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Multi Asset Solutions – Julian Howard

Julian Howard shares his summary of Q2’s events and his outlook for the rest of 2023. He also discusses the investment implications of artificial intelligence (AI) and some factors he’s keeping the closest eye on. Despite this year’s narrow tech-led stock market rally, and some stretched valuations, he also outlines a scenario which could make equities look much better value into the turn of the year.

What were the major recent events and impacts on your asset class?

I think the main event has been the onward, upward progress of equity markets. Markets have had a very, very strong year-to-date period. And in fact, they've done pretty well since last October. So that has been a kind of unbroken, fairly linear progression. I think what makes it remarkable is that certain things are sort of running against it, so to speak.

First and foremost, the equity risk premium is actually very, very slim now. So investors in the S&P 500 are only getting paid 1% more to hold the S&P 500 than to hold the 10-year US Treasury bond. The forward earnings yield on the S&P 500 is only really 1%, let's call it very roughly, let's call it 5%. Let's call the 10-year Treasury yield, 4%, give or take. So you're only getting one more percent for taking on the risk of holding equities versus the risk what's traditionally known as the risk-free rate. So that's quite an extraordinary state of affairs that actually that fundamental indicator and the equity risk premium does have a very good prognostic significance as to future returns. So the higher it is, the more returns you get in the future generally and the lower vice versa. But actually, the risk premium is really poor right now, and yet the market keeps on going. Valuations are also ever more stretched. You know, we've all heard about AI and what's happening with what's called the Magnificent Seven sort of technology stocks in the US driving the market forward, particularly up to about the end of May. You know, they dominated the market and pulled the market upwards. I think if you strip them out, the US equity market would probably be flat year-to-date to around the end of May. So the market's made progress and despite this kind of lop-sided imbalance, poor equity risk premium and very, very stretched valuations.

In terms of what would the implications be for us? What would we do about it, I think it's actually possible, despite these fundamentals, that the market continues going on and on into the rest of the year. And there are a few reasons for that. Firstly, the AI phenomenon, it's very hard to quantify and predict what the outcome for the economy will be as a result of AI. There's kind of two sceptics, two camps, one very sceptical that actually it's not going to make any difference. If you look at the US railroads in the 19th century, they didn't actually have any effect on productivity. Really nothing that the existing canal system couldn't have provided for anyway. And then on the other side, that this is going to change absolutely everything. So the sort of Goldman Sachs camp, whereby they predict that many, many jobs are going to effectively become redundant and there's going to be a huge one-off productivity gain and GDP gain for the economy. I think that still needs to be worked out. And in the meantime, the market is happy to go along with it. And of course, in the short term, markets are driven by sentiment. So that's one reason the market could continue. I think the other thing that's profoundly important development over the last few months is that inflation, particularly in the US, has been coming down.

You know, they say three data points make a trend. US headline consumer price index (CPI) has been coming down since June, July last year – the latest reading, it's now at 3%. That's only 1% higher than the 2% Fed funds official target from the US Federal Reserve (Fed). So, inflation coming down. Obviously, that then has implications for interest rates. Is the Fed done? They're surely nearer the end than the beginning of the monetary policy cycle. So the equity risk premium could improve on that basis. If inflation comes down, rates come down longer-dated yields come down, suddenly equities become more attractive relative to risk-free rates. So that's something that could develop, you know, over the next few weeks and months. And I think that's also partly why investors are giving the market the benefit of the doubt, seeing inflation coming down, anticipating the end of the policy tightening cycle from the Fed. And from then on, you know, you probably get more gains at that point. If people are more relaxed about discount rates coming down, then I think there'll be more willingness to take on the risk of equities.

What can your asset class offer in this environment?

Multi-asset investing is really there to build a kind of risk-rated strategy for clients and investors who have who have a particular risk appetite over time. Most wealth businesses, actually their most popular product tends to be a balanced-type product. Let's call it 50% equities and then 50% bonds, alternatives and cash. And I think obviously there's room for manoeuvring around that 50% neutral point, depending on how the investor, the fund manager sees the outlook. I think for us at the moment, we're just above neutral. So we're sort of torn in terms of strategic asset allocation. As I said, we've noted that the fundamentals aren't great, but it is possible for this to carry on, this market momentum to carry on. So we're just hovering slightly above neutral. But the purpose of that portfolio of any multi-asset portfolio is to fit the specific needs of that client. So the most risk-tolerant client, crudely speaking, would be in 100% equities, and then you steadily deleverage that according to the descending risk tolerance of the client. As I say, most clients tend to coalesce around a balanced strategy, and the beauty of balanced is that it offers participation, but also smoothing out of returns when you get the bumps along the road, which you inevitably do. Of course, balanced probably hasn't been very useful since October, as I said, because the market has rallied very, very steadily. But there is one consolation around that and that is that actually the risk-free rate, particularly from, let's say, Treasury bills, is very attractive. You know, you're getting 4.5+ percent out of holding very near-dated government debt. And I think that's extremely useful in portfolio construction. It's a good way to build a risk-adjusted set of strategies to complement the equity sleeve of a portfolio.

