Investment Strategy Focus for June 2023

Summary

1.Central banks torn between current activity and forward indicators: current economic activity looks solid in the US and Europe, and today’s inflation remains high. But forward indicators point to sharp slowdown ahead. Expect a pause from the US Federal Reserve, but a further ECB rate hike to 3.5%.

2.Sharp inflation fall incoming? The US “truflation” measure hits 2.9%, while Spanish inflation suggests sharply lower Euro inflation to come. Food prices are the key problem today for European consumers, but should cool. We could potentially see surprising falls in headline inflation in the coming months.

3.Vigilant but still Positive on Equities: despite the risk of more difficult liquidity conditions ahead, we retain our Positive view on World ex-US equities, given rising earnings estimates and robust shareholder returns. Japan is May’s star stock market, now +20% over the year to date.

4.Artificial Intelligence, reality or hype? I believe that AI will unleash a 5th industrial revolution, fundamentally changing the nature of many white collar jobs. Identifying long-term AI winners is very hard, as we are early in this trend. Beware of investing in today’s AI “glamour” stocks at ultra-rich valuations.

5.Long-term beneficiaries of AI applications: Aside from diversified Semiconductors and Robotics & Industrial Automation funds/ETFs, Healthcare could be a key sector to benefit from AI-related advances.

Key Calls: Japanese stocks the stars

The month of May continued the general positive trend of the last six months for our Key Recommendations:

1. + Japanese stocks (+9% in May) led by semiconductors, robotics and electronics companies.

2. + German DAX index (+0.7% in May; +11% over the last six months) lead the European stock market (Euro STOXX 50 -0.7% in May; +9.3% over last 6 months)

3. + Trend-following alternative UCITS/hedge funds (HFRX macro/CTA index +0.7% in May after +1% in April)

Will central banks go too far?

Risk that Central Banks panic about inflation

At the moment, there is a huge disconnect in macroeconomic data series between what is happening today (so-called “coincident” indicators) and what is projected to happen in the near future (“leading” indicators).

Today’s economy: still fairly robust

Estimates of current US economic activity, such as the Atlanta Fed’s GDPNow GDP, estimate for Q2 this year show strong momentum – this suggests a 2.9% annualised growth rate for Q2, faster than in Q1.

Equally, UK economic activity continues to surprise to the upside for now, both in terms of stronger-than-expected growth (driven by a strong consumer) and also in terms of inflation that remains stubbornly high.

Only the eurozone is seeing a slowdown in economic momentum, driven by sudden weakness in the consumer, especially in Germany. The Eurocoin growth indicator has already turned negative, pointing to zero European growth at present.

While both headline and core inflation rates are falling from peak levels reached last year. They remain far above what central banks would consider comfortable (i.e. close to their official 2% inflation targets).

We should note, however, that there is a growing divide between strong growth in services (consumption) on the one hand, and widespread weakness in global manufacturing on the other.

On the basis of current economic activity then, central banks would be justified in increasing interest rates further in the months ahead. 

Forward-looking indicators: signalling recession

However, if we turn our attention to more forward-looking indicators of the global economy, then we see a radically different story.

Credit growth leads economic growth. Credit conditions have tightened dramatically in the US and Europe over the last few months. This should result in shrinking credit volumes, and thus in negative economic growth as lending to consumers and companies shrinks. This is more immediate in Europe, given the sharp change in eurozone bank lending standards over the last 3 months.

We can conclude from this that the interest rate hikes already enacted by the ECB are having a huge effect on bank lending already. As a result, both consumption and corporate investment will slow over the remainder of this year. Similarly in the US, the Fed’s Senior Loan Officer survey is relaying the same message, amplified by the ongoing stress in US regional banks. US commercial bank lending to companies has shrunk by 6% annualised over the last three months, a sharp slowdown from the strong lending trends seen up as recently as Q1 of this year.

The US labour market is also weakening rapidly – temporary help in services has declined by 4.4% over the last six months. This is the most sensitive segment of the US labour market, and is consistent with US recession before the end of this year.

