The first half of 2023 saw strong returns from asset classes that were not supposed to deliver strong returns. It also saw stronger growth from the US economy when the expectations had been that Europe and China would be more buoyant. Investors who were on the wrong side of these themes have luckily been able to earn the highest returns on cash for a generation. Recent discussions with investors on a trip to Asia don’t suggest much change to how capital is allocated in the short term. Peak rates, core inflation and the odds of a recession remain the dominant themes in investment conversations. It may not be the consensus (or sensible view), but I would not rule out the ‘pain trade’ of solid returns from high yield and growth equities continuing, especially if the economic data remains so mixed.
In the East
I spent the second half of June on a business trip to Australia and Asia, meeting with investors across the region. In general, I found they shared many of the same views about the outlook. There is an expectation, or at least a concern, that developed economies face a not-insignificant recession risk following a year of monetary tightening. This is reflected in their investment stance. I can’t recall discussing with any of them an overweight position in equities. Fixed income is viewed more favourably with a peak in interest rates in sight. The view on credit was cautiously positive with current prospective returns attractive to institutional investors who no longer need to chase yield in areas like private credit. I came home with the view that no major asset allocation decisions are likely when cash offers a reasonable return and when credit and equity markets are not seen as particularly cheap.
The performance of equity markets was widely discussed. Most investors seem surprised at how strong returns have been, particularly when the default macro view is that a recession is (or may be) on the horizon. Of course, there is an understanding that the performance of the US market has largely been driven by technology stocks and the frenzy around artificial intelligence (AI). On that, investors seem open-minded. Non-technology experts, understandably, do not see all the potential benefits and risks from AI but seem sympathetic to the view that it has the potential to provide non-linear growth for those businesses directly in the AI supply chain and those that are able to use AI to boost productivity and profitability. At the same time, few investors want to chase the AI frenzy just now when all other macro indicators are negative for short-term equity returns.
My trip started in Australia and, you may be surprised to know given my ripe old age, this was my first visit. It happened to coincide with the first Ashes Test match. England lost, which made for a bit of friendly banter with the locals. For someone from Britain, much about Australia is familiar – obviously the language, the shared passion for cricket and sharing a head of state. There is something similar on the economic side as well. The Reserve Bank of Australia (RBA) has been raising interest rates since May 2022, taking rates from close to zero to a current target for the cash rate at 4.10%. Market expectations are for the RBA to take rates to around 4.5%-5% by year-end. Headline consumer price inflation reached 8.4% in December 2022. It has since fallen, to 5.6% in May, and consensus forecasts have it falling towards 3.0% in 2024, in line with expectations for the US and Europe. This is good for Aussie bonds – the current benchmark 10-year bond trades with a yield of 4.12%, just shy of the high reached in June 2022. These are decade-high yields at a time when inflation is falling, so very attractive for local pension and insurance funds.
The big talking point is what happens to the housing market. Australia has a similar mortgage market to the UK with loans tending to be on fixed rates for two to three years. Just like the UK, there is a wave of refinancing of mortgage loans ahead, at much higher rates than they were taken out at. This will hit household cash flow and the housing market. House prices peaked in early 2022 and have fallen around 10%-15% since. There is clearly a risk of further declines as housing finance conditions tighten. Is that enough to cause a recession? The consensus for GDP growth in 2024 is just 0.7%, so a modest recession is very much on the cards, especially as commodity prices have also fallen this year, hitting revenues to the mining sector. More on China later, but if the Chinese economy can strengthen this will provide some support to Australia, as will global monetary easing in 2024. While a small market, Australian corporate debt is trading with yields above 6%. So, like everywhere else, the near-term favours allocating to fixed income.
China was the last stop on the trip. The most common questions asked in Beijing and Shanghai were around whether foreign investors would be willing to increase their exposure to Chinese assets and whether geopolitical concerns were the main constraint. That’s not an easy conversation to have in China but it is likely to be one of the reasons at the crux of the lack of enthusiasm for Chinese equities. The other is that the post-COVID-19 recovery has been disappointing so far and this has been reflected in the performance of Chinese stocks.
Investors in the West got the recovery trade wrong. The impression I got from talking to people was that the lockdown has left long and deep scars on confidence in China. In contrast to the situation in many western economies, lockdowns lasted longer and were not accompanied by the same level of government financial generosity. Consequently, households and businesses have emerged with stresses on cash flow and balance sheets. The property sector remains troubled and companies are unsure about investing because of the overall stance of the government towards the private sector. Many are looking to the government to help the recovery but so far this has been limited to some modest easing on the monetary side. There are significant structural problems as well, around demographics, debt levels and job creation. None of this is likely to change the stance of foreign investors in the immediate future. Perhaps the July Politburo meeting will bring further policy announcements to boost investment and growth. Longer term, there are interesting things happening in terms of the green transition in China and around China’s need to respond to the controls put on US technology exports. These will provide potential opportunities in Chinese equities but the near-term macro outlook and the uncertain geopolitical outlook will provide major hurdles to inflows.
Convictions are low
When I discussed the overseas outlook with Chinese investors, the themes were the same: A potential US recession; what happens to rates; will inflation be higher over the longer term. There is little conviction. Looking at market performance in the first half of the year it is hard to reconcile investor sentiment with a repeat of the strong performance of things like leveraged loans, high yield in general, the Nasdaq and Japanese equities. But that might continue to be the pain trade. There is no reason why these trends can’t continue, especially if the downturn is a soft landing and the outlook for rates is for some easing next year.
The cautiousness of investors is likely to prevail for some time. Sentiment favours long duration in fixed income and a more defensive allocation in credit and equities. The US ISM manufacturing index fell to 46 in June, the lowest reading since May 2020 when the global economy was in lockdown. This is a level consistent with recession. Yet, at the same time, the US unemployment rate has remained low, at around 3.5% for the last 18 months, and the average monthly increase in non-farm payrolls was about 260,000 in the first half of the year. Jobs means income means spending. To give a clearer view on where the US economy is going, either unemployment needs to start to rise, thereby confirming a broad slowdown and increasing the probability of lower rates next year, or more cyclical business indicators must start to improve again. We are all data-watching. And for now, that means the surety of cash returns is not something investors will give up lightly.
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