A slightly celebratory atmosphere hangs over markets currently, albeit with momentum stalling in May. Year-to-date performance remains impressive, however, global stock markets delivered a broadly sideways move over the month. Sterling investors did enjoy modest gains at least, given the strength of the dollar and dollar assets which dominate global indices.

Beneath the surface, however, we can observe the aggregated market resilience reflects an average of exceptional performance from a narrow set of large US Technology companies (particularly those most closely attached to the Artificial Intelligence theme) and general malaise almost everywhere else. This backdrop highlights two keen points of interest:

• Investors must be alert to the perils of missing out on a potential investment frenzy on the way up, but also participating on the way down.
• Investment sentiment, in the main, is downbeat.

In relation to the first point portfolios remain committed to the US Growth sector. Clients, therefore, will have some exposure to this theme as a part of an appropriately diversified portfolio. An A.I. led productivity boom may be a distant prospect, but markets can look a long way ahead; particularly as wage inflation remains such a troubling force and A.I. offers a solution. Of course, the timing of any such outcome could well disappoint, hence our insistence to diversify portfolios appropriately from a sector, regional and asset class perspective.

Regarding the generally weak sentiment, we believe investors should consider this as a positive backdrop. When there are very few anxieties in the marketplace share prices are typically riding high, leaving them extremely vulnerable to bad news. Observing current conditions, we would suggest swathes of investors are anticipating bad things might happen and, therefore, the opposite thesis potentially applies i.e. good news could deliver meaningful gains to markets as the large cohort of bears start to buy back in.

But what constitutes good news? Well, this is a more complex question than it might first appear. Whilst economic strength might seem a welcome outcome, should an economy already be experiencing high levels of inflation, then ‘overheating’ becomes a material risk and policy would likely need to take a firm counter position to cool things down; typically via higher interest rates. This would not be such good news for markets, however, raising the prospect of a more troubling economic outcome in the future. ‘Good news’, therefore, would likely be some sort of middle ground for economic growth i.e. the avoidance of a stark economic resurgence that threatens elevated inflation and overheating, but also one that doesn’t deliver a dramatic downturn which might crush sentiment.

This middling path, which should see inflationary pressure continue to moderate, would also allow central banks to execute interest rate policy in a more forgiving fashion, and could bring further relief to investors in so doing. Evidence from the US (the world’s dominant economy and market) that inflation is fading and that recessionary risks are less imminent has, therefore, likely been a major catalyst behind the market recovery this year. Looking ahead, weaker energy prices, healing supply chains, soft housing markets and potentials cracks in the (still firm) labour market should allow inflationary pressures to continue moderating; and might yet propel markets higher. The ‘cracks’ referred to include a falling level of ‘quits’ which suggest confidence might just be ebbing within the jobs market. Indeed, the quits rate has historically been a good lead on wage growth.

The ‘cracks’ are far from gaping, however, and so investors must also be alert to the risks of ‘sticky’ inflation. Such an environment would likely precipitate a ‘higher for longer’ interest rate regime that, ultimately, might deliver a more punishing outcome for the economy and stock markets. Investors should brace themselves for further volatility on this basis, but we would again argue all may not be lost for equity investors in such a setting.

A recession that seems so widely predicted may not inflict the same damage as one that catches investors off-guard. The recession may not be so severe either, given the apparent absence of major economic imbalances i.e. corporations and households don’t (in aggregate) appear to be shouldering quite so much leverage as in prior, more devastating recessions. We should also remind ourselves that having moved off the zero bound, there are now interest rates to cut! Again, this policy flexibility might prevent a more pernicious downturn and prove sufficient to reignite economic and investor enthusiasm.

Timing a defensive pivot to then time the recovery is also a risky game, and one we are reluctant to play; preferring instead to take a more measured approach which incorporates longer term thinking.

We would also highlight the conditions driving a ‘higher for longer’ interest rate environment might be more constructive for market performance than widely communicated. ‘Higher for longer’ policy is still an end to further tightening and, if accompanied by low (but still positive) growth and falling (if above target) inflation, could still be a rewarding mix for investors.

Recognising the outlook remains uncertain, however, as well as our philosophical belief in the need for humility when investing, portfolios strive to seek appropriate levels of diversification to meet the investment challenges ahead. Relative to stocks for example, high quality corporate and government bonds might offer a more defensive return profile in the face of less encouraging growth outcomes, particularly given the increase in yields observed over recent months. Alternative asset classes also help diversify portfolios in a more troubling period for stock markets.

Kind regards,

iPensions Wealth Team

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