Are equity markets too complacent about the risks ahead?

Market narratives change quickly. A few months ago, investors were fretting about US bank failures and the risk of the US defaulting on its debt. Today, they are shrugging off the prospect of further interest rate rises and growing increasingly excited about an AI-driven tech boom. In the US and Europe, stock markets are up around 12% on the year as of mid-June. US equities have technically entered a new bull market, having risen over 20% from their lows last year.

The better mood is not entirely unjustified. Big companies have been performing relatively well in a challenging environment. Despite slowing growth and continued high inflation, they are set to report earnings for 2023 in line with last year’s, as they pass on cost increases to customers. US inflation is cooling and, while it is likely that growth will slow further, the US economy is proving far more resilient than anticipated.

Nor is the performance of markets as exuberant as it might appear. Stocks have been led higher by very specific sectors. In the US, the rally has been driven by large technology companies set to benefit from the AI boom – including the “Super 7.” In Europe, it is luxury goods makers that have been boosting returns. For now, investors are crowding into the few areas where they can see some assurance of growth, rather than betting on broad economic strength. Other parts of the market could catch up as investors look towards a wider economic rebound over the medium term.

The US “Super-7” are up 50% this year – the rest of the US market is flat

US Super 7 consists of Apple, Microsoft, Alphabet (Google), Amazon, Tesla, Meta and Nvidia.

^{Source: Refinitiv, Schroders as of 31 May 2023. Ex-Super 7 portfolios includes all the other constituents of the MSCI USA.}

It is also worth noting that in inflation-adjusted terms, US equities’ short-term performance has not been as impressive as headline returns suggest. This could indicate there is potential for a period of stronger performance as macro–economic conditions stabilize. Over the longer-term, the performance of US shares remains meaningfully ahead of inflation. Despite last year’s stock market declines, the S&P500 has delivered a real (i.e. after inflation) total return of more than 6% per year over the past five years.

The recovery in US equities has been less impressive when adjusting for inflation

The S&P500 (total return) adjusted for US consumer price inflation

^{Source: Cazenove Capital, Refinitiv Datastream}

^{Past performance is not a guide to future performance and may not be repeated.}

Nearer-term challenges

The key uncertainty remains the path of inflation and interest rates. In the US, core inflation – excluding food and energy – remains too high for comfort. In the UK, it is not yet even clear that it is on a downward path after it rose in April and May against expectations of a fall. 

One explanation for the persistence of price rises is the continued strength in employment markets. This is in part a reflection of companies’ success at passing on cost increases to their customers. By protecting margins in this way, they have not faced the pressure to cut staff that economists were anticipating. In the US, savings accumulated during the pandemic have also continued to boost consumer demand, though this source of support may be coming to an end.

The Federal Reserve had been hinting earlier this year that US interest rates were at a peak. It now looks more likely that the US central bank will press ahead with further rate rises over the summer. It is a near certainty that the Bank of England will do so, following the latest UK inflation data.

The higher that interest rates rise, and the longer they stay high, the likelier it is that economies eventually succumb to a meaningful slowdown or recession. Higher rates also raise the risk that we see another liquidity crisis, following last year’s UK mini-budget turmoil and the banking sector distress we saw earlier this year. Commercial property markets look like a possible candidate. The combination of high levels of debt, reduced levels of lending and changing work and consumption patterns have left some parts of the market in some geographies vulnerable.

Looking further afield, China’s post-Covid recovery is proving somewhat underwhelming. The country’s stock indices have fallen from highs recorded early in the year and commodity markets, which are highly sensitive to Chinese demand, have been under pressure. China’s rebound was never going to match what we saw in the US and Europe, given that households did not accumulate the same level of excess savings. Even so, the latest activity data has been disappointing. There are still some bottlenecks in the economy – such as for new passports – and momentum could pick up as these clear. It may be, however, that the longer-term challenges stemming from China’s property markets are limiting the scope of the cyclical rebound.

2024: an election year

Polls suggest that the Labour party is still on track to secure a reasonable majority in the UK election expected in 2024. UK finances are in a better place than they were last summer, but the bond market’s harsh treatment of Liz Truss and her short-lived administration is likely to cast a long shadow. A new government may well be wary of dramatic shifts in economic policy.

The US election could be more consequential for global investment markets. The battle over the “debt ceiling” – a legal limit on how much the US government can borrow – has been postponed until the start of 2025, just after the next US president is sworn in. This could be a tougher fight. For either party, the chance to significantly weaken a new president so early in his term may be too good an opportunity to miss – even at the cost of volatility in financial markets.

Besides the usual domestic policy uncertainty that comes with an election, this one is also likely to raise the geopolitical stakes. Tough talk on China has been a feature of each of the last two US election campaigns. The public perception of mistrust between the US and China has grown even deeper since then. The next election campaign could well see an escalation of the now long-running tensions, with the potential to depress profits and growth in both countries.