Chief Investment Officer’s Corner - October 2024

1. GLOBAL GROWTH IS SLOWING AGAIN – MORE THAN EVER, NOW IS THE TIME FOR COOL HEADS. 

Our analysis does not suggest that a recession is likely to start in the next 12 months in the US – the bellwether economy for Western investors. Still, we have increased our odds to 30% as some indicators – though by no means all – suggest that the slowing pace of net hiring has further to run. Economists refer to this kind of environment of slowing economic activity as ‘late cycle’, and during this period equity markets tend to produce positive returns but with increased volatility. 

Indeed, we saw some sharp moves down in markets during the first week in August, caused by weakening US economic data, a rate hike in Japan that caught investors by surprise, and some repositioning away from trades that had become rather overcrowded. As long-term investors, we need to return to the fundamentals at these moments, and ask if there are signs of systemic stress that could prevent a swift recovery. I like to break down systemic stress into four categories: banking stress, debt-market stress, macroeconomic stress and corporate profit stress. There were no clear signs of any, and therefore we weren’t surprised that global equities returned to making new highs within a fortnight of the early August selloff. 

This underlines the importance of keeping a clear head. Panic selling can be very harmful to long-term performance. By way of illustration, consider these facts. Over the last 40 years, there have been 73 days when global equities have notched up a rolling 1-month loss greater than 7.5%.* A sharp pullback over a short period of time starts to make investors’ palms sweaty and the ill-advised investor may sell in a panic. But in seven out of every 10 times, equities went on to beat cash over the following year, by a median 16%.* What about slightly slower but more persistent falls over two months? In the 161 days over the same time period when the 2-month loss was greater than 5% (and things haven’t turned around over the previous month) equities beat cash over the following year on 2 out every 3 occasions. 

Such statistics inform our ‘base case’. We believe that ignoring these odds and assuming the worst without good evidence of systemic stress could detract significantly from long term returns. 

*73 days since 1984. For this exercise, we don’t count days when a rolling 1-month loss great than 7.5% has also occurred on any day in the previous two weeks, as that’s effectively the same episode. We measure developed market equities in sterling terms using the Datastream Developed Markets index and cash using 3-month sterling deposit rates.

2. FINDING MARKERS OF QUALITY, RATHER THAN TRYING TO PICK THE YEAR’S BIGGEST WINNERS

There is a rich body of evidence that there are persistent market-beating returns associated with investing in companies that display markers of quality This is particularly true for companies that have historically shown relatively high returns on capital, but also other measures of quality, such as strong balance sheets and good accounting practices, among others. The evidence has won awards in academic journals and is confirmed by our own research over the last decade too. 

The ‘quality factor’ performs well across a variety of different environments, but it is particularly leading during the late-cycle period we believe we are now in, when economic growth is still positive but slowing down and when equity market volatility is picking up. 

We believe that building a well-diversified equity portfolio by identifying companies most aligned to definitions of quality (and are expected to continue to be aligned) is a better strategy than a heroic attempt to pick the biggest winners every single year. Unlike a firm’s status as high quality, big winners don’t tend to persist from year to year, as indominable as they often seem. When we look at the S&P 500 benchmark of US companies, in 15 of the last 25 years none of the ten highest-returning stocks in a given year made it into the top 10 the following year (see the chart below). In more than one in every three of those 25 years, those top 10 stocks underperformed the benchmark significantly in the following year. 

If we extend the list to the top 20, in all but two of those 25 years, two or fewer stocks from the previous year’s list of big winners repeated the feat again the next year. And on average they dropped down 235 places in the pecking order. 

3. POLLS APART

As we head into what is perhaps the most uncertain US election in living memory, the Republican candidate Donald Trump and his Democratic rival, Kamala Harris, are poles apart on significant areas of policy. These include corporate tax, energy policy, immigration and much more. That’s a key reason why this election looks more consequential for investors than the typical contest of the past few decades. The gap between the parties’ offerings has grown, and the breakdown of the previous economic consensus has expanded the options they’re willing to consider in implementing their plans.

Given a victory for Harris, the current Vice President, would likely result in the status quo, albeit with the risk of higher corporate tax rates, we’ll focus on what a victory for former President Trump might mean for your investments. A key thread running through our election analysis is the immense uncertainty that still surrounds it.

First, there’s uncertainty about the result. Harris is the favourite as put pen to paper, but only just. Her average lead in the polls is much smaller than President Joe Biden's was in 2020. It's also smaller than Hilary Clinton's was in 2016. The contests for the House and Senate are extremely close too and may not go the same way. Control of the two houses of Congress will have a huge bearing on what the new President is able to implement. 

Second, even once the result is clear, there are more question marks than usual about how campaign-trail rhetoric will translate into actual policy. This makes it hard to gauge investors’ response to the result, particularly as their preference between the parties is likely to vary from issue to issue. 

At the highest level, former President Donald Trump’s proposals appear more inflationary than the alternative of his rival, Democratic Vice President Kamal Harris. For example, the government’s budget deficit would probably be larger than otherwise given Trump’s tax plans. Labour supply would be restricted as his ‘America First’ agenda restricts immigration. And much more aggressive action on trade is possible, even if Trump’s proposed ‘universal tariff’ isn’t implemented in full. 

To balance all of the above, Trump’s platform does contain a very significant positive offset for the US stock market – corporate tax cuts. He’s also proposing deregulation for certain sectors, but the effects of these proposals on stocks are more ambiguous and probably smaller. 

It’s vital that we’re aware of the risks. But we also need to be realistic about our ability to foresee precisely what will happen. As always when it comes to elections, we should not forget the bigger picture either – the trends in the global economy and markets beyond the direct control of any individual politician. The election isn’t everything. All of this suggests we should take care not to premise our portfolios too heavily on any single election outcome.

We’ve written a US election report, Polls Apart, spelling the risks out more fully, and what the result might mean for your investments. You can access this through our Elections 2024 hub, along with a series of videos delving into the key policy areas that could be affected.