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Multi Asset Solutions – Julian Howard

Julian Howard reflects on the combination of stretched valuation and a tight equity risk premium that has made equities less attractive in the short term. However, it does not undermine the very long-term case for equities, in his view. He also notes the long-term structural case for China.

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

So the two major themes, certainly in the last quarter have been, one, the compression of the equity risk premium and two, the trouble coming out of China. And I think on the first one, if we cover the first one first, the equity risk premium is very, very narrow. Now, in fact, it is actually almost negative. So the S&P 500 is barely giving you any more forward earnings yield than the six month Treasury bill. And that is a major concern because what it is saying is that actually you don't need to invest in equities in the short to medium term, because if you invest in the six-month Treasury bill, which is giving you 5.5% completely free of risk, then that's actually a risk reward that is completely unbeatable.

It doesn't undermine the very long-term case for equities. I think that is still intact. All of the major academic studies suggest that long, long, long, long term you will get 7% real return from equities. But I think in the short to medium term, it's quite hard to convince investors that actually equities are a great place to put their money right at this moment because they can get 5.5% for taking no risk. They can take it out whenever they want and they won't make a loss. So that is basically sucking capital out of stocks. We have seen that in the flows data, particularly in the money market data. There is a lot of flows going into money markets, because clearly investors can make a fairly decent return. And in the US, bear in mind headline CPI is 3.7%. So that is a real return of over 1.5% roughly that actually investors can make without making any effort. So that's a tough story for stocks. And actually over Q3 we saw the S&P 500 or at least the MSCI world in local terms down about 2.5%. So perhaps the beginnings of some nervousness in the stock market just because of where valuations are. And similarly, and I'm talking about the US as well because that's the biggest component of the MSCI all country world index out over 60%. That's why I'm talking about the US. But the other point is that valuations are very stretched.

So I think those two combinations stretched valuation and a very tight equity risk premium means that equities don't make a lot of sense on paper at this moment. And then tied in with that, just to make things even more unpalatable for equity investors is what has been happening in China. Clearly, the real estate overstretch threatens to become a credit crunch. Not only that, but consumers are retrenching partly because of that reason. But it also means that the sort of growth boom that was expected after the end of, lifting of, zero Covid sanctions, that growth boom has never really materialized. So for a lot of investors, China is becoming a real drag on performance and also perhaps a drag on world economic growth.

So just on China, though, I would just say, I think there are some grounds for a little bit more optimism. It's easy to make that very bearish case for China. But I think there are a couple of things worth bearing in mind. Firstly, it is the structural case for China. The reality is that China represents 5% of the MSCI All Country World index, but it's actually 20% of the world economy. So the Chinese stock market will still have a major role to play in resource allocation in the country over the coming decades. That is not going away. And okay, the growth rate 4.5% is being framed as bitterly disappointing, but it far exceeds almost everything in the Western world. So I think there is still a structural case for equities in China.

I think the other issue with China, which people are overlooking, all the other benefit of China that people are overlooking, is valuation. And yes, you can argue cheap for a reason, but China is trading at almost half the forward price earnings ratio of the US. So certainly in the short to medium term, there may well be a catalyst on the back of very attractive valuations in China. So it is cheap and it promises long, long, long term returns. And I think that is a good combination for somebody with the right horizon. So I would not write China off completely. But unfortunately, in the short term it is putting investors off. It is contributing to the volatility that we are seeing along with the stretched valuations we see in the US.

What can your asset class offer in the current environment?

The key with multi-asset investing is the idea that it can keep you invested. If you buy into the idea that over the long term, stocks can deliver 7% real return. And all the major studies show this, seminal volume by Jeremy Siegel, Stocks for the Long Run, for example, or the National Bureau of Economic Research (NBER)'s 2015 paper, about the long run return of everything 1850 to 2015. A riveting read, but both of them corroborate that point that actually, over the long term, stocks can give you around 7% real return. So if you accept that point, but you want to smooth out the journey along the way and maybe sacrifice a little bit of that upside, then multi-asset investing is perfect. For the client who is happy to think into generationally 100% equities and take the rough with the smooth. That's fine. Most clients don't really have those circumstances. There is a liability to meet in the medium term, for example, which means that being purely in equities is not appropriate. So multi-asset is a very powerful way of really smoothing out that return, or perhaps another way of saying is deleveraging, the return from equities. So you still participate in the growth of equities give you, but it is done in a smoother manner. And that is highly prized particularly by wealth clients.