These forward-looking indicators would suggest that central banks have already tightened conditions enough to ensure much lower growth and inflation. 

US is already in recession, according to Gross Domestic Income

The Fed is already hurting final demand

According to certain measures of economic activity that were reliable indicators of recession in 2000, 2007 and 2020, such as real gross domestic income (-2.3% annualised in Q1 2023), the US is already effectively in economic recession.

If we look at the Q1 results of US companies, it is clear that these companies have boosted sales and profits entirely via higher selling prices. In aggregate, the volume increase in sales was zero, highlighting that consumers are not in aggregate buying too many goods and services. We can conclude from this that US final demand has already slowed sharply, with a further slowdown to come.

Equally, if we look to more timely measures of current inflation, such as the US Truflation index, US headline inflation has already fallen below 3% to 2.9% as of 25 May once lagging components, such as shelter are corrected for.

Commodities underline near-term economic weakness

The fall in copper prices since January, coupled with persistent weakness in crude oil prices and the CRB raw industrials index all point to one fact. Despite bullish long-term demand drivers for commodities, the weak near-term global economic demand outlook is dominating commodity price direction.

Remember that surging energy and food prices were a principal driver of rampant inflation in 2022. So the 40+% drop in energy prices since June 2022, and the 20% drop in the FAO world food price index should result in disinflation over the remainder of this year. 

The German engine is breaking down

Since the formation of the eurozone, Germany has been Europe’s economic powerhouse, driven particularly by its export prowess. However, until now, the German economic model has depended on a seemingly endless supply of cheap energy, largely provided by piped Russian natural gas. The energy burden has more than doubled from the 2016-2020 average if we look at today’s baseload electricity or natural gas prices.

It is perhaps no surprise that the Germany economy has fallen in the rankings, from Europe’s economic powerhouse in prior years to the worst economic performance of any major eurozone member in Q1 2023 – with negative economic growth over Q4 2022 followed by negative growth again in Q1 2023.

Germany’s dominance of the global car market is now being threatened by no other than China – today, China exports as many cars internationally as does Germany, with the German car-making industry struggling to catch up with Korean and Chinese carmakers in the area of electric vehicle technology.

The German consumer has been hard hit by rampant price rises and has reacted by cutting back on  consumption. German retail sales by volume were 8.4% lower in March this year than a year earlier, reflecting this household caution and preference for precautionary saving.

Given this weak demand backdrop and easing food and energy prices, one might ask why the ECB feels the need to raise interest rates further, with interest rate markets forecasting a 3.75% peak deposit rate. 

Reasons to Still Like Equities

Euro STOXX, Nikkei and Nasdaq lead this year

To summarise: a) economic growth momentum is clearly slowing in the US and Europe; b) central banks have not yet decided to pause their interest rate hiking policies; and c) stock markets around the world have performed strongly over the year to date, including the Japanese Nikkei 225 (+20%), the German DAX index (+15%) and the US Nasdaq 100 (+24%).

This then begs the inevitable question: why not take profits in stocks now?

I  must admit these are compelling arguments to want to “take some money off the table” and perhaps park it in money market funds, which today offer attractive 4%-5% yields in euros, sterling and US dollars.

However, I also keep in mind that “the trend is your friend” and that these trends can persist for longer than anyone cares to believe. Most importantly, following a strong Q1 results season, analysts are revising US and European earnings forecasts higher for this year and next. Thus, forward valuations remain modest for World ex-US, at 12x PE for the eurozone, 10.4x for the UK and 14x for Japan. In addition, European, Japanese shareholder returns are elevated.

Global liquidity remains the big unknown

The only area which has seen significant investor inflows in global stocks has been in mega-cap US tech stocks, boosted by the surge of interest in Artificial Intelligence. Outside of this narrow retail investor focus, there have been no net inflows into stock markets. Interestingly, there have been continued net outflows from Japanese stocks until last month (May), in spite of their strong showing this year.

