Cornelian Risk Managed Funds: Market Outlook – October 2023

By Hector Kilpatrick

Senior Investment Director & Head of Risk Managed Funds

In aggregate, equity markets have produced a high single digit return during the first nine months of the year. Given investors are forward looking, this suggests that the majority believe the outlook for economies and company profitability has improved. Implicit within this view is that the US Federal Reserve will manage to engineer, at worst, an economic soft landing in the US.

We continue to believe that this relatively good scenario for equity investors should be considered as an outlier possibility rather than the central scenario.

The equity risk-reward equation remains challenged, in our view, as US financial conditions continue to tighten appreciably. Yield curve inversion, which has been a reliable indicator of recession over the past 50 years, also remains problematic for the consensus view. Furthermore, quantitative tightening has resumed following its brief reversal during the mini-US banking crisis earlier this year and banks continue to tighten lending standards to corporates and consumers.

Despite policymakers indicating we are close to the peak of the interest rate cycle, it is interesting to note that the real return available from buying inflation protected US Treasuries (TIPS) has risen appreciably over the summer months. This may be down to short term influences such as slightly better news on employment demand from the manufacturing sector. However, since longer maturities are also seeing similar moves something else may be at play and this may include rising concerns about either US fiscal laxity or paralysis in legislative branch of the US government.

Whatever the reason, financial conditions are continuing to tighten and investors’ expectations of when interest rates may start to be cut is being pushed out. The ‘higher for longer’ interest rate mantra implicitly suggests an increased risk of a hard landing.

Many smaller businesses arbitraged their capital structure by adding cheap floating rate debt when interest rates were very low. Now that interest rates have risen significantly, the interest payments on these debts are beginning to consume significant levels of cash which would otherwise have been available for capital investment or return to shareholders. Default rates are now beginning to creep up and this move, we believe, is likely to develop into a trend, which could knock investor confidence.

Nonetheless, economic activity has surprised by its resilience this year. To our minds this just demonstrates the significant lags we see between market moves and the impacts on the real economy. US consumer spending has been resilient, despite higher interest rates, as the labour market remains tight and wage rises are strong. However, US mortgage rates are at new highs and housing transactions volumes have fallen significantly. Student debt repayments have re-started following the coronavirus-induced pause. Excess savings are continuing to fall and it is a matter of debate as to when they will be consumed entirely, but the majority view is that we are not far from that time. Perhaps as a precursor of this, auto loan defaults and credit card delinquencies have also started to rise, albeit from low levels.

Despite the concerns over rising defaults, we do not expect the US Federal Reserve to activate the pressure release valve of lower interest rates until considerable slackness in the labour market becomes inevitable.

The view that corporate profits can grow by over 10% during calendar year 2024, as the consensus forecast suggests, seems to be overly optimistic as we expect corporate profit margins to remain under pressure (given end demand weakness, inventory supply chain normalisation, higher energy prices and lagging employment cost inflation).

Elsewhere, the scope for the Chinese economy to provide the necessary boost to global growth feels rather limited. Chinese new property sales are down around 30% year on year, with little prospect of a large rebound despite some attempts by the authorities to stimulate demand. Furthermore, foreign direct investors are withdrawing capital from China as western corporates respond to the increasing risk of a fracture in relations between the US and China.

The above suggests that our cautious approach to equity risk continues to be warranted. It’s not all doom and gloom, however. Value is clearly emerging in government bond markets. At time of writing, the 30 year gilt can be bought with a yield to maturity of 5% per annum, a level of return not seen for over 20 years. As a result, we have been increasing the allocation to and the duration of our fixed income portfolios in order to lock in some of these returns.

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