Issue link: https://maltatoday.uberflip.com/i/1504928
5.12.19 12 3.8.2023 OPINION Josef Luke Azzopardi Josef Luke Azzopardi, CPA CFA, is a portfolio manager at BOV Asset Management Limited Embracing the new reality: A new age of greater macro and market volatility is here and now T he economic challenges that characterized 2022 weighed heavily on the investment outlook going into 2023. Prevailing predictions pointed to an impending global recession, causing concern for risky assets. Investment strategists be- lieved that bonds would out- perform stocks as aggressive rate hikes concluded. Con- trarians in turn argued that the overwhelming negative consensus meant that even a lack of bad news rather than a positive catalyst would be sufficient to spark a market rally. Market round-up Despite the prevailing bear- ish sentiment up and down Wall Street, the first quarter of the year ('Q1') surpassed expectations with robust global economic growth and improved business sentiment fuelled by consumer resil- ience and China's reopening. Banking turmoil however quickly got the bears growl- ing about how the fastest hik- ing cycle in decades was in- evitably going to cause a new financial crisis as bond mar- kets priced in a recession, with many pointing to US commercial real estate as the next shoe to drop. The nega- tivity was however overdone. Indeed, it was proven that 2023 is nothing like 2008. Market sentiment rebound- ed, fueling a continued rally and increasing optimism as Q2 approached. Despite con- cerns about the lagged effects of rate hikes and tightened credit on the US, the global economy showed resilience with the rest of the world poised to counterbalance any potential slowdown. China's strong growth of nearly 10% quarter-on-quarter in Q1, combined with lower energy prices benefiting European consumers and businesses, added to the positive out- look. Recent developments de- bunked this rotational shift theory as China's reopening underperformed and Europe entered a technical recession in Q4. In contrast, the US has shown resilience compared to its peers at this advanced stage of the hiking cycle. Resilience can be attribut- ed to recently moderately restrictive monetary policy, with the real funds rate turn- ing positive in March. The private sector's strength, as consumers improved their financial position and high inflation reduced corporate debt levels, also played a role. Market performance The first half of the year ('H1') was kinder to balanced portfolios, delivering around a 7% return in comparison to the -13.6% decline in 2022. Developed market equities performed well (Q2: 7%, H1: 15%) helped by growth and inflation surprises. In Q1, European stocks slightly outperformed US stocks, supported by positive flows into the region (EU: 7.8%, US: 7.4%). However, in Q2, US stocks staged a sig- nificant comeback led by Big Tech companies (EU: 2.5%, US: 8.8%), as the China reo- pening trade ground to a halt due to weak economic indi- cators despite government stimulus efforts. Lower earn- ings expectations and valua- tions entering 2023 resulted in strong performances for US (16.9%) and EU equities (10.49%) during H1. Optimism grew as there were hopes of US inflation moderating without signifi- cant impacts on growth and unemployment. This led to the S&P 500 leading global equities into a new bull mar- ket, with a 20% increase from October's lows by early June. Credit spreads narrowed, and the investor fear gauge (VIX index) remained low. It is im- portant to note that the rally in US stocks has primarily been driven by multiple ex- pansion, while forward earn- ings estimates have declined. Mega-tech companies, driv- en by the excitement over machine learning and AI, played a significant role in shaping this market trend. The Magnificent 7, includ- ing Apple (50%), the first 3 trillion listed company, Nvidia (189%), Tesla (113%), Microsoft (43%), Amazon (55%), Alphabet (36%), and Meta (135%), delivered im- pressive returns of +60% re- bounding strongly in 2023 (2022: -40%). Mega-cap Tech in the US has been the pain trade for investors, but funds are no longer underweight. The AI gold rush boosted Tech val- uations, with multiples re- bounding to 34x, reasonably below all-time highs of 41x. Semiconductor companies, vital for AI's computational power make for the proverbi- al shovel, gained 46.3% in H1. This valuation re-rating fue- led the rise of the S&P 500, while generative AI could drive further earnings growth while Tech's cash reserves lend valuation support. The AI Revolution prom- ises economic solutions to a world facing sticky prices and slowing growth, yet his- torical evidence, exemplified by Robert Solow's paradox, shows productivity gains take time. A sudden widespread productivity spike would be truly utopic. Navigating the New Reality The market's sharp turna- round and heightened macro volatility highlight a new era of increased market volatili- ty. Commodities, last year's top performer, faced chal- lenges this year (Q2: -3%, H1: -8%), with notable declines in oil (-11.9%) and gas (-37.5%). Global government bonds posted modest gains of 1%, while high-yield credit and Italian government bonds stood out with around 5% re- turns in fixed income. Performance divergence was evident globally across asset classes, geography, eq- uity size and style, sectors, and stocks. Equities decou- pled from the credit market significantly outperforming high-yield (15% vs 5%), de- veloped markets comforta- bly outperformed emerging markets, large-cap growth outperformed small-cap value (27.5% vs 3.4%), and technology outperformed energy (39.4% vs -3.2%). Mar- ket-weighted global indices also outperformed equally weighted indices (15.4% vs 9%). Such broad divergence in performance underscores the importance of portfolio diversification. Navigating this new reality requires granular analysis, selective sector and compa- ny decisions, and identifying shorter-term opportunities. Active and agile portfolio management is essential for capitalizing on opportuni- ties and adapting to evolving market dynamics. Honoring the legacy of Harry Markow- itz, it is crucial to remember the importance of a balanced portfolio, offering protection and opportunities across var- ious contingencies. Looking forward The market debate has shifted from hard landing to crash landing, soft landing, and even no landing, and back to soft landing over the year. The global economy is softening but not collapsing, inflation is declining slowly, and Western hiking cycles are nearing their end albeit some of the impacts are yet to play out. These unexpected devia- tions in H1 have deeply divid- ed Wall Street strategists on H2. Distinguishing pandem- ic-related disruptions from normal late-cycle patterns and the underperformance of leading indicators to hard data have complicated the as- sessment of economic trends. Rather than a typical reces- sion, the US may face rolling recessions across sectors, resulting in a modest overall downturn with minimal job losses. A full-employment re- cession is conducive of a soft landing. Strategist Yardeni even suggests that the econ- omy is already experiencing rolling expansions. Major asset managers are split on the outlook: short- term optimism but grow- ing pessimism on high-yield bonds and stocks. Long-dura- tion government debt is pre- ferred. As we enter the slow- er summer season, market focus turns to fundamentals as earnings estimates decline for non-AI beneficiaries. De- spite high valuations and a concentrated equity rally, a significant Q3 pullback is un- likely due to the resilience of US equities to higher rates. Labor market dynamics keep the market tight, but profit margins may face pressure without further loosening. Upcoming Q2 earnings will shed light on company per- formance in this context. Q3 is expected to bring market consolidation, with stocks and bonds trading within a range. Market pric- ing of recession risk and signs of a credit cycle emphasize the im-portance of balanced equity positioning and quali- ty in bonds. Active and agile portfolio management is essential for capitalising on opportunities and adapting to evolving market dynamics