deVere Group: Invesment Outlook July
Andrew.J. Barros ACSI
Area Manager at deVere Spain SL | Wealth Management Consultant for the Expats and International Investors
Investment Outlook
Tom Elliott
A fortnightly look at global financial markets
29th?July 2024
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Market sentiment:?a little nervous in large cap equities. Core bond markets look firm with U.S, U.K and German two-year yields at their lowest since February in anticipation of more interest rate cuts in Europe, and the Bank of England and the Fed starting to cut rates over the coming months.
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The Bloomberg Magnificent 7 index (of large U.S tech stocks) fell 10% from its 10th?July high, before recovering slightly at the end of last week. In hindsight, we may see the sell-off as a bout of profit taking, triggered by disappointing earnings announcements from Alphabet and Tesla. Similar sell-offs in big tech have been seen in recent quarterly earnings periods, notably in January (albeit not on this scale), only for a recovery to follow shortly. European luxury goods and industrial commodities stocks have also weakened, on weaker growth outlooks for India and China.?
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Meanwhile, global small caps have been rallying, in anticipation of interest rate cuts and growing evidence that a soft landing for the U.S economy has been achieved by the Fed. The Russell 2000 index of U.S small cap is up almost a tenth this month.?
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The VIX index of anticipated volatility on the S&P 500, sometimes called ‘the fear gauge’, stood at 18 on Friday’s close. High for this year, but average for the last four years.?
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Remain diversified!?Investors should maintain exposure across a broad range of equities, bonds and ‘real assets’ such as gold and property. This is perhaps most easily done through owning a multi-asset fund, that invests as broadly as possible by asset class, geography and currency.
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A busy week ahead.?This Wednesday the Fed is likely to keep interest rates unchanged (most analysts think rates will be first cut in September), Thursday’s Bank of England meeting is more nuanced. We also have second quarter results from more members of the Magnificent 7 (Meta, Microsoft, Amazon and Apple) – which may test investors nerves again! Nvidia reports its second quarter earnings on 21st August.?
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Small cap.?There is increasing confidence amongst that the Fed’s ‘higher for longer’ interest rate policy is reducing inflation, without inducing a recession. The ‘Goldilocks scenario’, of low inflation and moderate growth, appears attainable. Last week second quarter GDP growth surprised positively, at +2.8% annualised, while the Fed’s preferred inflation statistic, the PCE inflation number, increased by just 0.1% month-on-month in June.?
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When central banks start to cut interest rates, small cap often outperform large cap as smaller companies generally carry more debt. So they benefit disproportionality as interest rates fall. In contrast, companies such as Apple and Microsoft are hugely cash generative and carry relatively little debt. If, in addition, it looks like economic growth will persist despite the current high interest rates, and a recession will be avoided, so much the better for small cap stocks that tend to be more exposed to the economic cycle. In contrast, the Magnificent 7 tend are growth tech stocks, less dependent on the state of the economy and more on investors’ belief that that will keep coming up with new products.?
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Valuations have favoured small cap. However, after this month’s rally in small cap that argument is less persuasive than it was. Trailing price/ earnings ratios, which used to be noticeably lower for small cap, are now broadly similar. For the NASDAQ, the number is 31 times, while the Russell 2000 is at 30 times (source: WSJ, as of 26/7/24).
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The risk to small cap is that a soft landing becomes a hard landing for the U.S economy, and Goldilocks never arrives.?The Treasury yield curve is the least inverted since July 2022, with the ten year closing on Friday at 4.2%, just 0.16% below the two year. This reflects falls across the curve, but greater at the short end in anticipation of perhaps two rate cuts this year from the Fed (September and December).?
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Historically, the unwinding of an inverted yield curve is followed by recession, and there are voices warning that a Goldilocks scenario for the U.S economy is far from assured, given the upward creep of unemployment, and growing stress in U.S consumer debt markets.?
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If the Fed fails to maintain growth, because of its ‘higher for longer’ interest rate strategy, small caps will be hit worse than large cap in any ensuing recession. This is on account of their generally weaker balance sheets. Growth stocks, being less sensitive to the economic environment, may prove a better bet in such an environment.
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Is the new U.K government really pro-growth??Many commentators on U.K financial markets have made the point that global investors are hoping that that the new, stable, centre-left Labour government will not only be amongst the more politically stable of the G5 countries over the coming years, but that it will also deliver faster economic growth than the previous Conservative government. This will benefit domestic-focused stocks, and strengthen public finances.?
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If growth is to accelerate, a relaxation of planning laws, and an increase in public spending on infrastructure, is vital. Prime minister Keir Starmer has promised exactly this. The promise now needs to be followed up with public money and legislation.
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It is therefore disappointing that the new Chancellor, Rachel Reeves, is reported be wanting to pause some big infrastructure projects. This is to address an inherited black hole in the public finances of, the government claims, ￡20bn. Hospital and road building projects may be delayed. News of this gap in public finances isn’t a surprise, since the independent Institute for Fiscal Studies (IFS), amongst others, have long-warned that the previous government’s five year budget and debt plans were unrealistic.?
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Labour’s election promise, to stick to those targets, was equally unrealistic (as is its ‘surprise’ at the size of the black hole). But promising to stick with the targets helped shield the party from accusations that it would be a ‘tax and spend’ government.
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The pause in infrastructure building is one step towards filing that ￡20bn hole. But is it good housekeeping?? Many economists argue that hospitals and road building boost productivity and growth (assuming they are built in the right places!), and so they will ultimately contribute to tax revenues.?
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Shouldn’t it be current spending that is paused? And emphasis given on increasing public sector productivity? Yet here the government is moving in the opposite direction, with Reeves indicating that she will meet an 8.5% recommended public sector pay increase, which will cost around ￡8bn (at a time when inflation is back to 2%). The government argues that public sector staff recruitment and retention is near crisis-point, after years of below-inflation pay rises, and that the pay rise is needed to avoid widespread industrial action.
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One does not need to be particularly cynical to suspect that the choices made are political. The benefits of infrastructure investment are felt in the future, perhaps when the current government is out of office. While peace with public sector unions will reduce the risk of pay disputes and strikes, which is more embarrassing for a Labour government than it is for a Conservative one.?
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Conservative politicians have accused Reeves of using the black hole as an excuse to justify tax hikes to come. This sounds a bit rich, coming from the same people who bequeathed the hole to her, but there may be some truth in it.?
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More importantly, if investors suspect that the government prioritises its voter base over its election promise to grow the economy, their willingness to fund the 4.2% budget deficit (as a percentage of GDP) at current yields may be questioned. As we have written previously, the memory of Liz Truss still hangs over sterling and the gilt market.