Global stock delivered strong returns over the quarter, but returns were much more modest in sterling terms, reflecting a 6% appreciation of the pound versus the US dollar. Corporate earnings for Q2 were strong, particularly in the US, with S&P 500 earnings growing by 11.5% year-on-year. There was considerable stock market volatility in late July and early August, and this was caused by a sharp rally in the Japanese Yen. This caused many investors who had borrowed the Japanese currency as a cheap way of financing the purchase of international equities to close these positions, driving the main equity indices 7-10% lower, before subsequently recovering.
The biggest surprise to most economic commentators this year is just how resilient the US economy has proven to be. The consensus at the start of the year was that the unprecedentedly rapid 5.25% of interest rate hikes during 2022/3 would almost inevitably precipitate a US recession during 2024. It was felt that sharply higher borrowing rates would close the door on the soft-landing scenario by jolting households and the corporate sector into a sharp retrenchment.
Instead, it seems that key actors in the US economy have been less sensitive to rising interest rates than feared. Homeowners have locked in low borrowing rates and households and corporates have been paying down debt in recent years, with high levels of liquidity built up during the pandemic providing a significant cushion. Elsewhere, several government programmes (CHIPS Act, Inflation Reduction Act, JOBS Act) continued to provide significant fiscal support to the economy.
A predominant concern this year has been the sluggishness of the US labour market, with hiring running at around a 1% annual growth rate. This is unusually low for a period of economic expansion and does indicate a degree of private sector caution. However, with layoffs at low levels and household balance sheets strong we continue to feel that the outlook for US consumption is for reasonable growth.
The US central bank, the Federal Reserve (Fed), reduced its key interest rate by 0.5% at its August policy meeting. This was a larger reduction than many in the market expected and reflected the Fed’s shifting assessment of risks to achieving its dual mandate of price stability and full employment in the light of a pleasing fall in inflation and a downshift in the pace of hiring. Looking ahead, markets are anticipating another 1.5% of US interest rate reductions over the next twelve months, which we feel is consistent with an interest rate which is neither stimulative nor restrictive.
Outside of the US, developed market central banks are adopting a more gradualist approach to cutting interest rates because their economies have not so far exhibited the same combination of cooling inflation and a significant drop off in the pace of hiring. This is particularly true of the UK, and a shallower path of rate reductions is expected during 2025.
Another concern has been a worrying decline in global goods demand, with many regional manufacturing surveys slipping into contractionary territory. The Eurozone and China have been particularly disappointing in this regard. Within the Eurozone, much of the focus has been on the German economy, which posted a quarter of negative growth at mid-year and has seen its manufacturing sector contract sharply. With the German economy highly sensitive to the global trade cycle and the effects of higher energy prices (which we hope will begin to fade), the costs of the green energy transition, weaker Chinese growth and increased Chinese competition, a challenging environment for the automotive sector and unfavourable demographics feel more like a structural rather than cyclical headwind to growth.
There are, however, some bright spots, with the labour market exhibiting strength not seen in the US, real wages recovering and the scope for energy bills to adjust lower from current levels. Taken together, the scenario for the Eurozone economy remains “muddle through”, with growth likely to be modest over the balance of this year and a modest growth acceleration in 2025.
In Japan developments in the economy have been generally positive, and whilst headline growth is anaemic (reflecting the aging population), GDP per capita has been growing strongly after the pandemic-related decline. After a sluggish start to the year wages have been rising in real terms and consumption growth has picked up. Furthermore, it looks like the economy has finally exited the deflationary trap it entered in the 1990s. Recent currency strength needs to be watched carefully given its impact on domestic financial conditions, but the Bank of Japan is likely to tread carefully in raising rates whilst the Fed eases. Looking ahead, the unwind of cross shareholdings to facilitate business portfolio restructuring and increased business investment is a long overdue positive for the economy.
Offsetting this weakness in manufacturing has been an improvement in final demand as consumer spending has been reaccelerating during the third quarter, with retail sales surprising on the upside in the US, UK and Japan. Elsewhere, in Emerging Market Asia (ex-China) the picture has been somewhat brighter, with relatively robust export-led growth. High real interest rates and currency strength versus the US dollar should provide regional central banks ample scope to ease rates further, creating a tailwind for local and hard currency bonds and equities.
The key regional focus remains on disappointing incoming activity data from China, which has finally prompted the authorities to announce a range of policy easing measures. China remains mired in a domestic economic environment characterised by a Leninist obsession with production and export-led growth, without a western consumer model. As a result, industrial production growth has been consistently outstripping consumer spending, exerting downward pressure on the rate of inflation. Elsewhere, in the absence of the creation of a real estate resolution fund to provide a safety net for the housing market and allow real estate developers access to legitimate funding, the negative wealth effects from the property sector will be felt for several quarters to come.
Much attention has been focussed on geopolitics in recent months: it would be tempting to try to predict how events in the Middle East will evolve and invest on the back of this expectation. However, such an approach is fraught with difficulty as financial markets don’t trade on geopolitics but on revisions to economic growth, inflation, central bank policy rates, liquidity provision and the earnings outlook, with investor positioning acting as an accelerant when one of these drivers reaches an inflection point.
We can sum up our view in a nutshell: in the post 2008 global financial crisis period, the focus of policymakers was on shrinking debt/GDP via reductions in spending. Now, fiscal and monetary policy are aligned to support nominal GDP growth, and this reflationary policy mix is a supportive backdrop for equity markets. Whilst equity gains have been heavily concentrated in the US technology sector, we note that market leadership has been broadening out recently, and this is an encouraging sign from an overall market perspective
