The Macro Picture
The global economy is currently enjoying a nice tailwind from several sources: a coordinated reduction in central bank interest rates around the world (with the exception of Japan, whose rates have barely gotten above 0% in the recent cycle); a still-robust American consumer; significant growth in corporate capital expenditures, particularly focused on artificial intelligence (AI) investments; and promised stimulus (both fiscal and monetary) coming out of China. Financial markets have dismissed the present geopolitical risks and continue to focus on the forecasted strength in corporate earnings growth.
United States. U.S. equity markets continue to reach new highs as we kick off the fourth quarter. Inflation has dropped to more tolerable levels, though not all the way to the Federal Reserve’s target and with some potential bumpiness still ahead. Nonetheless, the Fed has begun easing interest rates to support the employment market. The boom in AI spending that has boosted the large tech companies now appears to be lifting the wider market, with sectors such as utilities as secondary beneficiaries of the AI build-out. Other interest rate sensitive sectors and smaller companies more dependent on borrowing rates have also begun to perk up recently.
The U.S. election results will certainly affect policy positions and thus economic and market prospects. With the expected winner of the presidency, not to mention which party will control Congress, seemingly a toss-up, we believe it is risky to lean too far into one set of expectations or another. One thing seems certain: There is little political will to reduce the deficit spending in the near term.
We still think it is important to keep a very close eye on the potentially trajectory-changing events on the horizon but expect that the current business cycle can be extended for some time as rates are expected to ease and consumer and corporate balance sheets are in good shape overall.
Europe and Asia. Covid had a dramatic impact on consumption, causing goods consumption to spike when there was very little opportunity to seek out services (travel, dining out, etc.). This balance has yet to return to its pre-Covid sense of normal, as manufacturing is still relatively weak globally, and services demand remains robust. Nowhere is this more distinctly evident than in Europe, comparing the French/German economies, where there are large manufacturing bases, vs. Southern Europe (Spain/Italy/Greece), which is much more service oriented. It feels like the European Union (EU) is at a crossroads. Either they can continue to enforce measures of austerity which may lead to a slow collapse of European social safety nets, or they could take a risk, borrow more, and try to stimulate their economies with an objective of providing a more secure future. They want to be leaders in the green economy but also realize they may have to spend more on defense and energy security. Some regulatory and fiscal changes would be necessary to achieve those goals. In the meantime, there is some hope that Chinese stimulus could be a benefit to Europe, its largest collective trading partner, but we’ve already seen some tariff wars starting between the two that may limit the potential benefits.
China has an outsized impact on the Asian region from an economic and geopolitical perspective. While India continues to grow and has more attractive demographics than China, its impact on the region is still muted in comparison. Japan and Korea have taken steps to push public companies to be more shareholder friendly to attract more investment but, while we have seen some dramatic market movements at times, these policies are yet to really have a significant and visible impact. We believe Chinese equities remain some of the least expensive around the world, and if the government were to get fiscal/monetary policy correct, it could have a very strong impact on market returns. Many investors are still sour on China, claiming it is uninvestable, but recent moves show that there are still enough investors willing to take a chance. In fact, year-to-date, Chinese equity market returns are competitive with U.S. equity returns, perhaps to the surprise of the skeptics. Unlocking consumer spending in China will be critical in giving their domestic economy a boost.
Fixed Income. The intermediate and long ends of the yield curve in the U.S. continue to look for clues from the Federal Reserve on the magnitude and timing of interest rate changes, and we feel are trading in a fair value range around the expected neutral rate of interest that the Fed is targeting. Though there may be some volatility around the current levels, we don’t expect drastic moves from here. Additionally, credit spreads remain at tight levels, another salient measure of investors’ relative calm around the risks on the horizon. This means that fixed income returns should be predictably similar to their starting yields until and unless the Fed’s efforts to get back to neutral are spoiled by a rebirth of inflation or if a recessionary scenario comes out of left field.
The Micro (Bottom-up) Picture
We continue to recommend a value tilt in U.S. Large Cap and Developed Non-U.S. equities based on relative valuations. Further to valuation differentials, we believe that falling interest rates should be supportive of the types of businesses captured in the value segment.
Please reach out to your client advisor or contact us here for the full Tactical Allocation Viewpoints report, which includes detail on Pathstone’s current recommended allocations by asset class and sub-class.
In case you missed it, read the September Market Flash Report here.
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