Focus on reviving economies
How do we get out of a situation characterised by high government debt, elevated household borrowing (despite reasonably high savings rates), and tight labour markets?
One potential route out of this stranglehold is economic growth. Robust economic expansion accompanied by moderate inflation would make debt easier to manage, but the big question for investors is whether we have the conditions for economies to flourish.
Reviving economic activity after years of lacklustre growth is currently a priority for politicians globally. It has become part of the narrative – from UK Prime Minister Keir Starmer to leaders in Europe, and even China where a blitz of stimulus measures was announced by legislators.
Although policymakers are focusing on growth, it can’t take place without the right conditions being in place. This makes it important to look beneath the surface to better understand whether a strong recovery in economic growth is realistic. With a clearer understanding of where growth might come from, investors can assess what is embedded in prices and the expectations of equity and bond markets.
Tailwinds for growth?
The Federal Reserve’s (Fed) financial conditions index (FCI) attempts to measure the broad economic situation in the US, using a range of variables including asset prices and interest rates, and how they could affect future growth.
At present, the FCI suggests that financial conditions are relatively tight but have been easing over the course of 2024. A large part of this has been the continued advance of the stockmarket, but the start of the Fed’s rate cutting cycle has also contributed.
Given governments’ fiscal positions are constrained and financial conditions for corporates and consumers are also restricted, central bank policy has taken on an ever-greater importance. If borrowing costs come down for consumers and governments, that could help support the growth outlook.
Where they go from here is critical. Interest rates are expected to continue to come down in the next 12 months which could provide a tailwind for GDP growth. But given that we are unlikely to see interest rates return to the low or even negative levels of the post-COVID era, conditions might not become as favourable as they were three years ago.
Growth expectations
If we consider the growth expectations implied by asset prices, we can see that in some areas of the market, principally US technology stocks, there is considerable optimism about future growth. Beyond this narrow category, however, equity markets have been rather muted.
Take Nvidia for instance. The stock rallied more than 170in 20243, amid anticipation about the potential of artificial intelligence (AI) and future demand for its semiconductors. Clearly, AI could have a broad range of potential applications, and it is starting to be adopted by businesses. However, it’s worth asking whether the productivity benefits achieved will match the expectations currently priced into the shares.
Could there be a degree of exuberance in certain parts of the market today? If economic growth does not reach the levels anticipated, corporate earnings could well be lower than forecast, disappointing investors.
What if growth disappoints?
Staying with AI as a focus, in order for it to flourish, there has to be infrastructure investment to underpin its operation: from the energy required to power data centres to the networks delivering the data. If future growth is below trend and governments can’t embark on infrastructure spending because of fiscal challenges, this could delay the rollout of the critical infrastructure needed to support AI.
As mentioned above, a potential consequence of weaker growth is that corporate earnings would likely be lower than forecast. This could result in less capital being available for investment (capex), which in relation to AI, for example, might consequently slow the rate of its adoption.
With scenarios such as this, it’s worth asking again whether we really do have the conditions required to drive above-trend growth. However, on a long-term view, a level of growth that falls short of expectations might not necessarily be disastrous for investors and markets.
Even if we experience weaker than assumed GDP growth, there will likely still be winners. Below-trend growth, leading to weaker earnings and likely lower levels of capex, may negatively impact the pace of AI adoption, for example. This may unsettle AI investors, but the story doesn’t just favour the chip manufacturers.
AI-related investment is needed for the additional power generating capacity required to enable it. For investors concerned about Nvidia, perhaps there are linked, but less GDP-dependent, opportunities. Might power generation and infrastructure providers prove to be safer and more rewarding opportunities?
A time for active investing?
Having examined a scenario where economic growth fails to revert to ‘normal’ levels, the critical question is what does this mean for investors? One observation is that only investing in broad markets presents a potential risk. Corporate bond spreads are extremely narrow, suggesting limited concern about defaults and the economic outlook. (Corporate bond, or credit spreads, are the difference between the yield of a corporate bond (a fixed income security issued by a company) and a government bond of the same life span. Yield refers to the income received from an investment and is expressed as a percentage of the investment’s current market value.)
Meanwhile, the government bond yield curve is pricing in some level of below-trend growth, or even recession in pockets. Does this mean that credit spreads might be vulnerable to a more challenging economic environment?
Within the equity market, there is arguably plenty of excitement about tech, but little else.
Thus far, investing broadly has been successful but as we look ahead, a more selective approach would appear prudent. If the growth story disappoints, some expectations could be upended.
This is not to say a recession is going to happen; that is not our prediction. But, in our view, there is still a great deal of normalisation that needs to happen to return to an equilibrium where the relative values of different assets make sense.
In this scenario, we believe a more selective, active approach is needed to identify investment decisions likely to deliver the best returns. This is no time for investors to become complacent.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. We are unable to give financial advice. If you are unsure about the suitability of your investment, speak to your financial adviser.
The views expressed in this article should not be taken as a recommendation, advice or forecast.
