Confidence builds in a soft landing for the US economy
Following strong gains in the final quarter of 2023, markets resumed their advance over January and February. US equities rose to a new record high for the first time since 2022, closing 6% higher as confidence grew that the Federal Reserve would achieve a soft landing for the economy. The strength was further fuelled by a positive results season for corporate earnings.
Earnings power the US, and Japan makes history
The standout numbers of the earnings season came from semiconductor stock Nvidia, the leading supplier of chips for artificial intelligence. Most other big technology names announced solid earnings, with the notable exceptions of Apple, where sales are struggling in China, and Tesla, which warned of weaker growth for electric vehicles. As a result, the so-called 'Magnificent Seven' has been reduced to five. The US market also shrugged off renewed concern over the health of its regional banking sector, reignited by weakness in commercial real estate: New York Community Bank, which took over parts of the failed Signature Bank last year, saw its share price plunge 45% after posting an unexpected loan provision of $552m, leading to weakness across the sector.
Japanese equities mirrored the strength in the US, also rising 6%. The market has recovered strongly in recent years as profitability has enjoyed a remarkable turnaround, and according to official data more than 40% of listed companies have submitted plans to improve shareholder returns. The government also announced the launch of the new NISA, the Nippon Individual Savings Account, for Japanese retail investors in a bid to increase capital inflows to listed companies.
UK equities closed marginally lower, despite a notable pick-up in corporate M&A that continues to highlight the value on offer across the market. Currys rejected a bid from US asset manager Elliott which, despite a 40% premium, still only valued the retailer at 7X prospective earnings. Further approaches were made to Direct Line and Wincanton, with a bidding war erupting for the latter between rival US and French suitors. Asia and emerging markets trod water, as China was once again a drag: the Chinese market closed 2% lower, although well off its lows, as policymakers stepped in with additional support measures against the fallout of the property crisis.
Gold became the third asset class to break convincingly to a new record high. The oil price also moved higher amid ongoing conflict in the Middle East and disruption to shipping in the Suez Canal. Bond markets, however, experienced a mild setback as hopes for an early cut in rates faded: gilts closed 4% lower, while corporate bonds declined by 1%.
Resilient growth pushes rate cuts further out
From a macro perspective, the theme is one of ongoing regional divergence. The US economy remains resilient, recording growth of 2.5% in 2023, led by strong fiscal stimulus and robust consumption. The latter is underpinned by a strong labour market, with a further 353,000 jobs added in January, although strong initial numbers have been prone to subsequent downward revisions of late. A less welcome development is that stronger growth has caused the downtrend in inflation that began last summer to stall at the 4% level in recent months. Not surprisingly, the Fed chose to keep rates unchanged. Stronger data pushed the prospect of interest rate cuts further into the future, triggering a correction in US bonds that was mirrored worldwide, and traders scaled back expectations for the total number of cuts in 2024 from six to three across the major Western economies. Yields have risen accordingly.
The ONS confirmed that the UK economy experienced a mild recession in the second half of 2023, following two quarters of negative GDP growth. The Bank of England held interest rates at 5.25% for the fourth time in a row. However, in a more upbeat statement than usual, Governor Andrew Bailey described the downturn as mild and saw signs of growth picking up. Recent data has been more positive across the economy: both industrial and manufacturing production exceeded forecasts, and retail sales rose 3.4% month on month in January, a strong rebound from December's disappointing 3.2% decline. The downtrend in inflation has also faltered at the 4% level here, although in the UK's case a further fall is expected due to the cut in the energy price cap next quarter.
Even at 15-year-high savings rates, the market won
Recent analysis by AJ Bell for Moneyweek shows that, despite savings rates hitting a 15-year high, the stock market still beat cash ISAs last year. When inflation is considered, savers made a loss, with a real return of -1.2%. Over longer periods the gap becomes much larger: for the five years to the end of 2023, the average cash ISA grew 5.5%, while the average UK equity fund returned 31.6%. Over twenty years, the gap widens to an average cash ISA return of 53.4%, compared with an average UK equity return of 257%.
That equities outperform cash over longer timeframes is generally expected; it is more surprising that cash ISAs underperformed last year, given the environment of rising rates. The data also shows that the average cash ISA lost money in real terms over both longer time periods, due to the corrosive effect of inflation. While the stock market does follow a more volatile path, it has demonstrated a clear track record of beating both cash and inflation over the long run. Data from Barclays going back to 1899 found that over a ten-year period, UK shares have beaten cash more than 90% of the time.
