Most major global equity indices quickly shrugged off the volatility of July and August, ending the third quarter close to all-time highs. This does however hide an underlying current of nervousness.
Whether markets will hold on to these gains will largely depend on whether the widely expected global economic slowdown is of the hard or soft variety.
Market optimism could spell disappointment
The US Federal Reserve’s short-term course is now clearer as it travels back to a neutral policy rate although even the Fed itself doesn’t appear confident about what level this is. However, it seems unlikely that there will be a return to the ultra-loose policy that characterised much of the past decade. The market has priced in a soft-landing but is also more optimistic than the Fed about the extent of rate cuts, which could spell disappointment ahead. However, we believe this is a more traditional easing cycle rather than a necessary reaction to unforeseen events. To that extent, the Fed is doing its utmost to not fall behind the curve. This means that the shape of economic data in the coming months will remain critical, albeit the focus is likely to be more on the labour market than inflation.?
Surveys of global equity investors suggest that they are uneasy but will stay the course for now. Strategists have been sorely wrong-footed by both the strength of global growth this year, most notably in the US, and the momentum behind equities. Whilst we still have another quarter to go, the S&P500 is currently more than 15% above the average end-year target predicted by strategists at the end of 2023 with most recent projections suggesting there is still more in the tank.?
The few dissenters to this rosy outlook point to the yield curve which has recently un-inverted after two years, which was itself the longest period of inversion by some margin since at least the late 1970s. Before each of the last six US recessions, the curve was inverted and for the four recessions since 1990, the inversion switched back to its normal upward slope prior to the onset of recession, driven by the expectation of falling short term rates. This time may be different but in general equities have performed well if a deep recession is avoided, which is why it’s important that the Fed does not fall behind the curve.?
Markets will struggle to make headway until after the US election – but they don’t care who wins
There is also a US presidential election to navigate this quarter which is likely to be a key driver of short-term volatility given the still very uncertain outcome. Recent research by Research Affiliates suggests that the political affiliation of the winning candidate in US elections has less bearing on markets than how close the election was. In the 24 US elections since 1928, the S&P500 generally weakened in the run up to a close election but then rallied in the final week and continued to improve, albeit with greater volatility, after the election. History also suggests that markets do much better after a close election is resolved compared to when a landslide is the expected and the realised outcome. Regardless, the market is probably going to struggle to make meaningful headway until the election is out of the way in early November. That said, the key message from previous elections based on longer time horizons is that markets often do not care who wins after the initial instability subsides.?
The US election will also have implications for the US dollar and EMs
Trump is clearly advocating the benefits of a weaker currency to improve the country’s trade deficit but his proposal to increase US trade tariffs is likely to have the opposite effect (e.g. the 2018-2019 US China trade war), particularly if tariffs are accompanied by looser monetary policy (i.e. fewer rate cuts). The dollar (as measured by the DXY index) declined by 5% during the third quarter in anticipation of looser monetary policy so some of this is already in the price, meaning that the risks are for dollar strength if Trump wins. If realised, this will be a headwind to emerging markets in particular.?
Will the big tech trade of the last 18 months continue?
After the Fed pleased the market with a 50bp rate cut in September, it was not a surprise to see a revival in big tech, but this was also fuelled by stock specifics as the artificial intelligence (AI) land grab continues. Despite much short-term noise, as a group, they broadly matched the wider market during Q3 but with some dispersion, primarily weakness in Amazon offset by the stronger performance of Meta and Tesla (although Tesla was playing catch-up after a weaker start to 2024). Year to date, their performance is more than double that the MSCI World Index but this is purely attributable to Nvidia (+145%) and Meta (+62%) as the performance of the other “Magnificent 7” stocks are all within spitting distance of the index.?
The big question is whether the big AI trade of the past 18 months will continue. Once again, fund managers appear to be increasingly cautious. The massive ramp up in AI related infrastructure investment has obviously benefited the largest hyperscalers (Amazon, Microsoft, Meta) as well as Nvidia. However, the debate over whether this capital spending will be justified is becoming less clear cut. In a recent Goldman Sachs research report titled “Gen AI: Too much spend, too little benefit”, the authors suggest that big tech and other corporates are expected to spend around $1 trillion in the coming years to support AI but so far have little to show for it. The paper suggests that we will see limited economic upside from AI over the next decade, arguing that the technology isn’t designed to solve the complex problems that would justify the costs.?
Will AI investors see their return?
Despite the enormous investment, no one can convincingly argue that the capacity will be used and over what time frame. That said, there is also an awareness that AI will be increasingly important and, having learnt the lessons of the internet 20 years ago, few corporates will want to take the risk of missing out on a new disruptive technology. Advocates of the AI trade point to recent earnings reports where companies like Walmart and Amazon have started to explain how it is improving supply chains and reducing developer costs, which may go some way to allay concerns about return on investment. On the other side, Morgan Stanley is more in the “AI winter” camp suggesting that the global chip industry will soon face huge oversupply.?
The consensus appears to be that AI is here to stay and while we are not in a bubble, the initial hype is unlikely to be sustained, which would be a healthy development from our perspective. As for the Magnificent 7 (Mag 7), our best guess is that the increase in performance dispersion we have seen this year will continue rather than them trading in unison. The expected path of their earnings will therefore remain under heavy scrutiny in the quarters ahead.?
Better opportunities exist outside of the index behemoths
Mag 7 growth has already started to shrink and by the end of next year, it is forecast that they will only account for 25% of earnings growth for the S&P500 (broadly their weight in the index) with the other 493 stocks generating the rest. By way of comparison, in the second quarter of this year, the Mag 7 accounted for more than 80% of S&P500 earnings growth with Nvidia alone representing 25%. This suggests that the July/August rotation from semi-conductors and AI to bond proxies, defensives and beneficiaries of lower rates was rational, but much will still depend on the Fed and whether the elusive soft landing is achieved. If it is, and rates fall more quickly than the market expects, it could be a good environment for cyclical stocks (such as materials and industrials) but these have already performed surprisingly well and much will depend whether the Fed is forced to cut by more to avoid a deeper downturn.?
Energy sector misses out on market rotation – and Middle East conflict could exacerbate this
Amidst the rotation that characterised the third quarter, only the energy sector lagged consistently, and surveys suggest that fund managers are the most underweight the sector in four years. With signs of a recovery in oil production and an end to OPEC+ cuts alongside no evidence of a rebound in demand, the risks to oil prices would appear skewed to the downside, albeit the more recent escalation in the Middle East conflict may prove otherwise.??
With so many unknowns, diversification is key
The wide range of potential outcomes ahead suggests that the best policy is to remain diversified. Greater clarity on the scope for global policy accommodation as inflation returns to more normal levels and some signs that the AI hype is fading, has not created any more certainty about what the next market phase will look like, regardless of the US presidential election.
Portfolio construction and risk management will remain critical, and we continue to favour a mix of value and quality stocks.