Cornelian Risk Managed Funds

Putting politics aside, there’s quite a lot to be cheerful concerning the investment outlook.

The interest rate cycle in major western developed economies has turned as central banks start to recognise that, with inflation subsiding to more normal levels, interest rates adjusted for inflation are too high and without action are at risk of choking off their economies.

The US Federal Reserve (Fed)’s outsized 50 basis points cut (the first this cycle) serves to emphasise the point. Labour markets remain healthy, but there are signs, at the margin, that demand for labour is softening. The US unemployment rate is ticking up and surveys of manufacturing and services companies’ hiring intentions are, at best, lukewarm. We anticipate further rises in unemployment which will strengthen the Fed’s argument to continue to cut interest rates. Falling US government debt yields translate directly into a reduction in the discount rate used to value forecast cash flows, thus boosting asset values.

However, wage growth is now in excess of inflation and with strong equity prices, consumer confidence should continue to pick up (albeit from low levels). The Fed’s actions, which seem more pre-emptive than usual, should help lower mortgage and other debt service costs.

The premium above the US government’s funding rate that companies have to pay to borrow has remained narrow which indicates that investors believe the outlook for corporate defaults within the publicly traded debt market remains benign. Corporate cash generation remains good and share buyback activity continues apace. Alongside this, we are beginning to see a pick-up in merger and acquisition activity – both indicators of improving management confidence.

Whilst some niche, sub-prime areas of the debt market have deteriorated, the risk of contagion into the wider debt markets remains low. Of all the debt sub-asset classes, commercial property debt is probably the area to focus on concerning any lead indication of stress, however this is far from ‘new’ news.

During the upward phase of the interest rate cycle, banks tightened their lending standards appreciably. This meant that corporates found it more difficult to borrow. The momentum to tighten standards has dissipated and it is not difficult to envisage a time in the not too distant future when banks start to ease lending standards and make it easier for corporates to borrow – which will help grease the wheels of the US economy.

One of the seemingly perennial issues for the global economy has been the poor performance of the Chinese economy which is labouring under a prolonged property market bust, which the authorities seemed unwilling to try to reverse. Recently, however, the authorities’ calculus appears to have changed as sizeable interest rates cuts have been enacted and mortgage interest rates have been reduced. The missing piece of the jigsaw is fiscal stimulus designed to ameliorate the property glut, however there are signs that, at last, some sort of fiscal intervention is being worked on.  

The icing on the cake would be any indication that Artificial Intelligence (AI) will indeed meaningfully improve corporate productivity across all sectors of the economy. Outside of some specific ‘big data’ applications, publicised, impactful AI use cases remain thin on the ground. This said, Google’s recently introduced AI Overview function is clearly an incremental positive to internet searches and demonstrates, in a simple way, some of the power that stems from AI-augmented services.

If successful in driving productivity improvements, AI may be able to take the credit for an extended goldilocks economic scenario where growth can continue without stoking inflation, which would clearly be a great tailwind for markets.

If the much hyped productivity improvements do not come through, the dramatic rise in the share prices of AI enablers (such as some semi-conductor stocks) are likely to subside precipitously, but this may have little impact across the wider market given analysts have yet to incorporate AI related efficiencies into their forecasts for other companies’ profit margins. There would, of course, then be the return of the more usual economic cycle to deal with.

The outcome of the US presidential election in early November is too close to call and the impact on the market from a Trump victory is hard to gauge. On the one hand, Trump is generally regarded as pro-business but, on the other hand, any moves to curb the independence of the Fed will be taken badly and new tariff regimes on key trading partners will be disruptive to trade and inflationary in the short term. With no promises from either candidate to rein in spending to deal with the burgeoning government debt, US Dollar weakness is likely to continue to be a theme.

As growth slows during a soft landing, the perceived risk of a hard landing outcome rises and so it is likely that, although we are positive on the overall outlook for risk assets, volatility is also likely to rise. Nonetheless, there remains significant monetary policy firepower to ward off a hard economic landing and support asset prices, and so we remain constructive; believing that it will pay to be nimble in order to exploit the market inefficiencies to come.