Markets balance a trio of risks

In April, the International Monetary Fund (IMF) published its latest world economic outlook. Alongside the usual update of its forecasts, the IMF also wrote about what it saw as a ‘knife-edge path’ toward beating inflation without causing recession. While the comments were written about Europe, frankly, they could have been about almost any major developed market economy globally. This so-called knife-edge, which at the start of the year was a two-sided interest rate dilemma between economic growth and inflation, was difficult enough for central banks to navigate. Through Q2, it became something of a balancing act of risks, cementing a third risk of financial stability.

After the hiatus in March of the downfall of three US regional banks and Credit Suisse in Europe, by early May, a fourth US regional bank, First Republic, had run into difficulty and failed. While regulators moved at pace to facilitate solutions, this is not necessarily the end of the story. Although the consensus is that we are not facing a global financial crisis, there are still real risks to navigate. In May, the US Federal Reserve (Fed) published its latest Senior Loan Officer Opinion Survey in which it noted that banks’ lending standards had tightened for both businesses and households, though the broad message around the scale was that conditions had ‘tightened somewhat’, rather than ‘tightened considerably’. Nevertheless, with credit creation and loan growth seen as the oxygen for economic growth, should caution amongst the banks grow, it would make the continued post-pandemic recovery harder to sustain.

Inflation continued to be a problem in Q2, but that is not to say it was a problem everywhere. While the world’s biggest economy, the US, continued to see rates of inflation still some way above target, the world’s second biggest economy, China, was instead grappling with the near absence of any inflation at all. Not just between countries, there was also little uniformity between ‘headline’ (all-items) inflation which saw annual rates ease sharply due to weaker energy prices, while ‘core’ rates proved to be relatively more stubborn. During the quarter, the UK made unenviable headlines as annual core (excluding energy and food) consumer price inflation accelerated, rising to the highest rate in over 31 years. As a result, central banks have been forced to re-think their plans.

During June, the Bank of Canada was something of a poster child - having previously paused for two meetings in a row, it took rates up again to 22 year highs, citing concerns that above-target inflation could ‘get stuck’. With interest rates across developed markets, in aggregate moving higher through Q2, this has lifted yields on government bonds, in particular for shorter-dated maturities. With ‘income’ very much back in fixed income products, and considered largely risk-free returns for government bonds (in nominal terms), this has quite-rightly raised the bar by which all other asset allocation choices are being made.

Against such a difficult inflation, interest rate and financial backdrop, it might seem hard to rationalise the resilience of stock markets during Q2. There are two factors to explain this. First, if inflation is proving stickier, in many cases it is just the flipside of marginally better than expected economic growth (albeit from a low base), whether from lower energy prices or continued consumer spending and evidenced by better than expected company results. That is not to say that growth is strong in absolute terms, just that it is better than what was feared previously. Second, market expectations are key – after all, investors invest indirectly in economies, but directly in financial markets. After the derating of valuations during 2022, even a modicum of better economic growth has proven to be a rerating force for developed market equities so far in 2023, and especially so if it comes against hitherto cautious investor positioning. Not for nothing are this year’s stock market rallies being described as a ‘hated’ rally.

Finally, one of the biggest investing themes to take flight in recent years emerged in Q2: Generative Artificial Intelligence (AI), a technology capable of generating text, images, or other media in response to input data and user driven prompts. We have seen that technology company share prices have been a powerful leading driver during Q2. The potential for Generative AI to lift productivity and profitability for many companies across all parts of the global economy has clearly caught the imagination of investors so far this year. Surely the biggest question of all currently is this: is the current narrow market leadership centred around technology a vulnerability, only to herald a collapse to come? Or will these technological gains instead lead to a broadening-out of performance across the rest of the market as tangible benefits are delivered? While only time will tell, balance, more than anything else, continues to underwrite our investment strategy.