Chief Investment Officer’s Corner

1. Concentrate

Much has been said about the dominance of the big tech giants at the top of the US stock market today. Yet comparatively little thought is given to whether they were at the top 10 years ago and whether they will still be top dogs in 10 years’ time. That matters! As obvious as it sounds, we invest for the next five to 10 years, not for the past.

Businesses often don’t stay in the top 10 for long, even if they look indomitable at the time. As the first chart below shows, four or five of the ten largest stocks in any given year have typically dropped out of that group half a decade later. As a group, the ten biggest stocks don’t tend to deliver market-beating returns (as you can see from the second chart below). The last few years have been the exception, not the rule. Theoretically, when a larger portion of an index is locked up in the 10 largest companies, the better chance there is of making better returns by investing outside of that group that, historically, tend to fade after reaching the top.

Today, the S&P 500 Index is more concentrated in its 10 largest companies than ever before (they account for 33%). And the speed with which their share increased was faster than any time in the past 60 years. While that’s not to say that some of these huge companies won’t continue to excel in the coming years, we think this makes the argument for active investing – picking companies on their merits and fundamentals rather than simply buying the index – much stronger.

2. Seesawing expectations for interest rates

At the beginning of the year, roughly six quarter-percentage point cuts were expected in the US. However, those expectations have steadily lessened as inflation has reaccelerated in the US. Now fewer than two are forecast before 2024 is out, with the first not expected until autumn at the earliest.

A short-term uptick in oil prices hasn’t helped inflation. Yet the great underlying driver, ironically, is something that’s typically regarded a ‘good thing’: a much-stronger-than-expected American economy in 2023 and uncertainty about how much longer it could power on. American economic growth slowed markedly in the first quarter of 2024, yet there were some volatile, technical issues at play that may be obscuring the reality. Under the surface, households and businesses are still spending and investing steadily.

Americans are getting paid more, spending more and are wealthier than ever. The median US household’s wealth – in real, inflation-adjusted terms – soared 37% in the three years to 2022. To paraphrase economist Milton Friedman, when the economy is riding high and people and businesses are spending, more money chases the goods and services on offer in an economy. Inflation rises and the chances that interest rates stay higher to combat it rise too. (I don’t like to quote Milton very often: the empirical revolution economics has undergone in the last 30 years has disproven many of his fundamental assumptions. But he can still teach you a thing or two about inflation!)

The benchmark US 10-year Treasury bond yield (which rises when its price falls) is about one percentage point higher than at the start of 2023. It’s three percentage points higher than at the dawn of 2022. That’s a huge increase in the cost of borrowing in very short order, and it affects businesses and households too. Like gravity, these interest rates will pull US economic growth back to earth. But exactly how long it will take is a tough call to make.

Markets are fickle. They can – and do – cycle rapidly from the sunniest optimism to the depths of despair. Six interest rate cuts seemed extremely fanciful to us at the start of the year, yet there’s a good chance that fortune could upend markets once more, now that they have almost completely written off any.

3. Red hot dollar affects those around it too

It’s perhaps overly obvious, but one person’s borrowing rate is another’s return for lending money. Because US rates are now forecast to be higher for much longer, there are higher ‘risk-free’ returns to be made from buying and holding US government bonds. All else equal, that attracts investors from around the world, who exchange their local currencies for dollars so they can buy US Treasuries. This makes the dollar more expensive compared with other currencies. The dollar has appreciated almost 5% against an average of its major trading partners so far this year.

You can easily get twisted up in currencies and their effects – both theoretical and real. Yet a stronger dollar should, all else equal, ease inflation in the US and export it to other nations through higher prices of commodities and other imported goods when converted to other currencies. We don’t expect this to be a wave that changes the flow of the current downward trend for inflation in Europe and the UK, yet it’s a phenomenon to keep in mind. We think the UK’s inflation rate should continue to drop over the coming months, however a strong dollar may slow down the falls slightly.

One interesting thought to mull over is the extent of ‘an economy’ in the modern world and how a strong dollar can have other effects further afield. There are many things that cannot be moved easily – if you want a fresh coffee in New York, it won’t help you if espressos are €1 at the counter in Rome. Yet there are many markets for goods and services that can spill over from one nation to another. The internet makes it so much easier to find the cheapest option, regardless of where it’s sold. Businesses are getting in on the act too. There are numerous reports of US firms muscling into professional services in London and elsewhere, poaching high-profile talent by offering American wages. Those people then spend salaries – boosted by US affluence – in those other nations, boosting their economies.

There’s also the old-fashioned way to take advantage of lower prices abroad and a strong currency – go overseas, whether to travel or live. There seem to be a whole lot of Americans abroad right now, whether retirees doing their big tour, working-age families enjoying holidays or students opting for an exotic university experience for a fraction of the price back home. This summer, more Americans plan on holidaying abroad than anytime since the 1960s (when records began).

To be sure, the US economy is likely to slow down from here, as the effects of the past tightening in interest rates feed through. Job creation looks particularly vulnerable, which will hurt the already struggling lower-income consumers. We assign a one-third probability of a US recession developing, which isn’t insignificant. But for now, the US is booming and its businesses, households and government are all spending a lot of money. That cash appears to be spilling over into Europe and other nations as well, perhaps helping lacklustre economies that have improved faster than expected in recent months.