Square Mile’s team of analysts conducts regular meetings with fund managers running portfolios across a broad spectrum of assets. While informing Square Mile’s conviction in a fund manager’s process and repeatability of performance, these meetings also offer invaluable insight into the wider market sentiment among asset managers.
Recent months have seen a period of heightened volatility and fears that the US may be entering recession – an eventuality which would have a knock-on effect across markets globally. As would be expected, fund manager conversations over the last three months have offered a variety of opinions given the broad range of strategies represented in Square Mile’s Academy of Funds. However, the following observations were regular themes running through these discussions:
- Lower interest rates in the eurozone should be more supportive of European small cap stocks, which are trading at compelling valuations.
- There are some signs of a rotation from growth to value in Europe.
- The sharp sell-off in Japanese equities, and equally rapid rebound, was dismissed by many managers as short-term noise.
- The market has favoured value stocks and lends itself to bottom-up stock selection.
- In the US, the market environment swung from one supportive of growth to the threat of recession.
- Many market participants now believe a full-blown recession in the US to be unlikely, but so too is strong economic growth from here.
- Nonetheless, there are few indications that the US market is in bubble territory.
- Continued infrastructure roll out is likely to present a tailwind for growth.
- The consensus is that the Fed will start to cut rates from September.
- Multi-asset managers are divided on whether a recession is a likely outcome or not, creating a divergence in risk positioning.
- Fixed income managers are also largely in agreement that the Fed will lower rates as early as September and the Bank of England and ECB will continue their cycle of cutting rates over the remainder of the year.
- Credit spreads are generally seen as being very compressed and that elevated yields are looking attractive.
- Overall, the market backdrop for fixed income favours active management and bottom-up security selection
European equities
Some European small cap fund managers take heart from the fact that inflation concerns look to have largely abated and that interest rates look likely to be lower from here. This more accommodative interest rate environment should be more supportive of smaller companies. Furthermore, from a valuations perspective, metrics such as price to earnings and price to book suggest valuations of European smaller cap stocks remain at decade lows relative both to their own history and to large companies.
More widely, there are signs of a broadening out within the European market and of a market rotation. Looking at our data, MSCI Europe ex UK Growth was down -2.4% in July, whilst MSCI Europe ex UK Value was higher by +2.6%
Anecdotally, one manager noted that “corporate aggression”, the proliferation of bad investment decisions taken by companies, remains fairly muted. This is a window into boardrooms and is an indicator that tends to peak going into periods such as the GFC. Its current low levels may be a good indicator of subsequent performance over the next twelve months. Should it rise, this could signal cause for more concern.
Japanese equities
Investors in Japanese equities have favoured value stocks overall, with financials and those with overseas earnings doing particularly well. However, Japan was not immune to the market correction in August and it experienced a sharp sell-off due to a combination of fears of a slowdown in the US economy and a surprise increase in interest rates, which led to the yen strengthening relative to the dollar.
Nonetheless, the market rebounded very quickly and many managers investing in the region dismissed this sell-off as short-term noise. Instead, they have continued to invest from the bottom-up in stocks that they believe fit their own approaches to investing, whether value or growth, seeing this as an opportunity to top up those holdings that were hit the most on a case-by-case basis.
US equities
In the US, there has been a significant divergence in the macroeconomic backdrop to date in H2, compared to the first half of the year, where data were supportive of markets. Inflation was coming down close to target and whilst not strong, GDP growth in the US pointed to a soft landing.
More recently, weaker data led to markets becoming preoccupied with the threat of a recession. While it is not universally accepted that the necessary components for a recession are in place, a slowdown is very likely. Nonetheless, there is the view that markets are too focused on overanalysing each incremental piece of data and looking for reasons to be fearful. In fact, since Covid, the market has gone through multiple short-lived periods of boom and bust. This time, however, there are no obvious bubbles or excess demand levels in any one sector or industry which point towards the end of the cycle. There have been recent concerns over the level of AI expenditure from corporates, but our conversations with managers do not suggest a widely held belief that AI is in bubble territory. Earnings remain resilient and those companies with the strongest fundamentals should shine going forward.
Indeed, several tailwinds for growth remain, notably a catalogue of infrastructure spending programmes. The Bipartisan Infrastructure deal focusing on roads and bridges is progressing well, and it is felt that both a Democrat or Republican administration would continue its roll out. Regarding the upcoming presidential election, a Democrat victory would represent the most continuity while a Republican administration under Trump would create more complications, but a clean sweep was felt to be unlikely.
Markets were pricing in five cuts at the start of H2 although waters are muddied by the election as the Fed tends not to want to act too much beforehand. However, one manager we spoke to felt five cuts are unlikely, but expects a cut to come in September with another two cuts over the remainder of the year. This would amount to a reduction in the Federal Funds Rate of 75bps
Multi-Asset
Our conversations with multi-asset managers suggest more polarised views, with opinion split on recession being the most likely outcome or that markets can push higher albeit with more moderate growth. This means that some have been increasing their risk exposure, mainly by adding to equities, with others, particularly those with a more negative outlook, holding firm in terms of their allocations to risk.
Approaches to building in downside protection are also varied. Some managers have increase duration believing that long-dated government bonds will act as a hedge to equities. The opposing view is that they remain positively correlated leading to a preference to shorter dated issuance which offer attractive yields and low term risk.
Many managers are seeing some good opportunities within alternatives; however they stress the need to be selective with regards to the asset class and sub-asset class.
Fixed income
Among fixed income managers, the expectation was that the Fed will start to cut rates from September and the ECB and Bank of England will continue to do so in the second half of the year. However, the rate cutting cycle may be shallow and we may be in a ‘higher for longer’ environment, although one manager believes that central banks will need to be more aggressive in lowering rates. While the US is likely to avoid a full-blown recession, employment growth should slow and wage inflation will moderate. Inflation overall is expected to be stickier than the market predicts and the economic backdrop is likely to be subdued, making security selection important.
Credit spreads are generally seen as being very compressed and that elevated yields are looking attractive. Views on high yield were mixed, with some citing rich credit valuations, a gradual economic slowdown, slow rate cuts and elevated re-financing needs. Others view high yield as being attractively valued relative to investment grade bonds, although this opinion is not universally held. Several fund teams see Europe as offering interesting opportunities for bottom-up security selection as the eurozone emerges from recession to a modest recovery. Overall, it was felt that the current economic backdrop is one which favours dynamic, active portfolio management and fund managers able to identify pockets of opportunity.