What’s your outlook in the near and medium term?

Financial assets at their heart really represent a series of cash flows. And the way you price that series of cash flows is according to the prevailing risk-free rate. So if that risk-free rate is very, very high, the net present value of the cash flows, whether it's an equity or a bond, will be lower and vice versa. So if inflation comes down and central banks feel that the job is finished, then you would start to see interest rates firstly flatten out, then start to actually come down and actually get outright rate cuts. So I think the major economy that's closest to that point would be the US. They probably have one, maybe two, rate rises left to do, unless there's some kind of inflation shock. But as I've said, there's been multiple data points now where headline inflation falls. Core inflation is a little stickier, but the general trajectory is one of easing. So that will be absolutely key if the US risk-free rates start to come down, I think that's going to be a massive boost for US assets which of course dominate global indices. US equities represent, crudely speaking, two thirds of the MSCI All-Country World Index. If you get a situation where the US equity market is being propelled by AI and the prospects that inflation is over and risk-free rates are going to come down, cost of capital is coming down, you could get this extended rally. So that I think is a key scenario for the future. Of course, it's not 100% guaranteed - we could get an inflationary upset. We could find that the Fed actually gets a bit too excited, wants to claim more of the credit for dealing with inflation, because I think one of the interesting facts of the last few months is inflation has sort of come down naturally, despite the Fed's intervention. And we know that it's despite the Fed's intervention because the labour market remains very, very tight. And it's quite rare that you actually get inflation coming down even as you have full employment and strong wage growth. So there's this sense that actually the Fed and the interest rates aren't making any difference at all. So might they be tempted to sort of participate in the final vanquishing of inflation with a belated, extra tightening more than is necessary? I think that's a risk. I think that's definitely a risk because their credibility is on the line. And I would actually say their very worth is on the line as well. So that's something that could potentially get in the way. But if we continue to see inflation fall in the US, we will see risk-free rates fall. And that just from a purely mechanical accounting perspective, that is going to be good for risk assets.

Is there one chart you’ll be looking at closely this year?

I think a really interesting one is the forward earnings yield on the S&P 500 as a line against just the US Fed funds deposit rate over time. And what's happened very recently is that they've actually crossed. So the Fed funds deposit rate is actually now yielding more than the forward earnings yield on the S&P 500. So from a retail investor's perspective, put the money in the bank or put it in equities right now, why on earth would you put it in equities? So I think that speaks to the that sort of fundamental headwind that we observe in equities. It doesn't mean equities are invalid long term. There's an extremely powerful case for them. I think that's one of the main ways to get growth out of a portfolio over a multi-year period. But right now, in terms of making it a tactical allocation, you're getting more from the deposit rate than you are from the forward earnings yield on the S&P 500. As I say, that may change very soon. If inflation comes down and the Fed drops rates again. But I think it's something that we're watching very, very carefully, because the sort of joke is that right now there's no point in equities because you're getting more for doing nothing and taking no risk. So that's something I think all investors, all investors who care about the very short term, even if they're not necessarily going to act on the very short term. I think if you care about staying up to date and care about what's happening in the short term and trying to understand what markets are doing, I think that's one of the most important charts out there.

Important disclosures and information
The information contained herein is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained herein may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information contained herein. Past performance is not an indicator of current or future trends. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice or an invitation to invest in any GAM product or strategy. The securities listed were selected from the universe of securities covered by the portfolio managers to assist the reader in better understanding the themes presented. The securities included are not necessarily held by any portfolio or represent any recommendations by the portfolio managers.

No guarantee or representation is made that investment objectives will be achieved. The value of investments may go down as well as up. Past results are not necessarily indicative of future results.Investors could lose some or all of their investments.

The S&P 500 index is widely regarded as the best single gauge of large-cap US equities. The index includes 500 leading companies and covers approximately 80% of available market capitalization. References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in indices which do not reflect the deduction of the investment manager’s fees or other trading expenses. Such indices are provided for illustrative purposes only. Indices are unmanaged and do not incur management fees, transaction costs or other expenses associated with an investment strategy. Therefore, comparisons to indices have limitations. There can be no assurance that a portfolio will match or outperform any particular index or benchmark.

This presentation contains forward-looking statements relating to the objectives, opportunities, and the future performance of the U.S. market generally. Forward-looking statements may be identified by the use of such words as; “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of any particular investment strategy. All are subject to various factors, including, but not limited to general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting a portfolio’s operations that could cause actual results to differ materially from projected results. Such statements are forward-looking in nature and involve a number of known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples. None of GAM or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made.

Julian Howard

Lead Investment Director, Multi-Asset Class Solutions (MACS) London

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