There is light at the end of the tunnel for investors

When markets are performing well, the global economy is in good shape and geopolitics is benign, investors tend to focus on a “bottom up” view of the market.

This view is based on corporate reporting, the commentary of brokers and the performance of funds. Gathering clouds are ignored and unsustainable pricing – such as interest rates at multi-century lows and negative bond yields – are regarded as the new reality.

In times of trouble, the reverse applies. The reassurance of companies, analysts and fund managers is regarded as complacent, deluded or dishonest. The focus shifts to “top-down” – an obsession with geopolitics, economics and gloomy if not apocalyptic forecasts.

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That is clearly where we have been this year, but is the mood about to change?

Interest rates are peaking and recessions will be mild

Russia’s invasion of Ukraine has been a failure and it is clearly losing the war. Commodity prices have fallen sharply from their recent highs, including oil (down 30%) and natural gas (down 50% in the UK).

In developed economies, inflation is at, past or close to a peak and likely to fall steadily next year. Global inflation, according to JP Morgan, was over 10% at mid-year but is set to drop below 4%.

Central banks, even in the UK, are evidently serious about bringing inflation down to historic targets. Interest rates are being raised but the peak is in sight and is as likely to be an overestimate as an underestimate. Ten-year bond yields of 3.8% in the US, 4% in the UK and 2% in Germany reflect confidence in central banks achieving their targets.

Economies are slowing but recessions are likely to be mild. The Federal Reserve expects 0.2% growth this year and 1.2% next in the US, while the UK is expected to grow by over 3% this year but to stagnate next.

Analysts expect negligible growth in S&P 500 earnings this year but 8% next year. On Ed Yardeni’s more cautious forecast, the S&P 500 is trading on 16 times next year’s earnings; UK, European, Asian and emerging markets are considerably cheaper.

At worst, it looks as if markets are discounting a great deal more bad news. At best, markets will rally strongly in 2023 leaving investors who have stuck to the sidelines scrambling to climb aboard. It is surely time to listen to the bottom-up view again.

There are still opportunities out there

“Investors dislike losing money twice as much as they like making it”, says Spencer Adair, co-manager of Monks Investment Trust, but “optimism pays over the long term. “It is important to be on the right side of structural change which is speeding up and spreading out.”

Ben Rogoff, the manager of Polar Capital Technology, says that “technology is still the story of the decade and has driven earnings growth both in its own and other industries. For example, it is hard to solve the climate challenge without technology.” Consultants Gartner expect IT spending to have increased by 3% this year to $4.5trn, with growth skewed to artificial intelligence, security and cloud computing.

Cutbacks in spending on personal computers, tablets and printers mean faster growth elsewhere; Rogoff expects revenues and earnings growth in the IT sector of 11%, noting that sector weakness is entirely the result of a sector de-rating to multiples “in the low 20s. We didn’t expect the scale of the pullback.”

“We are increasingly optimistic about the opportunities” says Adair. “They are similar to the midst of the global financial crisis when we bought Amazon at a time when other investors weren’t interested. At present, investors are just not interested if revenue and profits are a few years out.”

Claire Shaw of Baillie Gifford says “our core skill does not lie in macro predictions. We follow Warren Buffett’s dictum of knowing your circle of competence and sticking with it. We don’t know the outcome of all the macro-uncertainties in the market but knowing them would not result in better long term decisions.”

“What we do know is that progress on the deep underlying changes in the world, such as energy transition, digitalisation and the interaction of technology with healthcare, is not going to reverse. Market volatility is inevitable but we have been through volatile times before – for example, Tesla has been down more than 30% five times in the last ten years. Change drives growth so we focus on the deep underlying changes in the world.”

Hold your nerve for a little while longer

Even where business downturn is visible, share prices have over-reacted. Monks has agreed a merger with the Independent Investment Trust following Max Ward’s retirement but intends to keep half the portfolio, including its holdings in UK housebuilders. The share prices in this sector have fallen between 30% and 50%, far more than can be justified by rising costs and a likely moderate fall in prices, especially as this will, in time, feed through into lower land costs.

A timely warning about the short term outlook for the market is provided by Charles Gave of Gavekal. He shows that the reported profits of S&P 500 companies are running well ahead of those calculated by the US National Income and Product Accounts (NIPA). This, he says, is a sign that companies are resorting to creative accounting, a regular feature late in the economic cycle. This is invariably followed by a recession in which reported profits fall way below NIPA profits, That, he says, is the time to buy.

That suggests that there are shocks to come in the profit reporting seasons ahead featuring significant write-offs. That would be accompanied by a sharp fall in the share prices of the companies concerned and, probably, general market turbulence. Investors may need to hold their nerve and be patient for a few months longer.