Short-term problems and long-term transformation
The key, we are told, to learning to ride a bike is to stare into the distance and not down at the wobbly wheel in front of us. However, this is a hard thing to do on those early, frightening journeys.
Today, if we stare down at the markets right in front of us, we see a wobbly wheel. Central banks are seeking to navigate the peak in interest rates. Whilst there is evidence inflation is falling, which enables them to lower rates again, they cannot take this action until they are sure the inflationary enemy is driven away. They are, after all, seeking the most elusive of economic phenomenon, a ‘soft landing’. This is a situation where rates rise enough to bring down inflation without causing a recession.
The US Federal Reserve and the Bank of England decided to take a ‘wait and see’ approach in September. Both central banks highlighted continued vigilance as they kept policy rates unchanged. However, the Federal Reserve went further and hinted at another rate increase by year end. This took investors by surprise and bonds were sold off in recognition.
The US economy has shown remarkable resilience in the face of tighter monetary policy, with strong job creation and consumer spending keeping GDP growth positive even as inflation remains high.
This stands in contrast to Europe and the UK, where growth has slowed more noticeably due to spillovers from the Russia-Ukraine war and energy cost pressures. This has led investors to believe that US rates will stay higher for longer than the rest of the world. This is now being priced into currency markets and the US dollar has risen significantly against the euro and sterling. While the US is better positioned for now, its consumer and labour markets will be tested against a backdrop of global slowdown.
Equities declined in September and into October, led by large technology shares, capping a painful third quarter. However, stocks could rebound if upcoming third quarter earnings confirm stability in corporate margins amid weak but still positive earnings growth. Valuations have moderated and improving trends in key sectors could lift sentiment while waiting for a rebound in cyclicals. Investors will be watching earnings closely to gauge the resilience of corporate profits in the face of rising risks.
Government and corporate bonds declined as rising yields hurt bond prices. Yields are unlikely to fall substantially until core-inflation (inflation ex-food and energy) declines meaningfully. While rate cuts may still be a way off, policy actions mitigate inflation risks and support bond prices. For multi-asset investors bonds can play an important role in portfolios, offering returns and diversification.
Overall, staying invested in a balanced, diversified portfolio gives investors the best chance of participating when the clouds clear.
The Long-term view
The past few years, beset as they have been with crises, have led many people to question whether markets will ever return to winning ways.
But despite pandemics, wars and inflationary surges the long-term case for making strong returns over the next decade remains intact. It is built on one central thing; the capacity of humans to build an ever more productive economy.
Technology is a powerful driver of productivity because it increases what economists call ‘total factor productivity’ that typically delivers around half of all productivity growth. This is, in essence, a measure of how much more valuable the things coming out of the end of an economy are than the things going in the front.
The next decade could be the period of the most rapid productivity growth since the early 1990s when the personal computer arrived. Goldman Sachs estimates that by 2030 global productivity will be improving by 1.5% a year due to artificial intelligence. This is massive by economic standards and offers compelling long-term opportunities for investors.
So, the message is to look ahead and not down at the wobbly wheel.
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