A note from the desk
I am pleased to share our update on market events. The overview seeks to summarise market movements together with our views and the rationale for the positioning of investments going forward. As always, should any aspect of this commentary prompt a question, we would welcome the conversation.
Martyn Charlwood · Managing Director
The question is divergence
With US GDP growing at 2.5%, an unemployment rate below 4% and inflation stuck in the region of 4%, it is hard to make an aggressive case for rate cuts at this juncture. Markets have dialled back expectations for 2024 as central banks have made it clear they are in no hurry to act. However, a slow normalisation away from where policy stood when inflation was in double figures seems reasonable, and this, combined with recent data, continues to point to a soft landing, which is good news for both corporate profits and equities in general. Markets should continue to attract cash from the sidelines as rates fall.
The key question going forward is whether recent gains in the US, led by the mega cap technology names, will spread out to other areas of the market, including undervalued regions such as the UK. Investors have been caught up in the exciting potential of AI, in a move that has drawn parallels with the internet boom of early 2000. Many of the early winners of the internet era, such as Cisco, did subsequently see their earnings soar; in share price terms, however, the company still trades below its heady 2000 level today, as valuations gradually fell back to earth. Hence our mantra that while valuations may not matter in the short term, they are key to generating stronger returns over a longer time horizon. Expensive valuations among mega cap technology stocks do not preclude further gains, but opportunities elsewhere look much more attractive on a relative risk-reward basis.
Another reason for the strength of the US market has been the relative strength of its economy. The US has been an outlier in growth terms, but should face headwinds as the extra boost from record fiscal stimulus starts to wane. In contrast, growth elsewhere is forecast to pick up, helped by falling inflation and rates. This should allow the relative valuation discount between the US and the rest of the world to narrow. The recent pick-up in M&A among UK listed companies is an extremely encouraging sign: on average, two companies are now being snapped up each week, by private equity or other corporates, and average premiums have risen to above 50%, highlighting the degree of undervaluation at current levels.
Thirty-four years on, the Japanese stock market has finally set a record high.
It might surprise readers to learn that Japanese equities have had higher earnings growth than the US since the financial crisis back in 2007, at an average rate of 9.9% in Japan versus 6.6% in the US. The key difference is that Japanese equities have become cheaper over this period, as share price gains have not kept pace with growth in earnings, whereas the opposite is true of the US. As a result, despite strong performance in recent years, Japan still trades at a 25% discount to global markets. The corporate sector has undergone a material restructuring, with share buy-backs and rising dividends driving a step change in shareholder returns, and earnings should receive a further boost as the economy finally exits deflation, helping to restore pricing power and increase profitability.
Portfolios remain tilted towards the regions where earnings are growing and valuations trade at a discount, with US exposure held through the index.
A long-standing overweight to Japan
Our standard portfolios have remained overweight Japan for a considerable period. Historic returns received an additional boost from the decision to own a share class hedged back to sterling: while the stock market rose, the yen declined, allowing our clients to benefit from both trends. Positions have more recently been switched back to local currency shares, as the yen now looks undervalued and should benefit as the Bank of Japan finally raises rates.
Underweight, but indexed, in the US
Exposure to the US remains indexed to the S&P 500 for now: given the dominance of the mega cap technology stocks, we feel it is easier to capture these returns through a passive approach. Portfolios are underweight in aggregate, in line with our preference for other regions.
Building the UK position
Exposure to the UK has been gradually increased, with a focus on small and mid-cap stocks that are especially attractive at current levels. Valuations are trading at 9X earnings, a material discount to the long-term average of 14X, and share prices have lagged large caps despite superior earnings growth.
Overweight Asia and emerging markets
Earnings are growing across these regions and valuations are trading at a discount that is close to 20-year lows. Falling US rates combined with a weaker dollar will remove what has been a major headwind.
Important information
This article is a marketing communication intended for general information only. It does not constitute personal advice, a recommendation, or an offer to buy or sell any investment. If you are unsure whether an investment is suitable for your circumstances, please seek personal advice.
Past performance is not a guide to future performance. The value of investments and any income from them can fall as well as rise. Capital values are at risk and not guaranteed. Forecasts and views expressed in this commentary represent our assessment at the time of writing and are subject to change.
To discuss how this commentary applies to your own portfolio, we would welcome a conversation.
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