SustainAbility: Running with the bulls?

Despite continued geopolitical uncertainty, concerns over the Chinese economy, worries of a US recession and a US presidential election in November, equity markets are making new all-time highs.

The near-term reason is the cutting of interest rates in the US and Europe, which should support future economic activity and reduce recession concerns. The long-term reason is that we are witnessing a level of innovation and investment in the global economy which is arguably unprecedented.

The physical world is seeing a huge amount of infrastructure investment, due to a need to support the digital world’s expansion, tackle climate change through electrification, and bring back manufacturing to home countries (reshoring). The digital world continues to grow rapidly, as new technologies such as generative Artificial Intelligence (AI) are only just beginning to change the way we work. The natural world is also seeing huge potential to improve disease outcomes in areas such as cancer, Alzheimers and obesity.

Each of these areas, which can be described as atoms (physical world), bytes (digital) and genes (natural) will have a significant role to play in defining investment returns in the coming years and they all look very positive to me.

Why is the US Federal Reserve cutting interest rates?

Something unusual happened this month. The US Federal Reserve cut interest rates with the US stock market at all-time highs, economic growth at good levels, and unemployment still relatively low. Why did it feel the need to reduce interest rates by 0.50%?

There are several theories to this. The first is they are making mistake. Cutting interest rates into a strong economy when inflation is not yet back to the 2% level previously seen as acceptable will reignite inflation and lead to the need to increase interest rates again in the future.

Another theory is that the US economy is weakening in a way that investors don’t yet appreciate. Those who favour this argument point to some weakening in the labour market and an increase in the unemployment rate. If the Federal Reserve were to be taken at face value, this is the correct explanation.

One final theory is this is to do with fiscal deficits and the ability to fund them. The US government needs to refinance a huge amount of debt in the coming years which was borrowed at much lower interest rates than exist today. This refinancing, at current rates, would place significant pressure on its finances. Cutting interest rates will help this refinancing to occur at lower rates, thereby alleviating some of this pressure.

To some extent however, the reasons that interest rates have been cut, are less relevant than the fact they have been. As investors our role is not to agree or disagree, but to accept and evolve. Interest rates have been cut, and the only question of value is how that changes the view of the future.

Recession 101

Perhaps the most important influence the cut in interest rates should have is on our views on the likelihood of a US recession. After all, interest rates influence economic growth – albeit with a time lag.

It’s worth understanding the basics of recessions, and in particular US recessions. As per Yardeni Research, an economic research provider, since 1945 there have been nine US recessions, with the majority of these a result of either an oil or financial crisis. As a consequence, the US economy has been in recession 14% of the time. What can we learn from this?

One key observation is that recessions are quite rare, at 14%. Thinking of this another way, each year there is a 14% chance of a recession, and 86% chance there won’t be. It really doesn’t make much sense to bet on recession occurring. If you were to imagine a roulette table with 86% of squares red, logically you would bet on red every single time. It is often different in investing, where investors will consistently bet on the 14% black squares. It seems to me that has been the case in the last few years.

Another observation is that recessions do not come out of nowhere.

Another observation is that recessions do not come out of nowhere. It usually takes an event, like the financial crisis of 2008, or the oil crises of the 1970s to offset the natural tendency of economies to grow.

As we look at the US economy today, bank lending is increasing, and banks are well funded so there is no obvious financial crisis ahead. Despite geopolitical problems in the Middle East and Russia, the oil price remains muted, so that doesn’t appear to be an obvious source of economic slowdown.

Add into this, a decrease in interest rates increasing the chance of stronger economic activity in the future, and if the average probability of a recession is 14% then as we look at the world today it seems logical to me that it is currently below that. Although no one can rule out a recession in 2025, I think it seems unlikely.

One important consequence of this view is how to position portfolios. Speaking to a range of clients in recent days, it appears to us that the risk most investors are hedging is one of recession. It could be argued this is the wrong risk to be hedging. In my view, it seems at least as likely, and perhaps more so, that the real risk to investment portfolios is that the US (and therefore global) economy is stronger than investors expect in the coming months and years. All other things being equal (which they rarely are) this should mean inflation will be stronger than expected too.

The importance of this point is simple. When looking to hedge the risk of a recession, bonds and cash are usually the default choices. To hedge the risk of a stronger economy equities are needed. Of course, choices in portfolios do not have to be binary – it’s often more about the right mix rather than all or nothing. I would observe however that bond markets are quite pessimistic about the future currently, and if that is incorrect, they may have to adjust.

Life on the road

The annual Royal London sustainable roadshow is occurring in September with several cities already visited. Attendance has been strong and the feeling that sustainable investing can be a successful investment approach suitable for all is once again growing. At these events, we have been emphasising Atoms, Bytes and Genes as a way of looking through all the economic uncertainty to a positive future both societally and for investors. In my view, optimism is the best mentality to have as an investor, and will prove correct many more times than not. Looking at all the variables – good and bad – that we have to deal with today, I believe it is still right to have an optimistic bias.

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.