Global Market Update by Graham O'Neill

03 Nov 2023

Global Market Update by Graham O'Neill

Markets have remained relatively sanguine, even as the attack on Israel and heightened tensions within the Middle East have dominated news flow. Investors might be surprised at this, but markets generally separate humanitarian tragedies from economic ones and with limited impact on the oil price to date, events in the Middle East remain a left field tail risk to markets rather than central case. Clearly, if Hezbollah attacked Israel, a US response would be likely and a strike on Iran would, in the short term at least, see a sharp jump in the oil price with adverse sentiment potentially dominating markets. Since the conflict started, the primary driver of the S&P 500 in the US has been the movement in the US Treasury market.

In most geopolitical crises, the worst fears expressed in newspaper headlines rarely come to pass. While the US suffered after 9/11, we must remember that it was already into an economic recession at the time and did in fact recover these losses around a month after the attack. In the post-World War II period, the US has generally recovered from setbacks driven by geopolitical events after a month.


Market Surprise

At this stage it is impossible to be definitive about how the cycle will eventually play out, but we can see that conventional economic models have not been able to forecast or predict the continued strength in economic activity, especially in the US during 2023. A significant slowdown in the US economy in Q4 would be the market surprise now, when a year ago, this was the consensus view. Sentiment to China remains very negative, but the authorities still have plenty of levers to pull to ensure the economy does not collapse and China remains a very entrepreneurial society. It should also be remembered that a year ago there were two big consensus calls: the first was for a recession in the US and the second was forecasting a strong reopening economic boom in China. Anti-China sentiment is so high that any small mood change could see the market rally. The elephant in the room remains the property market which may well unravel further with land and home prices contracting at an annual rate of around 5%. In this environment, the consumer in China is likely to remain under pressure.


Novel Features

There are both cyclical and structural elements to the current economic cycle. It is often harder to implement correct policies at the end of a cycle with a risk of over tightening or easing too soon. This time around, there are of course novel features from both the pandemic and Ukraine war and much heightened geo-political tensions resulting in de-globalisation. The Fed seems to expect the US to slow as the impact of pandemic handouts fades, although capex from onshoring will continue to prolong the cycle. On balance, it seems likely that most central banks will err on the side of caution before changing stance. Structural elements have inflationary components: de-globalisation, defence, and demographics and deflationary ones: debt levels and digitisation. 


Market Focus

In the short term, markets will be focused on the outlook for interest rates and the realisation that rates will remain high by post GFC standards for a long period of time. The oil price remains a threat to economic growth and could hinder the falls in inflation which are expected in the developed world, and some emerging market economies such as India, have always been vulnerable to oil price shocks. An upward move of over 30% since June is not something to be ignored and would favour US economic growth over that of Europe. Europe faces a double whammy of a weak currency versus the US$, which oil is priced in, and currency weakness, if it occurred, would put further pressure on the ECB on the interest rate front.  The recent language of President Lagarde suggests that rates, while not having to rise further, will be held until there is definitive evidence that inflation is on its way back to the 2% target rate. Unlike the US, the ECB does not have a dual mandate and so is not focused on preserving full employment if inflation remains above mandated levels. The Bank of Japan continues to look ‘behind the curve’ on interest rate policy with the Yen taking the strain.


Regime Change Impact

While there has clearly been a move away from an ultra-low inflation world, the extent of regime change is still not certain. In the 70’s and 80’s, inflationary forces dominated markets, but in the 90s and 2000’s, disinflation boosted equity market valuations. Even today, there are both disinflationary and inflationary forces at work over the longer-term, so it would be dangerous to be categoric about how inflation will evolve over the next decade. Markets have not sold off due to significant declines in earnings estimates, but rather through pressure on valuation levels as real yields in the US have risen over the quarter. The US, on conventional measures such as equity yields vs bond yields or the market PE vs real interest rates, looks expensive, but of course, this has been the case for a while.  


Market Sentiment & Portfolio Repositioning

Investors still need to proceed with a certain level of caution in this environment but be prepared to act if markets do sell off sharply as seasonal factors are usually supportive of equities in the final part of the year. Evidence emerging of a slowdown of sufficient magnitude that the Fed would change its stance would see a rally in both bonds and equities. The caveat on this would be if economic activity nosedived and it became apparent that the Fed was not going to respond with market friendly measures. The ‘goldilocks’ type scenario would see lower bond yields and a reduced oil price, a retreat in the US$ and a corresponding rally in equities. For a definite move into a new bull market phase, there needs to be clearer evidence that interest rates globally have peaked, and inflationary pressures will continue to ease, allowing scope for rate cuts of a meaningful nature, especially if economic activity weakens, even if these do not start to occur until the back end of 2024 or 2025. Investors are still faced with an unusually wide scenario of potential end outcomes and, therefore, this remains an environment where, going all in on any one style or market carries high levels of risk, since market sentiment can change quicker than most investors can reposition a portfolio.

Graham O’Neill, Senior Investment Consultant, RSMR


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