Retaining faith in equities

Equities are enjoying a good run of late with even the much-maligned UK market doing well. This is confounding many investment strategists, while year-end forecasts are being revised up as previous estimates become redundant. Despite the many economic and geo-political challenges facing policymakers, markets are climbing the wall of worry. The question is whether this can continue? All-time highs often make investors nervous. Yet, while accepting volatility will be a constant companion, there are good reasons to believe progress is sustainable. The challenge facing investors is to ensure adequate exposure to those markets offering better potential – and this may involve taking profits elsewhere.

The wall of worry

Equity markets are building on the solid gains achieved last year. Year-to-date figures to 31 May 2024 suggest total returns of 8.68% for the FTSE All-Share Index, 9.65% for the MSCI World (£) Index, and 5.03% for the FTSE All-Share Closed-Ended Index. Each time there has been a pullback, sometimes when expectations of interest rate cuts in the UK and US have been reduced or postponed, markets have found renewed strength and moved on. The market adage ‘sell in May’ has had little traction by way of financial commentary.

The geo-political challenges are well-rehearsed. The war in Ukraine may be edging in Russia’s favour and many eastern European countries are understandably nervous. Diplomacy and strategic alliances are also having to contend with the threat of China invading Taiwan and a widening conflict in the Middle East. The current demise of Western influence is perhaps illustrated by the UN vote on Ukraine last year which saw more than half of the world’s population as represented by their governments not condemning Russia’s invasion. Meanwhile, Haiti is in anarchy and wars exist elsewhere, particularly in Africa.

Economic concerns also abound. Interest rate cuts have been postponed in large part because of some disappointing inflation figures and the relative strength of the US economy. As such, government bond yields have been edging up and this raises the hurdle for equities to overcome – higher yields elsewhere offer greater competition for investors’ funds. Together with political uncertainty and especially the conflict in the Middle East, oil and gold prices are higher – the latter also being helped by some aggressive central bank buying.

There are also market concerns about the extent of budget deficits and national debt levels. The situation is not helped by economic growth slowing globally as productivity has largely stalled in recent decades. The exception is the US, but even here productivity remains below its long-term average. It has levelled off in the UK and EU, and the gap with the US has therefore widened. It is no surprise US economic growth has far outpaced that of Europe, and this is reflected in their respective unemployment rates (except for the UK, among the larger economies).

At least part of the divergence between the US and Europe can be accounted for by their different approaches to risk – and concomitant attitudes to regulation. While governments must ensure a ‘safety net’ for the vulnerable, they must also encourage growth. Yet Europe abounds in regulations. In the UK, overzealous regulation and guidance has resulted in a cost disclosure regime which makes investment trusts look unduly expensive – so hindering investment into sectors such as infrastructure, renewable energy, etc. In Europe generally, MiFID rules are hindering bank lending to smaller companies. And far fewer government regulations on AI have been passed by the US when compared with Europe. The list goes on.

Hope springs eternal

Yet there are reasons to remain positive about markets. The better economic picture in the US is key given its impact on equity markets more generally. Growth is relatively strong, corporate earnings are increasing at quite a pace, and a growing number of companies are participating in the rally. The Inflation Reduction Act is increasingly contributing to the momentum. Higher cash generation from listed companies will make for higher dividends and more share buybacks, which in turn will further reduce equity supply. Meanwhile, as next year approaches, the market’s prospective multiple will fall to a more reasonable level of c.18.5x – perhaps lower, if earnings continue to be upgraded.

The graph from Montanaro Asset Management highlights the correlation in direction between the US economy and global equity markets over the last 25 years. While no correlation is perfect, it does highlight the importance of the US economy in providing markets with a sense of direction. This is rational given its size, transparency and dynamism. And given the usually long economic cycles, the current juncture suggests further – possibly strong – equity gains, despite markets being close to all-time highs. Early signs that M&A and IPO activity is picking up certainly suggest things are stirring at the coalface.

A common refrain is that terminology such as ‘all-time high’ can spell danger, in that prices are higher than ever before and so buyers should beware. Yet logic suggests for markets to advance, they must break through previous highs otherwise no progress can be made. A journey consists of an increasing number of steps. Indeed, recent research regarding the S&P 500 index has shown that investing solely at all-time highs would still have produced returns close to the index average over the last half century or so. All-time highs are very common. The greater danger is missing out on the best market days, which is why investors should remain invested relative to remit.

Of course, volatility will be a constant companion as markets digest the various challenges. And the gradient of the market’s rise will depend on several factors, particularly the extent and timing of interest rate cuts. For reasons first cited in the column ‘Preparing for inflation’ (12 March 2021), there has been a long-term structural shift in inflation – three has now become the new two. However, this does not stop inflation falling further in the short-term for various reasons including sluggish economic growth, Quantitative Tightening, one-offs falling out of the equation, and the increasing risk of overly restrictive central bank policy – particularly the Bank of England, which risks being behind the curve again.

As such, interest rates will fall faster than markets expect once the penny drops, and bond yields will retreat. This backdrop will be supportive of equities. Meanwhile, geo-political risks and tensions will continue but, while never complacent, we have been here before and markets progress. Again, the penny is finally dropping that strong defence is the best deterrent. Government finances will remain stretched globally but there is more cross-party talk about the need to secure greater efficiencies. Reality is dawning, and elections in some cases may be the catalyst. Most importantly, we should never underestimate the potential of human ingenuity, enterprise and kindness to generate wealth and overcome adversity.

However, this narrative should not encourage complacency. Having turned positive on equity markets in the spring of last year, my columns at the time and since have highlighted market and sector preferences when increasing exposure. Our portfolios are underweight the US in favour of the UK, Japan and emerging markets.

At a more granular level, we favour smaller companies given valuations suggest strong potential relative to outlook – particularly as inflation recedes. Other attractive sectors highlighted in previous columns include private equity and, to assist with diversification, infrastructure, commodities, corporate bonds and renewable energy. In fact, perhaps reflecting perceived crises, markets are awash with opportunities for the patient investor.

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