative improvement in financial conditions. With more interest rate cuts in the US and other developed countries likely, the financial burden on smaller companies is expected to ease, potentially boosting their performance.
Anticipating this shift, we increased our exposure to US small and mid-sized companies earlier this year. Further, despite the general industry trend of reducing UK equity allocations, we maintained our UK small and mid-sized company holdings. Encouragingly, these companies have outperformed large-sized ones globally since July. Looking ahead, smaller companies could benefit from falling financial costs and increasing valuations.
While we see opportunities in small and mid-sized companies, maintaining a diversified equity allocation remains crucial as larger companies will continue to be profitable and attractive investments.
Can investors defend against the changing nature of government borrowing?
A diversified asset allocation strategy can help to manage some of the risk. Government borrowing is a hot topic, both in terms of the amount of money borrowed and how it’s being raised. Recently, governments have been borrowing more money, seemingly regardless of economic conditions, especially during the pandemic’s rapid economic shifts.
Traditionally, governments increased spending during economic downturns but reduced it during growth periods. Many governments are running significant annual budget deficits, even in stable or growing economies. This shift might be driven by the need to finance large projects or political pressures to fulfil election promises.
However, this approach carries risks, potentially making economic cycles more extreme and creating vulnerabilities if investor sentiment shifts. The short-lived Truss UK government in late 2022 showed just how quickly borrowing costs can rise with adverse sentiment.
Excessive borrowing can also threaten the value of a country’s currency. To guard against such risk, investors should diversify geographically and across asset classes, including equities, bonds, and alternative assets.
Diversification helps mitigate single country risks and provides a balanced approach to investing. Despite the risks, staying in cash and not investing at all arguably poses a greater long-term risk, especially when considering inflation.
Is the traditional asset allocation mix of equity and bonds still suitable?
Despite the challenges of 2022 still fresh in the memory, we should keep it in perspective. Our investment strategy focuses on diversifying risk across different regions and asset classes. For bonds, we include both government and corporate debt, considering their maturity and mix. For equities, we look at regional bias, investment style, company size, and themes. We also add a third category, which includes alternative investments, which often don’t follow market trends and may include other income-generating assets.
Successful asset allocation is crucial, potentially determining over 80% of client returns over time. But there are three main challenges: tactical (short-term opportunities), dynamic (regular rebalancing), and structural (long-term suitability). The latter is arguably particularly relevant after 2022, when both equities and bonds failed to offset each other’s losses for the first time since 1988.
In 2022, markets faced a toxic combination of post-pandemic inflation combined with initially low bond yields. As Western central banks rapidly raised interest rates, both asset classes were negatively affected. While a similar situation could happen again with renewed inflation, the starting point now is different, with much higher bond yields. Most interest rate hikes are thankfully likely behind us. Higher yields now offer attractive returns for future bond investors and provide a cushion, as bond yields could decrease in a mild recession, restoring their traditional role of balancing portfolios.
In summary, while 2022 challenged the traditional model, current conditions suggest our existing asset allocation mix remains relevant.
Contact us
0203 418 0257
info@onekc.co.uk
References
Source: https://www.brooksmacdonald.com/individuals/resources/insights/quarterly-edit-q3-2024
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