In this Market Briefing Note we aim to provide an update to our 2023 annual outlook, outline key factors likely to mould our investment recommendations for the remainder of the year and highlight how investors may consider recalibrating portfolios to maintain their resilience and take advantage of opportunities that may lie ahead.

Executive Summary

Simply put, cost of capital is too high relative to growth, demand is slowing. We anticipate a slowdown in demand to pick up pace by year’s end as the large fiscal stimulus measures from the pandemic era which resulted in a large excess savings for consumers and households, come to an end. We recommend staying the course – underweight equity, overweight high-quality income, and overweight Real Assets.

Market Recap

In our 2023 Outlook, our base case “Moderating Inflation Favours Income over Equities”, we called for peak dollar, peak rates at around 5% and a broad consolidation in US equity markets. This was anchored in our views that the cost of capital is no longer cheap relative to the growth prospects, earnings yields do not provide enough premium over income yields, inflation is likely to moderate, and corporate profitability does not support equity valuations. We concluded then that 2023 is a year for income generation and equity transition and this remains our base case.

The DXY dollar index is weaker at 104.3 after peaking at 120 in October 2022. US Fed Funds rate is now 5.08% (target range is 5.0-5.25%), at our peak target rate of 5%. The S&P500 is currently at 4,200 and has remained range bound between 3,800 and 4,200 for over the past 6 months, while market volatility has dropped. In international equities, Euro Stoxx 50 is up 12%, Japan +19% while Asia Pacific x Japan is marginally positive.

Update to our Outlook

Inflation, real economy, and income: Supply chain bottlenecks have now cleared with commodity prices down, and inflation has now moderated. We continue to believe inflation is now likely to bottom out at current levels +4% annually for the remainder of the year.

The traditional engines of growth are waning, but the US consumer is still holding up. China’s economy is strained, with youth unemployment north of 20%, interest expense as percent of GDP at 4.9% (higher than the U.S at 3.9%), and manufacturing PMI contracting. After two years of near double-digit growth,

U.S. corporate spending has been tapping the brakes as companies assess the risk of a downturn and contend with higher financing costs. U.S. consumer demand, however, is still holding up but slowing.

U.S. consumer and overall household financial health continues to benefit from several tailwinds; the opportunity to have locked in fixed rate mortgages from the infinite pool of “free money” during the zero- rate policy era; excess savings primarily built up from the massive pandemic fiscal boost (we estimate it to be about $750 billion down from $1.7tr last October), and a continued tight labour market.

Yet, U.S. mortgage rates are now 6.90%, and the San Francisco Fed Reserve estimates the excess savings available to support personal spending to run out by Q4 2023, and labour markets continue to remain tight. Other financial health factors, such as delinquencies on all consumer loans are rising but not to crisis levels. So, consumer financial health seems stable overall. But as the burn rate of excess savings comes to an end, squeezing consumer pocketbooks, and with the savings rate of 3.4% near the lows, we are concerned that the pace of U.S. consumer demand will decelerate. We interpret this to mean that the Fed is likely to hit “pause” on rates and take a wait and see approach. Any more monetary policy tightening may end up being detrimental to growth.

Equities: We have been more impressed with the ability of corporations to pass on price increases to consumers with little consumer pushback. This has prevented a more significant compression of corporate margins from inflationary pressures than originally thought and has helped equities remain within their range, yet valuations remain elevated at 18.3x (top 15% of its historical levels going back two decades)¹. Breadth remains narrow with 60% of this year’s positive performance attributable to 4 stocks, only technology and consumer sectors are up this year, and NASDAQ up 20% while the Russell 2000 small cap index is still in the cellar.

Artificial Intelligence (AI) is an emerging driver not just for technology, as evidenced by Nvidia’s latest earnings call (NVDA +159% YTD), but also for other industries such as biotechnology and financials. Nvidia has been one of our high conviction pure plays in AI and are ahead of the curve in advancing AI through their product base, such as their latest line-up of AI supercomputer chips called DGX GH200. To illustrate their value, these chips will be playing a key role in enabling other technology companies create successors to ChatGPT. This is a company we have researched and are actively involved both directly and indirectly for client portfolios.²  We see AI being a key enabler for productivity within companies and believe it will play a leadership role in the next secular leg higher for equities through the companies that are able to harness the technology.

In our view, overall equity fundamentals are not compelling enough to change our outlook, given our view on slowing demand and where cost for funding corporate liabilities outweigh the potential returns for growth. That said, performance can be found within the mix, and in our view, there are opportunities to be had through top-in-class managers focused on high quality stock selection.

Real Assets: John Podesta, senior advisor to the Biden administration, who is overseeing the implementation of the Inflation Reductions Act’s expansive clean energy and climate provisions mentioned that deployment of new solar is already cheaper than fossil power. He estimates that 75% of new power generation will come from solar in the next 5 years.³  He predicts clean energy will reduce costs by 25% by 2030, enabling further adaption. The power grid is the backbone behind global decarbonization helping with the electrification of energy and the transition to renewable power supply. As the demand for interconnection grows, investment is needed in power infrastructure to modernize, and digitize to support renewables.⁴

Conclusion

All told, we believe investors should be patient and stay the course. Given that the cost of capital is too high relative to growth, investors should maintain a prudent risk management policy towards equity exposure, remain overweight fixed income where yields reflect good value and continue with an overweight in real assets where the long-term growth story is compelling.

1 Morgan Stanley Equity Research, May 2023

2 64NW High Quality Growth Portfolio offering

3 Bloomberg Leadership interview with John Podesta, 28th May 2023

4 Guinness Sustainable Energy Research, Investment Commentary, May 2023