With a potential US debt ceiling agreement in the works, attention will turn to the huge expected wave of US Treasury bond issuance that should follow, potentially as soon as July. JP Morgan estimate as much as USD1.1 trillion in US Treasury bills could be issued over the next seven months. Will this drain global liquidity away from stocks and corporate bonds, prompting a correction in asset prices?

Investment-grade corporate bond spreads continue to tighten, highlighting a steady decline in perceived risks from recession and from US regional banking stresses. Equally well, the US ISM manufacturing PMI may have troughed in March – with any rebound in the ISM historically a positive signal for US stocks.

Investment Conclusion

The S&P 500 index hovers close to the key 4200 level which, if breached to the upside, would signal a new US stock bull market in our view. European stocks remain close to all-time highs, while Japanese stocks have surged to a new 33-year high. Yes, liquidity remains a key concern and a threat to our Positive view on Equities. But for now we retain this Positive view, backed by improving earnings estimates and improving shareholder returns (via dividends, share buybacks). Sharper falls ahead in headline inflation could cool real bond yields, supporting stock valuations.

Artificial Intelligence: A bubble, or the next big thing?

Reality or hype?

There is no doubt that there is a huge amount of hype in today’s financial markets around the theme of Artificial intelligence (AI). While AI has been around for many years, the technology finally seems to be hitting the mainstream in terms of applications in the everyday and business worlds.

For many in Main Street, the image of Artificial Intelligence is perhaps best personified by the risk that one day, computers will rule over people, Terminator-style. However, I would rather argue that Artificial Intelligence and Machine Learning are technologies that can potentially magnify once again the impact of Information Technology on our everyday lives, after the advent of the Internet/World Wide Web and then of Smartphones.

Of course, as Artificial Intelligence captures the imagination of investors in much the same way that the Metaverse did a couple of years or so ago, there is always the risk that investors today will price in over-optimistic sales and earnings expectations. This is a hype pattern that repeats itself over and over again, as it has done for over a hundred years in stock markets with former “technologies” such as railroads, radio and mainframe computers.

I am not saying that there is no solid reasoning behind this excitement. For instance, consultancy PwC sees AI-related productivity savings and investments generating USD15.7 trillion worth of global economic output by 2030, almost equivalent to the gross domestic product of China.

But I would temper my excitement, for historical reasons.

Gartner’s Hype Cycle

The advent of new technologies tends to follow the Hype Cycle mapped out by consultancy Gartner. According to Gartner:

“The Hype Cycle is a graphical depiction of a common pattern that arises with each new technology or other innovation. Although many of Gartner’s Hype Cycles focus on specific technologies or innovations, the same pattern of hype and disillusionment applies to higher-level concepts, such as IT methodologies and management disciplines. Hype Cycles characterize the typical progression of innovation, from overenthusiasm through a period of disillusionment to an eventual understanding of the innovation’s relevance and role in a market or domain.“

This hype cycle can be then closely linked for investors to asset bubbles, which have occurred many times in the past around new and hyped technologies, such as cryptocurrencies and the Internet.

This is most certainly a psychological phenomenon and not a question of intelligence - in the past, there have been plenty of examples of famous intellectuals being sucked into asset bubbles, such as Sir Isaac Newton in the South Sea Bubble of 1720. Greed and the madness of crowds can get the better of even the most intelligent amongst us.

Conclusion: Investors should beware the hype around the “next great thing”, as it can often mean investing in an asset bubble when asset valuations are already heavily inflated, running the risk of taking a huge loss when the asset bubble finally bursts.

If you want to invest in AI, how else can you invest apart from Nvidia?

ChatGPT, the trigger for AI excitement

The trigger for this latest excitement around AI comes from the mainstream adoption of the use of ChatGPT, which holds much promise in a number of different types of business.

Reuters reported that AI bot ChatGPT had reached an estimated 100 million active monthly users in May, a mere two months from launch, making it the "fastest-growing consumer application in history" according to UBS.

