The Important Thing Is Not the Fall, but the Landing

The resurgence of inflation in the US has prompted investors to drastically revise their 2024 interest rate cut expectations from 5 rate cuts in January just a single cut in May.

Admittedly, the scale and timetable of rate cuts has already changed considerably since the start of the year, but the direction remains the same: central banks are determined to continue to bring inflation down and reduce interest rates only once inflation is under control.

The reality is that it will clearly have been much easier to steer inflation down from its peak of over 8% in 2022 to the current 3.5%-4% than to get it back to the FED's target of 2%.

A "higher for longer" scenario is therefore likely to emerge. This will have an impact on investors' current allocations and on the sectoral trends in the equity markets that we have been witnessing for several years now.

Are the valuations of growth stocks, particularly those in the technology sector, compatible with a scenario of higher long-term interest rates and persistent inflation of around 3%?

Although buoyed by highly resilient corporate results, the market has become rather complacent about “growth” stocks.

In the event of a temporary upturn in inflation, these valuations may well be justified. On the other hand, in the event of a new interest-rate paradigm and higher long-term inflation, they are likely to be seriously challenged.

Four decades of inflation stabilised at around 2% and almost linear interest rate cuts have strongly supported growth sectors, particularly technology, to the detriment of real assets and value stocks.

However, we must not forget that the last four decades have been defined by some key trends. Globalisation has grown rapidly, whilst major geopolitical risks have declined since the fall of the USSR. The services industry has grown rapidly alongside the fall in trade unionism. There has also been a broad if vague consensus on budgetary balance. Today, we’re faced with different factors. Geopolitical tensions are rising, as economics and industries become more focused on re-shoring. Consumer demand and fiscal stimulus are supported by chronic public deficits and ever increasing debt levels, following the “whatever it takes” approach to the Covid era. These factors are inherently inflationary and are all stumbling blocks on the road to a returning inflation to the current target set by the FED.?

The important thing, therefore, is not the duration of the "fall", as the markets can live with a longer period to achieve this objective and carry out the numerous rate cuts that investors are anticipating on a delayed basis. On the other hand, if the Fed finally settles on a new 3% inflation target and puts an end to the downward rate cycle, this will inevitably change the dynamics of the equity markets.

We therefore need to keep a close eye on the formation of a potential speculative bubble in certain growth stocks, which could reach its peak before this probable paradigm shift. For the record, we do not believe that we are yet at the peak of a bubble, and every bubble burst in history has coincided with a rise in the cost of money and therefore interest rates.? The bursting of such a bubble in the future could be all the more significant given that these stocks have been artificially supported by massive share buyback programmes over the past few decades. They have also, and above all, been supported by passive management, which currently accounts for more than 50% of global asset management and feeds market biases without first questioning their rationale.

A return to favour for stocks linked to the real economy (such as those in the energy, manufacturing and materials sectors), which currently account for less than 15% of the S&P 500 index whereas they peaked at more than 50% in the early 1980s, is not impossible. Many stocks in these sectors are exposed to today's world: copper is needed for electric vehicles, industry is fundamental to the automation of tasks and relocation, energy is key to the green transition, and so on.

In conclusion, a cautious, diversified approach to growth sectors and a significant allocation to securities linked to the "real" economy and "value" securities should be considered.

Nicolas Bickel | Group Head of Investment Private Banking