Grumble in the Jungle

Back in 1974, Muhammad Ali beat the formerly unbeaten George Foreman for the undisputed heavyweight world boxing title in Zaire in one of the greatest contests of all time. At the time it was billed as the ‘Rumble in the Jungle’.  Fast forward to today, and with stock markets appearing finely balanced for the remainder of the year, Evelyn Partners pitted its finest strategic minds against each other in an epic bull versus bear battle in an in-house ‘Grumble in the Jungle’ debate. Daniel Casali, Head of Investment Strategy (bull) and Richard Griffith, Partner and Investment Director (bear) go head-to-head over 10 rounds, covering the most important issues influencing markets today.

Round 1: The global growth outlook

In finance, a bull is someone who has a positive outlook either on financial markets or the economy.  A bear is someone who has a negative outlook either for financial markets or the economy. 

Bull case: The consensus points to 2.6% global growth in real GDP over 2023ⁱ. Economists are encouraged by three factors: Europe avoiding an energy crunch, China reopening and the resilience of consumers across the US, UK and Eurozone. The Federal Reserve appears to be engineering a soft landing, where job openings are falling, but there has been no significant rise in unemployment. The services sector – the most important in the US economy – has proved strong.

Bear case: The bond market doesn’t lie. The yield curve, which shows the interest rates, or yields, of government bonds with different maturity dates, has inverted eight times in the last six decades. An inverted yield curve means that interest offered on short term bonds is higher than that offered by longer dated bonds. Typically, this is a powerful warning sign that markets are missing a looming black cloud as it indicates that investors expect lower interest rates (and economic growth) in the future. Indeed, a recession has invariably followed within 12 to 14 months of the yield curve inverting. The data is starting to support this view.

Round 2: Market risks from monetary tightening

Bull case: As non-US central banks continue to raise interest rates, it is having an impact on the US dollar, which is down 12%ⁱⁱ from its highs. A falling dollar means there is more supply than demand. These dollars will find a home, probably in riskier assets. The bulk of global debt today is in dollars and a weaker dollar means the value of that debt is falling. 

Bear case: There has been the steepest rise in interest rates for decades. The concern is central bankers will stick with higher rates over the long term. Due to the steep rise, the full effects of tightening have not yet been seen in the system. Silicon Valley Bank is the first casualty, and there may be more to come. There is significant debt maturing in the next 12-18 months and will move onto higher interest rates when it is renegotiated. Banks are also tightening their lending standards.

Round 3: Geopolitics

Bull case: The greatest impact from geopolitics is usually felt when it involves energy, otherwise the impact is usually short lived. Indicators of geopolitical risk are falling. Ukraine is likely to grab fewer headlines, particularly now that Europe has avoided an energy crisis. Taiwan is the major outstanding issue, but that doesn’t involve energy.

Bear case: Taiwan is important because of its semiconductor capabilities. These are the components the world needs to move Artificial Intelligence (AI) forward. The Chinese have done a good job in the last decade of controlling the most important commodities. Geopolitical issues are still very much alive.

Round 4: Inflation concerns

Bull case: Inflation is slowing across the world. US CPI inflation has fallen to 3%ⁱⁱⁱ, with significant falls in areas such as housing costs. This makes it clear that the US has got ahead of the curve in terms of bringing down inflation.

Bear case: The genie is out of the bottle. A decade of monetary easing and quantitative easing has unearthed dormant inflationary pressures. The inflation news from the US is encouraging, but the tightness of key commodities markets, supply chains breaking down, and the transition to renewable energy, are all likely to be inflationary factors.

Round 5: Asset market bubbles

Bull case: AI companies have led markets higher. There is a question over whether they will deliver for the real economy, but the performance of semiconductors has typically been a strong leading indicator for improvements in manufacturing. AI could deliver productivity and growth to the real economy. CEOs will want to be seen to be investing in AI, which could give the trend further to run. Where these asset bubbles are felt in the real economy, animal spirits – market sentiment and momentum – may pick up and drive markets.

