Under the Macroscope: CIO Macro View

Here are my key takeaways from the discussion:

The Macro Backdrop

Whilst some may believe that the US is headed for uncharted territory, we do not think that is the case. In fact, we think a strong case can be made that we are headed to a period—before the advent of quantitative easing and a zero-interest rate policy—that looks very much like the conditions experienced from the 1950s through to the Global Financial Crisis.

Of course, things are never exactly the same as before and differences exist. One major difference is the transmission speed of higher policy rates. The average 30-year fixed rate mortgage rate in the US had been on a steady decline over the last couple of decades and many US homeowners were able to obtain mortgage financing at favourable rates. This means that it will take longer for the Fed’s rate hikes to filter through to the economy than in the past.

Another difference is that much of the growth has been of lower quality; in other words, it has mostly been fuelled by low interest rates amidst expansionary monetary policy. Had rates been at higher levels, we do not believe many of the business models that emerged over the last 15 years or so would have been viable. For the same reason, whilst we cannot argue with the performance of many risky assets, equity investors have to be mindful about corporate America’s ability to weather an economic downturn without the benefit of lower interest rates.

Given the consumption-driven nature of the US economy, the health of the consumer is always an important factor. What we have seen thus far in the face of the US Federal Reserve’s (Fed’s) hiking cycle is a very resilient US consumer. Moreover, consumer indebtedness is not at an extreme level; we are at levels comparable to the early years of the century. However, the danger we see here is that the Fed, as they have done in the past, may overshoot their targets in their zeal to tame inflation. Should unemployment rates start to climb meaningfully, the US consumer will be under stress and the situation is likely to be exacerbated by the lack of mobility; consumers will be tied to their homes. So, a third difference is that the US economy is less flexible than it has been in past cycles.

Eventually, growth will likely slow as the Fed’s tighter policy takes hold more broadly and the impact of inflationary fiscal policy fades. When that happens, we think the US dollar may struggle to maintain its momentum of the past couple of years because government debt still matters. Faced with twin deficits (fiscal and trade), we think slower growth and higher taxes are going to be a factor going forward. As a result, the greenback looks to us like a currency past its cyclical and structural peak.

Outside of the US, the last few years have been challenging. Faced with the first violent conflict in decades, political strife and structurally rising energy costs, European assets have struggled to make headway. Japan, on the other hand, has been making strides in implementing structural reforms that could deliver an economic boost.

In contrast, emerging markets (EM) are more resilient than many remember, with implications across both debt and equity. Many thought EMs would have difficulty coping in the post-COVID period but, broadly speaking, we have not seen that. In a scenario of slowing growth, we think EM corporates will be under less stress than commonly perceived. Moreover, we think EM equity valuations look less than demanding, especially against their developed market (DM) counterparts. In addition to favouring EM equities, we are also seeing particular opportunities in EM small caps.

With all these as a backdrop, and while we cannot predict the exact timing, we feel that there is ample reason to believe the tables may be set for different opportunities which we will discuss in more detail below.

Major themes for the coming months

With the macro backdrop described above, there are a number of important issues that will have meaningful implications for markets in the months ahead.

First, we are clearly in a period where global trade is in retreat; the era of big global trade agreements is behind us. However, it is important to explain that this does not mean free trade will end—just that it will likely look very different. More regional trade agreements between allies may be one manifestation of this. In a related development and driven largely by the strategic decoupling between the US and China, supply chains are in the process of being reconfigured. The resulting “near-shoring” or “friend-shoring” will have implications for certain markets and assets.

On an unrelated, but equally important note, some have been alarmed by the prospect of artificial intelligence (AI) supplanting a human workforce. However, history has shown that new technology does not necessarily displace workers permanently; they simply migrate to other sectors of the economy. At the same time, AI might be able to step in where humans cannot. For instance, ageing populations have important implications for economic growth and, as large cohorts end their prime spending years and transition to lower rates of consumption, these trends will have a meaningful impact on economic growth. AI appears to hold the promise of at least a partial solution to this issue.

Opportunities that stand out to us

For many investors, 2022 was a year of significant financial setbacks, with both stocks and bonds experiencing substantial losses. This rare occurrence served as an educational experience about the effectiveness of balanced portfolios under certain conditions. The primary lesson from 2022 was the vulnerability of stocks and bonds during periods of rapid inflation and aggressive interest rate hikes by central banks. In such situations, traditional diversification strategies become less effective. Looking ahead, the economic landscape appears different. Anticipated lower growth, possibly even a recession, is expected to bring about reduced inflation. Whilst some stocks and corporate bonds may suffer due to disappointing earnings, this could be counterbalanced by an increase in bond prices, driven by declining yields in response to expected Fed policy easing. In essence, 2024 is shaping up to be a year where balanced investment strategies and diversification could yield better results.

Second, we think that as rates peaked and expectations of lower rates persist, fixed income will once more be able to play its traditional role in portfolios. With generally lower volatility and low correlation with equity or equity-like assets, fixed income can deliver meaningful income returns while providing portfolio ballast at the same time.

Last, we think it makes sense to keep an eye on areas of the market where cyclical and structural changes are working in your favour. In terms of EM debt sectors, for instance,Mexico and Brazil look poised to benefit from geopolitics. Amongst equities, international small-cap companies are offering good relative value versus their large-cap DM counterparts whilst Japan’s structural reforms leave it with room to surprise investors.