Mid-Year Outlook

Parmenion Investment Management MD Peter Dalgliesh gives his expert assessment of the last 6 months and what's in store for the next 6 months.

In a nutshell

• Index returns better than expected

• Core inflation proving stubborn

• Interest rate rises higher than predicted

• Credit is squeezed and cracks are appearing in labour markets

• Quality, dividends and selectivity come to the fore

• Sticking to a long term investment plan is sensible and pragmatic

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It’s been a challenging first half of the year.

We’ve had persistent inflation, rising interest rates, regional US bank failures, corporate earnings downgrades, continued tightness in the labour market.

Yet index returns have held up better than expected.

Led by the US, EU and Japan, growth assets have relatively outperformed so far in 2023. Globally diversified defensive assets have also delivered positive absolute returns. But before assessing the outlook, let’s look back. Were our projections for 2023 pretty much on the money?

Source: FE FundInfo (30/01/2022 - 16/06/2023)

How Did We Do?

Following the rapid increase in interest rates by central banks through 2022, we expected inflation to moderate sooner than it has.

Headline inflation is trending lower, but core inflation is proving more persistent than anticipated, and this is what central banks are fixated on.

As a result, interest rates have continued to rise ahead of expectations, weighing on fixed interest returns and causing elevated levels of bond volatility. We believe that the lag effect of higher interest rates will become increasingly obvious in the next 12 months, and that interest rates will peak.

With slowing growth, we predicted corporates would ease up on their hiring plans and we’d see a moderation in labour market tightness. Redundancy announcements in IT, financials and telcos duly followed, but continued solid demand for labour in healthcare, leisure and service oriented sectors has kept the labour market buoyant. Cracks are starting to appear though, and we believe the labour market is not as strong as many assume.

We also predicted that quantitative tightening (QT) would become more widespread and, in conjunction with rising interest rates, squeeze liquidity hard. This will always increase the risk of unintended consequences and financial accidents, as seen in the failed regional US banks.

We foresaw China learning to live with Covid in 2023, but not the radical abandonment of their Zero Covid approach. This provided a sentiment boost towards Emerging Markets (EM), but it faded swiftly as Chinese growth in Q2 failed to keep up with investor expectations. Our overweight to EM has yet to deliver the upside we expected, but we remain confident that the valuations and cyclicality EM offers will drive improved returns once investors look beyond the peak in interest rates.

What's In Store?

Disinflation is already widespread with the Institute of Supply Management's (ISM) manufacturing prices and services prices indexes both declining.

Energy and commodity prices have contracted significantly and food prices are showing signs of rolling over. Inventories are being proactively sold down as the cost of capital to fund them rises, and the passing of prices to consumers is starting to hit a wall as the cost of living reduces household disposable income.

Services inflation is softening

The final sticking point in US inflation is shelter. The measure of owners’ equivalent rent follows the lead of the observed rent index, albeit with a lag. This could see shelter, currently still elevated, almost halve from today’s rate of 8% by the end of the year.

Rental inflation beginning to rollover

With growth expected to slow as higher interest rates stifle demand, inflation is likely to move closer to central bank targets. The anchoring of long term inflation expectations close to target will help assure central banks, encouraging them to ease up on their monetary tightening crusade.

US 5 Year forward inflation expectation rate

In the UK, inflation has proved to be broader and more persistent, raising Bank of England (BoE) concerns that it could become entrenched. The source of its persistence is not raising rates more aggressively sooner, labour supply shortages from the wave of early retirees during Covid and loss of European workers post Brexit, plus years of underinvestment constraining competitiveness and productivity.

Higher interest rates may seem like a blunt tool when it comes to addressing these issues. However, the BoE has little option if it’s to re-establish its credibility, so rates can be expected to stay higher for longer. And that points towards a rising probability of recession.

The Inevitable Credit Squeeze

The inevitable credit squeeze that has come from the fastest rate rises for four decades is all too clear in the US Senior Loan Officers Survey, UK Credit Conditions Survey and Bank EU Lending Survey.

All show a marked contraction in credit availability and demand as the cost of credit has taken off.

Tighter US credit conditions

Source: Alpine Macro

Credit demand tends to be a reliable lead indicator of economic activity and, when combined with negative growth in money supply, points firmly towards the probability of easing inflation.

Applying a 2 year lag to the Covid-inspired expansion in money supply aligns neatly with the spike in inflation in 2022. Assuming the same relationship holds in reverse, the contraction in money supply we’re seeing today suggests inflation will wither into 2024, with growth subsequently becoming the primary point of concern.

UK Consumer Prices & Broad Money (% 6m annualised)

Source: Refinitiv Datastream and Janus Henderson

Cracks Appear in the Labour Market

The factor that has managed to defy expectations so far has been the strength of the labour market.

Difficulties in recruiting post Covid mean companies have been reluctant to let people go, even as demand slows. But slowing sales and pressure on margins will, in time, lead to fewer job hires and more layoffs. And cracks are already appearing in the labour market as average hours worked falls, wage increases drop from their highs and overtime shrinks.

