Are we heading towards “reflation”?
At True Potential, we work with world-class fund managers across a broad spectrum of asset classes and markets. We use their insights to inform our own outlook on global markets and economies. Here, we set out the key themes that we believe are driving markets at the moment.
- Economic indicators point to a shift from disinflation to reflation in the second half of 2024.
- In this scenario, real GDP (i.e. GDP adjusted for inflation) would trend positively, but inflation would bottom out and move marginally above central banks’ 2.0% targets*.
- It is our view to remain positive on equities. In our opinion, we favour the US and Japanese markets but are also positive on global sovereign bonds. Their attractive yields provide greater portfolio protection in the event of an economic shock, and their downward-trending correlations with equities offer diversification. Meanwhile, we see improving risk-adjusted returns from high-yield corporate bonds.
- A risk to our view stems from rising inflation induced by an acceleration of real GDP. This is an important consideration in our portfolio construction.
Around the world
In this section, we set out our views on the world’s main equity markets. True Potential have a positive outlook on the US and this is reflected in the asset allocations of our True Potential Portfolios, given the rude health of its companies and economy, and Japan, in light of the encouraging economic and corporate developments underway there.
United States
Our outlook on the US stock market is positive given improving economic data and strong corporate earnings. Real GDP continues to show a positive trend. The latest forecast from the Federal Reserve Bank of Atlanta puts GDP growth at +2.1%* for the first quarter of 2024, a scenario in which equity markets can perform positively.
The six-month annualised core personal consumption expenditures (PCE) index has ticked up from 1.9% to 2.5%*. This index is regarded as a reliable measures of consumer inflation in the US. The change in the PCE reinforces our view that we are moving into a reflationary regime. Under this regime, real GDP averages 2%* and the core Consumer Price Index (CPI) averages 2–4%*. Over the next 12 months, we expect core CPI to remain in the lower half of that range. Markets have acknowledged this development, halving the number of rate cuts expected for 2024 (from six at the end of 2023 to three at present) and pushing out the timing from spring to summer. At the most recent meeting of the Federal Open Markets Committee, its members pointed to three rate cuts this year and a slightly slower pace of reductions thereafter. The uncertainty over the timing of cuts encourages us to not to lower our exposure to high-quality, strongly cash-generative equities.
Further support for our positive outlook comes from the potential for a liquidity impulse (a sudden injection of money into the market) ahead of November’s presidential elections. The Treasury General Account ($770 billion*) is currently in surplus of the $750 billion* average that the Treasury seeks to maintain, so there is room for this to occur.
We have confidence in the current earnings cycle, with earnings and revenue beats for the final quarter of 2023 ahead of historical averages, and we expect greater sector breadth to emerge. Evidence of a turn in the inventory cycle would provide an encouraging signal and support cyclical earnings growth.
There are two key risks to our outlook. The first would be the continuation of narrow earnings growth and multiple expansions driven by the ‘Magnificent Seven’: Alphabet (owner of Google), Amazon, Apple, Meta, Microsoft, Nvidia and Tesla – technology giants that are among the largest stocks in the US market. The second would be higher housing costs following a liquidity impulse.
Rest of the world
In Europe, the core CPI has fallen by 45%, to 3.1%* in the last 12 months (from the peak of March last year) As this is coupled with a weak real GDP forecast (<1.0% for 2024*), we believe that the European Central Bank has scope to lower interest rates by the summer, ahead of the Bank of England and the US Federal Reserve. The market currently expects four cuts this year.
Core CPI in the UK has remained unchanged at 5.1%* over the last three months. This is above the 2.0%* target set by the Monetary Policy Committee (MPC) and reflects a moderation of just 28%* from the peak in May last year (7.1%*). Although real GDP is likely to be positive in 2024, it is also expected to be less than half the long-run average of 2.0-3.0%*. We anticipate the sticky inflation components, notably wages, shelter, and service costs will encourage the MPC to hold rates until summer, with markets expecting three cuts in 2024. By this point, we expect to see disinflationary forces commence as the upward contribution from wages moderates. Our preference is to be underweight UK equities and overweight gilts.
In China, there is little evidence of a sufficient growth impulse or ability to stimulate demand and combat credit challenges in the property sector. The equity market has responded well to an intervention to limit short selling, however.
In Japan, we have just seen the return of monetary tightening, with the first increase in interest rates in 17 years*. With policy rates no longer negative, the Bank of Japan has abandoned its policy of yield-curve control and has drastically scaled down its quantitative easing. We believe that the strength of earnings growth in Japan and the weakness of the yen should help support the equity market. The market is also benefitting from structural shifts to enhance shareholder returns (encouraging a price-to-book ratio above 1). We note, however, that our largest allocators have been trimming their overweight positions in Japan on recent strength.
Valuations and asset views (for further asset-class and currency views, please refer to our asset-allocation dashboard)
Besides equities, we invest in bonds, alternatives and currencies on behalf of our clients. Here’s how we view each of the major asset classes at present. As ever, we pay particular attention to valuations.
- Equity valuations remain below fair value in Europe, the UK and Japan. However, only Japan is undergoing structural changes that support multiple rerating. Although US valuations are high, companies continue to produce solid results.
- We are positive on equities, the US and Japan. Resilient earnings and positive economic growth support our overweight positions here. We have turned negative on UK equities.
- Meanwhile, we are positive on our current weighting to sovereign bonds for the yield and total-return opportunity, as well as a potential portfolio hedge should we see a negative economic growth shock. Our preference is now for UK gilts over global sovereign bonds.
- We are less concerned about economic growth, so the yield and risk-adjusted return in high-yield credit are more interesting.
- Alternatives are a useful source of diversification in the event of higher-than-expected inflation, which could challenge traditional assets.
- In the currency markets, we are neutral on sterling, seeing conflicting forces of stickier inflation components in the UK (vs the US and Europe), which may impact interest-rate differentials in the future.
Summary
We are multi-asset investors who take a long-term view on the world’s markets. At present, we favour the US and Japan in the equity markets and UK gilts in the bond markets. We remain alert to opportunities across the full span of markets, however, and are committed to global diversification across our portfolios.
*All data sourced from Bloomberg L.P. (31/03/2024)
With investing, your capital is at risk. Investments can fluctuate in value and you may get back less than you invest.
This material is not a personal recommendation or financial advice and the investments referred to may not be suitable for all investors.
Opinions, interpretations and conclusions represent the views of True Potential Investments at the date of publication and are subject to change. Forecasts are not a reliable indicator of future results.
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