What is your outlook in the near and medium term?

So on interest rates, I think it is a difficult one as far as the US Federal Reserve is concerned. I think part of the problem is they have been caught out so many times saying that inflation was transitory. This was their narrative in late 2021, early 2022. And then inflation got a bit more entrenched. Yes, inflation has come down now US headline inflation is now 3.7% but core inflation is still quite sticky. We have got OPEC on manoeuvres. We have got oil and gas prices are rising. That is quite problematic. And the Fed also I think has been disturbed by the fact that inflation has been coming down even though there has been no damage done to the labour market. So there has been a lot written on what is called Potemkin rate rises, whereby they have been raising rates, but it actually has not had any noticeable effect. So the usual transmission mechanism for raising rates is that you effectively damage the economy. That slows things down and that brings inflation down. But we have a situation in the US where the economy is not damaged. The US consumer is in quite good shape, but inflation has come down quite a bit. That means that the Fed is on a sort of pathway looking for credibility. And I think that is a dangerous phase. So we have Neel Kashkari just the other week talking about how more we will need to be done. We have not really seen the full effect of interest rates. So that concerns me slightly that we could be in this higher for longer phase. And that is going to keep the pressure up on risk assets.

I talked about the risk premium being very compressed. I talked about at 5.5%, the Treasury bill (T-Bill) giving an unbeatable risk reward. If the Fed keeps rates where they are now, raises once more, you know that situation does not change and that is going to be very tough for stocks. The other thing that can happen to make stocks more attractive is clearly a major, major sell off. That would be helpful in a way. But who wants to be on that journey at the outset? It wants to get to that point via being where we are now. So that is quite problematic. The third route to improving the risk premium would be a jump in earnings, I think where growth is, I mean, US growth is okay. It is a bit better than expected, but I think it is unrealistic to expect a major, major jump in earnings. Over the last 12 months, we can see that a lot of costs have been taken out of the US companies. So there has been a sort of one off lift to earnings. But really you need to see that top line growth. And that is not particularly in evidence at the moment. So I am a bit fearful to be honest over the short to medium term given where all the valuation metrics are, the relative, the equity risk premium as well, we have got a whole heap of geopolitical risk. On top of that, we have got the US presidential election starting. The prospect of an indicted president actually sitting from within a jail cell. I don't think there is any precedent for that kind of actually, legally happened. A huge amount of uncertainty there, which just adds to that backdrop of nervousness.

I have mentioned China. Yes, it is cheap. Yes, the structural case is there, but more volatility could be delivered in the meantime. So all of that taken together, I think multi-asset investing is going to be very useful in terms of smoothing out potential volatility that we might see over the next few months. I think for all but the most committed investors, we really need that non-equity sleeve of our books to perform exceptionally well and to keep investors invested. I think that is the end goal. I think it is when we have investors capitulating, it is always at the worst possible moment. And then choosing the right time to come back in is very, very challenging indeed.

Is there one chart you’re currently monitoring closely?

Yes. So I mentioned Chinese valuation so I really like sharing the forward price earnings ratio of the MSCI China index against the MSCI USA index. So you can see that China is almost at sort of half price versus the US index. Like I said they are cheap for a reason, but that gap, the valuation gap between China and the US, certainly in the last 20 years or so, has only been seen twice in 2020 and 2021. So there is an opportunity, for investors who have a long term enough horizon to actually get involved with Chinese stocks, but obviously being aware that there are a lot of headwinds in the short term.

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 MSCI All Country World Index (ACWI) measures the equity performance of more than 3,000 stocks from both developed and emerging markets. The MSCI ACWI can be used as a benchmark to evaluate the performance of a global equity portfolio. The MSCI China Index captures large and mid cap representation across China A shares, H shares, B shares, Red chips, P chips and foreign listings (eg ADRs). With 717 constituents, the index covers about 85% of this China equity universe. Currently, the index includes Large Cap A and Mid Cap A shares represented at 20% of their free float adjusted market capitalisation. The MSCI USA Index is designed to measure the performance of the large and mid cap segments of the US market. With 627 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in the US. The MSCI USA Index was launched on Mar 31, 1986. The S&P 500 Index is a stock market index tracking the stock performance of 500 of the largest companies listed on stock exchanges in the United States. It is one of the most commonly followed equity indices. 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 US 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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