US profits and payrolls – weakening profits are normally followed by weakening employment

Source JP Morgan AM

The most widely anticipated recession in history

With inflation at 4% and overnight rates at 5.25% in the US, positive real rates are already in place. The EU and UK are expected to follow as the year unfolds.

The fixed interest market has been anticipating this for some time, with the yield curve deeply inverted across all maturities. This has been a reliable indicator of recession through recent history, and we have no reason to doubt its predictability this time.

US yield curve: 10Y Treasury bond yield less 3M T-bill rate

Source: Federal Reserve Bank of St. Louis, US Treasury & Grizzle

Recession is widely expected, but the question is how deep and long it might be. The consensus answer is short and shallow, with the potential risk of it not occurring at all or that it’s longer than anticipated.

The good news is that current interest rates give central banks scope to cut rates if required. On average in a recession the Fed has cut rates by 450bps, so the prospect of material monetary easing is not insignificant, but only after a notable economic contraction as suggested by lead indicators.

The annual growth rate of the US Lead Economic Index (LEI) continued to decline, signalling weak GDP growth ahead.

US Lead Economic Index continues to decline

Source: The Conference Board and Bureau of Economic Analysis

So where are the opportunities?

Despite the excitement surrounding AI related stocks, especially in the US, investors became increasingly worried in the first half of the year.

Thanks to attractive nominal short term interest rates, allocations to cash and money market funds are at historic highs.

Investors’ flight to cash has now surpassed that of the pandemic and financial crisis.

ICI Money Market Fund Assets (USD Trillions)

Source: Capital Group

As interest rates peak, the reinvestment risk from short dated bonds increases, with maturing bonds rolling into lower yielding instruments. The prospect of this liquidity being reallocated into longer duration assets over the next 6-12 months is high, most likely into fixed interest where the scope for picking up an attractive yield in conjunction with potential capital gain is not insignificant. History shows that, on average following the peak in interest rates, bonds tend to take a lead over equities.

Asset Performance Around Peak Fed Funds Rate (Aug 1971 - Dec 2019)

Source: Sarasin

Valuations in equities are not compelling given where we are in the economic cycle. However, consensus earnings expectations are more realistic, following notable downgrades in the first half of the year.

12m forward P/E

Source: Thomson Reuters

Caution is warranted. Slowing revenue growth combined with margin pressure is likely to limit scope for upside surprise. In this environment, quality, dividends and selectivity are key. Over recent years, quality as a style has been left behind while growth or value has led returns.

During more challenging economic environments however, quality has proven to outperform, offering ballast and resilience to portfolios - something that PIM firmly believe in.

Quality stocks outperformed during previous periods of economic stress

Source: J.P. Morgan Asset Management

With sluggish growth and higher inflation than we have been used to since the global financial crisis of 2007/8, dividends should be an increasing component of investor total returns in the year ahead. Payout ratios have notably declined since pre Covid, giving scope for resilience in dividend distributions and potential upside surprise.

Dividend payout ratios (% 3m moving average)

Source: J.P. Morgan Asset Management

Dividend growth prospects also appear encouraging as the breadth of sector contribution expands beyond the historic norms. Energy, mining, financials and utilities are joined by cash-rich technology, consumer services and consumer discretionary companies in distributing more to shareholders. With improving dividend growth expected from Japan, US and the EU, geographical diversification is further strengthening the outlook.

Dividends projected to grow through 2025

Source: Capital Group

Stay disciplined and don’t despair

Avoiding consensus and crowded positioning is a core contributor to success in generating relatively stable returns.

As central banks continue to withdraw liquidity from the system, this is all the more important. We remain cautious, anticipating a further slowdown in growth as the effects of monetary tightening flow through the system. But there are opportunities, and we will remain disciplined to lean into these as and when they arise.

For now, we have a clear preference for government bonds and quality investment grade debt, where yields are above equity earnings yields – something that tends not to last for long.

UK corporate bond yield vs UK equity dividend yield

Source: Artemis

We also believe the cheap valuations in Emerging Markets (EM) are compelling for long term investors. Having started their tightening cycles sooner, disinflation in EM is widespread and that positions their central banks nicely to start cutting rates, potentially meaningfully, over the year ahead.

The UK is unquestionably cheap. However, it is also saddled with deep rooted structural challenges. Until a new sustainable investment cycle that drives improved efficiency and productivity emerges, it is likely to remain unloved by global investors. Of course, with expectations so depressed, the potential for upside surprise is all the greater.

UK forward P/E multiple discount to the US – close to record cheapness

Source: Schroders and Refinitiv

It’s a potholed outlook, so a well-diversified portfolio to protect against recession and persistent inflation is key. The central banks quest to achieve a soft landing looks challenging with increasing risk that something breaks as rates are kept higher for longer. But disinflation is underway and investors will start to look ahead to when interest rates can start to come down.

Attempting to time an inflection point is virtually impossible, and macroeconomic data is expected to be highly variable, so increased volatility is assumed. But there is cause for some optimism. After the travails of 2022 and the continued monetary squeeze in 2023, our long term capital market assumptions of projected future returns for investors are looking better. Sticking to a long term investment plan is a pragmatic and prudent approach to take.