Cornelian Risk Managed Funds: Market Outlook

By Hector Kilpatrick

Senior Investment Director; Head of Risk Managed Funds

Some specific sectors of the stock market seem to be exhibiting a degree of euphoria. Exposure to anything Artificial Intelligence (AI) or obesity drug related is being handsomely rewarded and, as a result, a degree of caution is required. However, the focus on very large growth companies masks an improving environment for smaller companies in other sectors. Overall, the US results season was a good one and fears that the US economy was close to a recession were misplaced. Indeed, far fewer companies are talking about the prospect of recession than a year ago. 

Furthermore, banks had been tightening lending standards to corporates aggressively, but this momentum has now faded. The slowing rate of change in tightening lending standards has, in the past, been a reliable indicator of improved earnings growth to come. 

New order activity for service companies remains healthy, whilst manufacturing companies have seen an improving trend in new orders following a prolonged period of negative demand as customers destocked (after over-ordering during the supply constrained, demand boost following the release from Covid lockdowns). A diverse range of lead indicators point to an improvement in the demand outlook for manufacturing companies. Whilst housing activity has been depressed, it is interesting to note that, despite much higher interest rates, year on year changes in house prices have stabilised in many countries and are back on a rising trend in the US. 

With full employment, real wage growth, improving house prices and a rising stock market, US consumers, in general, are in a pretty good place. 

This begs the question: should we be worrying about another burst of higher inflation rather than the consequences of a hard economic landing? After all, in this US presidential year fiscal policy remains stimulatory.

Despite rising government bond yields over the last five months, it is interesting to note that equity investors have been able to shrug this dynamic off. It was the fall in longer term government bond yields last year that was believed to have stimulated the strong equity market performance then. However, the reversal of some the bond market gains since, has not triggered a retrenchment in equity markets. This suggests the consensus has moved on and no longer believes inflation is likely to get out of hand, relative to today’s levels, despite full employment, etc. Absent a significant economic slowdown, the answer, if there is one, has to lie with improved productivity. 

Companies have had to re-assess supply chain security and this has led to a reshoring investment boom in (and around) the US. Combined with a major infrastructure spend program, the potential for productivity to improve is clear. However, on their own, these factors are unlikely to shift the dial materially.  The game changer is the potential that comes from the deployment of AI. In essence, AI could help upskill employees and radically streamline some processes. The potential boost to companies’ operating margins has been forecast, by some, to be material. As the year progresses, we are likely to hear more about ‘real life’ AI use cases which have tangible benefits to profitability for individual companies across a range of different sectors. 

Whisper it quietly, but there is a chance that if a prolonged period of productivity growth is truly upon us (and it’ll be some time yet before we know whether it is), then this would call for a multi-year bull market akin to the mid to late 1990s. 

Fund managers, in aggregate, have not fully bought into this positive scenario, fearful of what high real interest rates could bring during a period of significant government leverage and geopolitical risk. These concerns remain wholly legitimate, however investor enthusiasm for companies that are providers of AI technologies must soon shift to those companies who will benefit by using AI technology. If not, AI is a bubble which is about to burst spectacularly. 

We, your fund managers, had been concerned that end demand would be curtailed by high interest rates and leverage, and that this might lead to an unforecasted earnings recession, thus producing a shock to market participants. Recent data, as well as company trading updates, have not been supportive of this hypothesis. 

Regardless, which scenario wins out (negative earnings shock induced by high real interest rates or sustained non-inflationary growth as a result of much improved productivity), there is no doubt that the probability of the positive productivity surprise scenario panning out has increased markedly. As a result, the probability of a decent out-turn for equity markets has also improved and we have, therefore, been adding equity risk to the portfolios financed from the funds’ fixed income and absolute return holdings. 

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