Rêves d'été

Rates bullish 

The path of interest rates suggested by current futures’ pricing implies that recession will be avoided, and real short-term interest rates will remain positive. Unlike the textbook cycle of raising rates, causing a recession, and then cutting rates to close to where they started, futures markets suggest rates will bottom out around 300-350 basis points (bps) above the levels they were at when the tightening cycle got underway. Short-term rates are priced to stabilise at 3.5%-4.0% in the US and the UK, and 2.5%-3.0% in the Eurozone. It’s a goldilocks scenario. The alternative, which is bond supportive, is that at some point rates will fall below what is priced, because growth will be weaker. Under that scenario bonds will outperform. But the onus is on the data, to prove or disprove, this goldilocks backdrop. Recent softer data suggests the bond friendly scenario cannot be discounted.

Indeed, June’s inflation data from the US might have started to tilt the narrative. Prices actually fell over the month with the headline consumer price index down 0.1% and the annual inflation rate falling to 3.0% from 3.3% in May. This, together with the “Sahm Rule” suggests the US is only a “0.1% higher unemployment rate” away from being in recession. The interest rate forward curve is looking too high.

Credit income 

I remain comfortable with credit as an asset class. Credit spreads widened in June, driven by political risk in France, but have since fallen once again. However, scope for significant narrowing is limited, and certainly the spread-narrowing driven outperformance of credit relative to government bonds that occurred in the fourth quarter (Q4) of last year and Q1 of 2024 is not likely to be repeated. If a growth slowdown becomes more material, some widening of credit spreads in lower quality sectors of the market may be seen. Still the additional 90-120bps of yield available on an average investment grade index will drive income returns. So far there is no evidence of credit deterioration. If the upcoming earnings season goes as expected, returns should hold firm. High yield remains the favoured credit asset class for now.

Politics will remain noisy 

So far this summer, Europe’s politics have not had a lasting impact on markets. The UK general election results were as expected, and so far, the new government has been well received. France’s inconclusive election has left French government bond spreads (versus Germany) higher than where they were a month ago, but lower than in the immediate wake of the surprise election announcement. There has been little contagion to other assets. However, the US election does have the potential to provoke some volatility. US President Joe Biden appears determined to remain the Democratic candidate, but there is clearly a desire in some quarters to replace him before November - throw that into the mix with heightened recession risk! Many market commentators are already saying that a Donald Trump victory means higher interest rates and inflation. Volatility is not likely to remain as low as it currently is.

Are small caps telling us something?

Small-cap US equities, as represented by the Russell 2000 index, have gone sideways this year. They have underperformed S&P growth equities by around 27%. Large-cap value stocks have not done much either – the Dow Jones Industrial Average and the S&P Value index have only managed 6.5%. The story is familiar. US equity returns have been very concentrated in growth stocks. The Information Technology index total return is 34%, Nvidia’s is 159%. The relative pricing of the S&P Growth index and the Russell 2000 index is at an extreme, last seen in the run up to the dot.com bubble which started to burst in 1999.

The current relative valuation of growth to small cap stocks does have some end-of-cycle characteristics. In 1999-2000, the factor that gave way was the valuation of technology stocks. Given how much talk there is about the concentrated nature of the US equity rally, some kind of valuation adjustment cannot be ruled out. However, it is hard to identify what the trigger for that would be. Earnings disappointment, or some sense the post-US election political environment might not be friendly for technology companies, are potential triggers. Equally, the upcoming earnings season might deliver strong revenues again, highlighting just how fundamental the technology revolution is.

Small cap equities have gone sideways - there could be a message about broader underlying business conditions in the US. Small-caps have underperformed US high yield bonds as well (although the rolling 24-month correlation between the two asset classes is close to 90%). Most of that high yield return has come from carry – reflecting the higher interest rate environment we are in. The small cap multiple has barely moved while 12-month earnings forecasts have been cut since the end of 2023. High yield bond performance suggests limited issues around cash-flow, but small-cap equity price performance suggests little growth in those cash-flows, or at least points to investor preference for lower risk bonds relative to higher risk equities - even when the returns have tended to be quite similar.

However, the small-cap index rallied in the wake of the good inflation data. Rate cuts might just be what the market needs to see smaller company equity prices to perform. Lower rates, profit taking in technology and small caps starting to perform. One potential scenario for the summer and autumn.

The big trends 

Economists see both artificial intelligence (AI) and the shift to a lower carbon economy as being potentially boosts to productivity over the long-term. The benefits of AI are starting to be seen while lower and more stable energy costs will be beneficial to businesses and households in many economies. Interesting then that the performance of AI and renewable-energy-related stocks has been so different. Technology has outperformed while the NASDAQ Clean Energy Liquid Series index has underperformed since oil prices rose in the wake of the Russian invasion of Ukraine. It might be a question of time horizon. AI technology is being delivered right now, while the returns on renewable energy production are still hindered by significant upfront investment and financing costs and an uncertain pricing environment as renewable energy secures a growing market share for electricity generation. However, the picks and shovels approach to equity investing around the ‘green theme’ is paying off as increased investment in the carbon transition takes place.

All I need is electricity 

Renewable energy generation is growing rapidly, and costs of production are falling. Financing costs should fall too as interest rates come down. The International Energy Agency estimates that electricity demand will grow by 3.4% per year to 2026. Better global growth, policy incentives and targets, and the electrification of transportation are key drivers. So is the technology sector. The build-out of data centres to power AI is creating rapid growth in demand for electricity. Big technology firms are committed to using 100% renewable energy and are securing renewable energy generated electricity to power their data centres and broader corporate operations. Between them, Meta, Apple, and Microsoft, for example, have recently announced that they have collectively secured over 30,000 megawatt hours of renewable energy powered electricity. This demand is increasing the share of renewable energy in power grids and improving the competitiveness of renewables pricing, to the benefit of all users. As the cost of wind and solar comes down even more, the share of renewable energy generated electricity will rise rapidly. It would be surprising if this were not reflected in broader sectoral share prices at some point.

Indeed, it is for some stocks. First Solar, a US company that designs and manufacturers solar panels, is up 33% this year. American Superconductor Corporation is a renewable generator and supplies components for power generation and grid solutions. Its share price is up by about 150% this year. There are other examples of companies in the renewable energy ecosystem that are seeing growth in revenues and rising free cash-flow. As demand grows further, revenues and profitability will improve. And the relationship between technology and renewables works in other ways. A quick look at one of the sections on Nvidia’s web site touts how its chips are being used in the energy sector to optimise demand forecasts and distribution of renewable electricity. It is a powerful twin-engine economic revolution.

Dreams of summer 

So, allow yourselves to dream a little on your holidays. Think of a future where AI delivers better outcomes in healthcare, transportation, urban planning, finance, and manufacturing, all powered by clean, renewable electricity. The potential for positive economic transformation is huge. For equity investors, having a significant exposure to these long-term trends where market growth is all but guaranteed, is clearly attractive. Valuations might adjust but the underlying economic trends are clear and should potentially bring strong returns over the long-term.

(Performance data/data sources: Refinitiv DataStream, Bloomberg, as of 11th July 2024, unless otherwise stated). Past performance should not be seen as a guide to future returns.