Investment Strategy For The Second Half

Feature Stories | Jul 04 2023

Analysts offer their views on global markets as we head into the second half of 2023.

-Central banks to keep hiking
-Wall Street driven by tech alone
-AI to change the world
-Recessions still on the cards

By Greg Peel

This time last year all talk was of a return to Living in the Seventies. Inflation was surging, impacting on economic growth, and leading to warnings of stagflation, as had been the case in the seventies – a decade of economic recession.

While the seventies brought about the first attempts by central banks to control inflation with monetary policy – not previously a mandate – the mistake made, in hindsight, was to hike rates rapidly but then to quickly reverse those hikes when recession hit. While central banks, most notably the Fed and RBA, were very slow to act on inflation amidst the economic drag of covid, they have since increased rates both dramatically in quantum and in speed.

To the extent that for most of this year, markets were expecting rate cuts to have followed swiftly – if not by now at least in the second half of 2023 – as economies entered recession. But that assumption has now waned, given (a) recession is yet to be seen (by backward-looking measures) and (b), central banks have insisted there will be no cuts for the foreseeable future, and likely more hikes instead.

Central Bankers such as Jerome Powell and Philip Lowe remember the seventies. Only when then Fed chair Paul Volker decided the only way to tame inflation was through hiking rates well into double digits and forcing a recession upon the US economy did inflation begin to recede. Powell and Lowe are not going to make the mistake of cutting rates and risking a second wave of inflation growth, no matter how unpopular that makes them.

Moreover, the seventies saw prolonged double-digit inflation that make numbers under 10% look tame. Inflation is now receding globally. Slowing growth and disinflation mean there will be no stagflation.

As long as there are no external shocks, such as a new pandemic or prolonged war.

And what’s more, talk of living in the seventies has now turned to living in the nineties. The seemingly sudden rise of AI and resultant tech stock surges is being compared to the advent of the internet, and the nineties culminated in the 2000 burst of the dotcom bubble.

But is it 1995, when the internet and dotcoms took off, or 1999, being the peak of the frenzy?

Narrow-Minded

The jury is out.

“Rarely (indeed perhaps never) are bubbles forecast by the majority of market participants – or indeed much discussed ahead of time,” notes Longview Economics. “In that sense, this one will be somewhat unique if it continues to behave like it’s 1999 (which is the current favoured analogy in many circles)”.

Longview points out the advent of the internet in the nineties was accompanied by an existential digital threat – what happens when the clock ticks Y2K? Fearing planes dropping out of the sky, then Fed chair Alan Greenspan flooded the market with liquidity, just as central banks did during covid. When planes landed safely, that liquidity was withdrawn.

By 1999 any company listing as X.com surged from day one irrespective of no earnings or even revenues – just a website and a dream. Cheap money fuelled risk-takers.

US tech companies similarly surged in 2021 on zero interest rates, but met their comeuppance in 2022 when rates surged. It was not a tech wreck, rather a bear market. Those same companies have been on the move again in 2023, because it wasn’t until this year that anyone paid attention to AI. Microsoft’s ChatGPT has changed the world for ever, so we’re told.

But this time it’s not about companies with no earnings or revenues to speak of, indeed quite the opposite. The so-called “Magnificent Seven” are the most highly capitalised stocks in the world, have more money on their balance sheets than they know what to do with, and continue to be earnings machines, AI or not.

Four of those seven – Microsoft, Apple, Amazon and Nvidia – are tech wreck survivors. Google, Meta (Facebook) and Tesla are twenty-first century listings. All are seen as AI beneficiaries (Nvidia actually makes the chips) and indeed had been working on AI adoption long before 2023.

E&P Research (Evans & Partners) notes recent strength on Wall Street has taken the S&P500 net forward price/earnings ratio to 20x, for the third time in history. The first was in the nineties dotcom bubble and the second in the covid bounce of 2021.

Much of the spike in valuations is due to the tech sector, particularly the Mega Tech companies. The Mega Tech companies are now trading at a combined PE well over 30x, notes E&P. The bulls say take out the Mega Techs and the remaining PE for the rest of the market is reasonable, although E&P warns still elevated – around 10% above long term average valuations.

Brandywine Global notes the ten largest stocks in the S&P500 have accounted for nearly 90% of the index’s year-to-date returns, the highest percentage in history.