This article appeared in the Sunday Times on 30th July 2023.
In many ways, financial markets in 2023 have been the opposite of 2022. Last year rising inflation, higher interest rates and an almost universal expectation of recession weighed on stocks and bonds and being diversified away from financial assets was a big theme.
This year, the US economy in particular has confounded the pessimists with further growth, low unemployment rates and generally declining inflation which has boosted markets.
A key question for investors now is whether 2022 was an anomaly and we are moving back to a “goldilocks” scenario of growth with low inflation similar to the 2010s, which was favourable for financial assets. Or whether 2022 was a taste of the kind of environment we might see again in the years ahead.
One reason for caution is growth. Although the global economy to date has been resilient, monetary policy impacts with a lag. It can take time for consumers and businesses to adjust to higher rates and the impact of higher rates can vary over time depending on factors such as how much debt people have and whether it is fixed or floating rate. Economists estimate that the lag is typically 12 to 18 months but a key reason why it may be towards the upper of the range this time is because the impact of COVID-19 is still being felt.
When the pandemic struck central banks cut interest rates aggressively allowing many households and companies to lock in low borrowing rates. At the same time households built up excess savings during lockdowns which are still being spent. After three years of COVID disruptions the theme in 2023 has been of “revenge spending” particularly on events, travel and entertainment. That has kept the service sides of the global economy growing but it remains to be seen how long such spending can last.
When inflation spiked after COVID many government governments provided supports to address the cost of living crisis. Such fiscal supports may have offset the impact of higher rates on households. In its recent annual report, the Bank for International Settlements suggested that governments should tighten fiscal policy to aid in the fight against inflation.
Not only has growth held up but falling inflation and optimism around Artificial Intelligence (AI) have been important supports for markets. A recent report from McKinsey suggested generative AI may deliver $4trn in value on an annual basis. Greater adoption of AI would result in higher output and lower inflation over time as the same amount of labour can produce a higher level of output boosting corporate margins.
However there are reasons not to get carried away with the AI boom. In particular both the timing and magnitude of the gains are uncertain. According to McKinsey AI will boost labour productivity but it could be by anywhere between of 0.1% to 0.6% per annum with the gains accruing between 2030 and 2050. After the development of the internet it took ten to fifteen years before there appeared to be a sustained pickup in productivity.
For markets and investors, the key question for now is whether the potential of AI will translate into higher IT spending and stronger corporate profits. However, that brings us back to the economic outlook: should the economy slow later this year as the impact of monetary tightening takes hold, spending on information technology could be cut which would be a significant headwind for corporate earnings in the tech sector.
Meanwhile stacked up against the potential positive of AI there remain a long list of risk factors for the global economy such as geopolitical risk in relation to the current trend of disengagement between the US and China, the risk of structurally higher inflation due to deglobalization and the greening of the global economy, financial stability risks from falling commercial real estate values and potential disruptions to crops and food prices from El Nino.
After the rally this year equity valuations are also less attractive and point to more muted longer-term returns. Whereas TINA (there is no alternative) was an important driver of stock gains in the last decade, with interest rates in Europe heading to 4% and in the US towards 6% there now are alternatives in short-dated government bonds and money markets.
Yields across fixed income markets are now more compelling and despite the weakness in commodities this year the longer term structural challenges around globalisation and the greening of the global economy point to longer term opportunities in commodities and commodity trading.
In short, notwithstanding the rally this year, a return to the persistent equity market gains of the 2010s looks unlikely. Investors may be better served looking to diversify away from equities rather than chasing the AI wave.
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