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 have started to recognise that 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 (bps) cut (the first this cycle) served to emphasise the point. They have since followed-up with a further 25 bps cut. Labour markets remain healthy, but there are signs, at the margin, that demand for labour is softening in some sectors. The US unemployment rate is ticking up and this dynamic may strengthen the Fed’s argument to continue to cut interest rates.

However, wage growth remains in excess of inflation and with strong equity prices, consumer confidence is likely to continue to improve, unless there is a labour market shock. The Fed’s actions, which seem more pre-emptive than usual, should help 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 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. Fiscal stimulus designed to ameliorate the property glut has been announced but further policy support is needed. This cannot be ruled out, especially if the Trump administration levy punitive tariffs on Chinese exports.  

Taking a step back, the icing on the ‘stock market’ 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 widespread productivity improvements, AI may be able to take the credit for an extended goldilocks economic scenario where growth can continue despite low unemployment, 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.

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.