Market commentary: 1st January to 31st March 2023

At the end of 2023 we said that the direction of stock markets depends on two questions:

1. Whither the Magnificent Seven?
2. Have markets fully absorbed that the period of declining and/or ultra low interest rates are behind us?

As for the Magnificent Seven we suggested that “some of [them] (as in the film) come to the end of 2023 party battle scarred and road weary”. Following the film analogy, the 2024 sequel to the Magnificent Seven has been numerically diminished to the “Four Musketeers” as Amazon, Meta, Microsoft and Nvidia have left the others for dust. This narrows even further the market leadership in the US – a lingering concern to the benchmark – but we prefer to focus our attention on the many good companies and opportunities that exist in the US outside the psychodrama of these companies.

As for market perceptions around interest rates: no central bank now says that inflation is transitory or interest rates will rapidly revert to zero. The late response to inflation by central bankers in 2021 has meant it is now stickier (it has become wage inflation which is hard to shift). Interest rates have yet to come down despite the price of fuel and food easing out of the system, so persistent inflation appears better hemmed in and markets and central banks are demonstrably less self-deluded about its existence.

Inflation will likely remain higher than current market expectations because of geo-political trends we have often discussed: governments have demonstrated desire for deficit spending, a safety-first interventionist style and net-zero and climate change drives western energy prices higher. Inflation will linger. The rise in US treasury yields and gold over the last quarter suggest that, gradually, this is becoming accepted.

Looking at economic growth, we can say with confidence that over half of US GDP growth is supported by deficit spending. This is unsavoury and (classically) unsustainable. But so what? If we look at the politics, neither Biden nor Trump has any desire to reign back deficit spending. This means that we can expect at least another five years of deficit spending. US valuations appear acceptable in this context.

At some point the unprecedented peace time growth in debt must end, but it is hard to predict what will be the trigger. Looking for long term risks we would highlight that there has been a significant shift in finance risks over the last 15 years from banks to private capital (Blackstone, KKR and Apollo in particular). Banks have substantially stronger balance sheets (in aggregate) than before the global financial crisis and are being squeezed out of many traditional areas of risk – corporate credit in particular. These new pools of private capital have thrived on this trend and this is still nascent – they will grow rapidly over the next decade as they capture a greater share of corporate credit.

The difficulty with these private capital behemoths is that they are opaque and complex. As they grow ever more dominant they become harder to understand, harder to manage and harder to regulate. We would also note the close intertwining of private credit with the private equity (PE) giants, many of whom are finding liquidity hard to come by. There are hundreds of billions worth of assets in PE funds that are for sale, but so far a shortfall in transactions; the obvious conclusion being a valuation gap between what PE thinks they are worth and what markets will pay.

It seems likely that this gap will narrow and we expect to see (especially in the context of low-volatility rising stock markets) a surge in initial public offerings in 2024 and 2025. PE is structurally illiquid and has never before had such an inability to exit investments and raise new funds, or rather it has, but not since it has assumed such financial scale as an industry. Allied to the risks we have discussed with private capital then missteps in execution, regulation or policy could create a systemic shock.

The other systemic credit risk we would highlight is China. It is grappling with disinflation and a property bubble collapse stemming from the misallocation of capital. China’s growth has been credit fueled, but credit can rapidly switch from being a benign amplifier of economic growth to a malevolent destroyer of wealth and employment. We shall see how a command economy with hyper concentrated power can manage tensions that are usually better dissipated by free markets.

Europe is essentially a slower growth US. Many of the same risks and opportunities overlap but in aggregate it is either zero growth or in recession with a lingering war on its border.

Taking a step back from geography, economic data is becoming more consistent, with the distortions from lockdowns and government interventions receding. Perceptions around interest rates and inflation are much closer to the reality we face and so, in short, we must conclude that markets are pricing these risks more effectively.

As such, over the last quarter we have taken steps to move client portfolios towards a neutral equity allocation. We have increased client exposure to US equities, predominantly through exposure to smaller company investments. We have taken steps to remove exposure to China, but boosted the overall exposure to emerging markets. Finally, we have increased the overall exposure to UK equities, which are offering good value at current prices.

There remain asset classes, such as property, that lag behind in repricing and therefore we have no exposure to. Elsewhere however opportunities are appearing and we are well positioned to take advantage of them to achieve your investment objectives.