Bear case: The AI trend might have further to run, but valuations in this part of the market appear to be edging closer to bubble territory – where prices far exceed their fundamental value. While we are not there yet, and there may be some momentum to this, the situation can turn very quickly. Non-financial loans are another worrying area and have been highlighted by the International Monetary Fund (IMF) as a significant risk factor.

Round 6: Earnings Per Share expectations

Bull case: The outlook for company earnings supports equities, with consensus estimates for 10-11%^iv growth. The earnings contraction this year has defied expectations. At -0.3%^v, earlier predictions were for a far larger fall. Companies have not seen significant sales weakness and have been adept at raising prices and offsetting higher input costs.

Bear case: Analysts have consistently misread the earnings outlook, saying it will rise when it’s about to go down and vice versa. There is the potential for further weakness in earnings. When we talk to companies, they report demand is drying up. As such, it is right to see a degree of caution. Companies are putting prices up, but that game doesn’t go on indefinitely.

Round 7: China uncertainty

Bull case: Certainly, China’s reopening has been weak. China reaction to the pandemic has been very different to the West; the government didn’t provide significant handouts to households. Equally, Chinese GDP is difficult to measure. However, the Chinese government is putting stimulus into the system, which should boost manufacturing. Property is an issue, but China is a command economy, and the government will take steps to smooth over any problems. Property prices are stabilising.

Bear case: The one child policy is likely to create a demographic shock, which is a looming problem for the Chinese economy. Investors need to be cynical on Chinese growth: the GDP numbers are produced very quickly. The situation may be worse than the official figures suggest. There is also evidence of some lasting damage from the pandemic, with manufacturing moving to Vietnam, Thailand, Indonesia and Japan.

Round 8: market valuation and positioning

Bull case: Global stock market valuations are not demanding. There are pockets of overvaluation in the US, but this is not the general picture. There has also been a lot of short selling activity in the market, but those short sellers are now being forced to unwind their positions. This should be supportive for stocks.

Bear case: Abundant liquidity has pushed the stock market higher over the last 10 years. As this hot air comes out of the market, there could be sharp falls. There could be opportunities, but if passive flows reverse, it could push valuations down quickly.

Round 9: Rising debt levels

Bull case: There has been a fall in consumer debt in the US. It has been as high as 134%^vi of take-home pay, but it is now around 98%^vii. High interest rates are a factor, but they also mean that savers are getting a higher return. Equally, in the UK, the effect of interest rates is staggered. Five-year fixes are around 60%^viii of the overall mortgage market, so not everyone will feel the pain straightaway. There is a cushion for interest rates that helps both companies and individuals.

Bear case: US government debt to GDP is at an astronomical level. It’s the same for the UK and Europe, plus most of the G7 economies. There will be an impact from higher debt levels is at some point. There is also pressure from non-bank lending, such as private equity. This could be a lurking liquidity crisis and create waves in the market. This is probably the most significant potential risk to markets.

Round 10: Risk from quantitative easing

Bull case: The contraction in liquidity is not as significant as it may first appear. The People’s Bank of China is expanding credit and the impact on market liquidity from the fall in global central bank assets has been offset by weakness in the dollar. 

Bear case: Quantitative easing was one of the great experiments. After about five years, it had probably done its job. The central bank should have turned it off several years ago. There are still considerable risks from the unwinding of the QE experiment.

Often, one of the biggest mistakes any investor can make is not being able to change their mind. The economic outlook is balanced, with plenty of reasons to be positive, or bullish or negative and bearish. Good portfolio management is about being prepared for either scenario and anywhere in between.  Currently, the consensus view is that economies will achieve a soft landing, we remain vigilant. 

Sources

^i-viii Refinitiv/Evelyn Partners

Important information

By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.

The value of investments, and the income from them, may go down as well as up and investors may not get back the amount originally invested.

Past performance is not a guide to future performance.

Underlying investments in emerging markets are generally less regulated than UK ones. There is an increased chance of political and economic instability with less reliable custody, dealing and settlement arrangements. The market(s) can be less liquid. If a fund investing in markets is affected by currency exchange rates, the investment value could both increase and decrease. These investments therefore carry more risk.