Nvidia, the poster child for investing in AI

In my view, we are too early in the adoption cycle of Artificial Intelligence techniques and programmes to know who the real long-term corporate and business winners will be. We have long advocated a “picks and shovels” approach to investing in AI for this reason - preferring to invest in sectors and companies that will provide the hardware and software tools necessary for the widespread adoption of AI and machine learning in large corporations. We have thus advocated investment in both semiconductors and cybersecurity subsectors of Information Technology.

It seems that investors are going one step further in this approach in identifying Nvidia as the key long-term winner of the boom in AI applications - given that their Graphic Processing Units are well-placed to provide the heavy processing power necessary for AI models to “learn” by training on large datasets.

Nvidia is now richly priced post Q1 results, valued at 35 times sales. At this point it is also worth remembering that a great company does not necessarily make a great investment. Think back to the Technology bubble in the year 2000. 

Service sector wage deflation impact?

The most significant impact of AI in the real world may be much more about “creative destruction”, rather than a huge benefit for certain mega-cap technology companies like Nvidia, Google or Microsoft.

The widespread application of AI and chatbots could mean the devaluation of a whole swathe of white collar office jobs which involve a lot of routine, repetitive tasks. Think of call centres, or junior lawyers drawing up and checking standard business contracts, or junior auditors for instance.

Just as previous waves of industrial innovation have allowed for the mass production of goods and for people to move away from working in agriculture as machinery and fertiliser use has massively improved agricultural productivity over the decades, so a similar phenomenon may be seen in the near future in a number of service industries.

We are already seeing the beginnings of this trend in automatic voice recognition in call centres to better direct phone enquiries, and even to answer simple queries without human intervention. We also see this in the widespread introduction of automated self check-out tills in supermarkets, which require a minimum of supervisory staff to handle problems and watch for fraud, as opposed to one cashier per manual till.

Ultimately, companies may be forced to adopt these technologies in order to simply remain competitive, if others in their industry are adopting AI and improving productivity and cutting costs are a result.

What could the macro impact of AI really be?

Adopt AI or vanish?

Recall the story of Blockbuster, which did not change its business model quickly enough with the advent of Netflix video streaming, and went out of business as a result. Or the example of Nokia, which in the pre-iPhone era had a global smartphone market share of over 50% in early 2007. Today, it is zero.

Today economists worry about the surge in wage growth that we are experiencing in the US and Europe at present, at a time when unemployment rates are at (or close to) historic lows and when long-term illness and incapacity accounts for more and more of the working-age population. But if both manufacturing and service-sector companies really implement AI and machine learning software in their business models to its fullest potential over the next few years, then we could see the elimination of huge numbers of jobs as they exist today, potentially creating a wave of deflation in wages in these industries.

Of course, this technology will also lead to the creation of new types of jobs which could be based more on human creativity for instance, which AI may struggle to really replicate in the near term.

I maintain that it is simply too early to be able to reliably identify the long-term winners from any supercharged growth trend in AI. The eventual winner(s) may not even be listed in the public stock markets today. 

Who could be the long-term AI winners?

A slightly more diversified approach might be to invest in funds and ETFs focused on either Semiconductors or Industrial Automation and Robotics, as these are areas which should benefit from leverage to AI and also from other megatrends such as ageing populations, nearshoring of Asian goods production and the need for companies to reduce their exposure to high wage growth.

I would focus on funds and ETFs that avoid too great a fund weighting to any specific stock (like Nvidia, Google or Microsoft) in order to retain the benefits of within-sector diversification.

Which sectors could benefit from AI productivity?

There is huge potential to improve the effectiveness of new drug discovery and of diagnostics in Healthcare, and also to accelerate the democratisation of affordable higher education and of learning of essential skills via AI-based teaching platforms. These are just two examples of industries that could see a huge acceleration in productivity as a result of AI technologies and techniques.

We would thus also focus on Healthcare innovation funds and ETFs as an indirect long-term beneficiary of the AI revolution.