An uncertain growth outlook
Loucas Savva 11:56 - 11 September 2023
The travails of US regional banks and Credit Suisse in Switzerland earlier this year have created market volatility and raised uncertainty about the path for growth and interest rates. Despite these woes, European risk assets have continued to trend higher since the October lows with optimism over avoiding a deep European recession increasing. Although we believe that the economic environment this year will make it harder to grow profits, limiting equities’ upside potential, for investors who have abundant liquidity, this year should present opportunities to deploy liquidity in less liquid areas at attractive valuations.
Europe leads risk asset rebound
European equities continue to lead risk asset strength, with European markets continuing their rally which started in October 2022. The avoidance of tail risks around a severe energy crunch has been the main driver and, although inflation has been high, the European economy has so far avoided a deep recession. This has also driven a rally in the euro, which has meant there has been a headwind for non-currency hedged overseas assets. There have been some interesting rotations. Growth stocks rebounded after being relatively weak in the last quarter of 2022. Just as faster than expected rises in yields in 2022 particularly hurt growth equities, this key market driver has worked in reverse. One interpretation of this is that the discount rate applied to the free cashflows from equities to derive fair value is driven by risk-free rates and, with growth stocks’ free cashflows more likely to be further in the future, these stocks are more sensitive to moves in rates.
Bank credit tightening and its effects
With First Republic joining Silicon Valley Bank and Signature, Silvergate and Credit Suisse needing to be rescued, concerns about the health of the global banking system persist. Our view continues to be that the problems look more like the Savings and Loans crisis of the late ’80s and early ’90s than the global financial crisis of 2008. Those institutions needing to be rescued have insufficient equity when assets are marked to market. However, most banks continue to retain the confidence of depositors and regulators appear to have successfully stopped contagion effects. Nonetheless, lending surveys show that banks have become a lot more cautious, and this might impact their ability to extend credit.
An uncertain growth outlook
Growth expectations for most regions are increasing, with the EU now expected to have positive growth in 2023, albeit only around 0.6%. Growth expectations in emerging markets are also improving, helping to drive a higher overall growth picture.
Despite this, some signals are flashing red. The Federal Reserve Board of New York (FRBNY) forecasts the probability of a recession in 12 months’ time based on the shape of the yield curve. This suggests that the US economy will be in recession within a year. Another popular indicator is the Conference Board’s LEI index which includes a range of economic and financial variables (including the yield curve) which also suggests that a recession in the US is likely.
How do we reconcile these red flags with rising growth forecasts? Growth at the end of 2022 and the start of 2023 has been much faster than economists were anticipating. This means that, when the whole of 2023 is compared to the whole of 2022, overall growth can be significantly positive even if we get stagnant quarter-on-quarter growth in the second half of the year. However, recent strength also shows that the economy currently has managed to maintain decent momentum, despite all the shocks that have been thrown at it.
Outside the US, the yield curve is less successful at predicting recessions. Indeed, the majority of recent recessions in Germany weren’t predicted by the yield curve and in the UK, it has regularly given false positive signals. However, the credit growth outlook is poor and real money supply is contracting sharply. These monetary signals are indicative of weakness.
Equities going nowhere – emphasis on other sources of return
Though global equity markets have been making some gains lately, we still find it hard to work up enthusiasm for at least three reasons. First, the combination of pressure on interest rates and slowing growth is likely to turn recessionary. Earnings growth has turned negative now, and a further slowdown in the economy is likely to mean more pressures emerging. Second, multi-decade high US profit margins, a key support for the US market, look now to be eroding slowly. Lastly, our equity risk premium indicator relative to bonds continues to be lower than the average over the past decade, showing a loss of support compared to cash and bonds. Allowing for these headwinds, current valuations do not suggest a good base on which to build further gains. We believe that it pays to be cautious about valuations in markets and look for substantial discounts to net asset values when investing in some areas. For example, real estate investment trusts suggest that commercial property valuations have fallen far more than private property funds are marking them at.
That said, current economic conditions should create attractive opportunities for some types of private asset and discounts will, therefore, be much harder to come by. Retrenchment and risk aversion by banks will mean that many firms will need to shift to private credit funds in order to raise capital. Funds in this area are likely to be in a position to demand higher spreads and stronger covenant terms. We therefore believe that investors with ample liquidity are in a position to earn higher than normal illiquidity premia if they select their investments carefully.
By Loucas Savva CFA, Consultant, Aon Wealth Solutions
(This article was first published in The Cyprus Journal of Wealth Management. To view it click here)