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Client Update - 3rd November 2023

I thought this week I would take a break from global conflict and covid enquiries and focus on some of the areas of the marketplace that are interesting our investment team. I will start with the perennial under-achiever, Japanese equities. The Japanese Prime Minister Fumio Kishida has taken a bold step to secure his long-term future with a $113bn stimulus plan recently announced that focussed on tax cuts and cash handouts, as he seeks to tackle high inflation and record-low approval ratings. This makes an interesting backdrop for us to consider further investment in this region. At the heart of the package are measures to address higher costs of living, including an estimated 5 trillion yen in temporary cuts to income and residential taxes as well as cash handouts to low-earning households. The package also includes an extension of subsidies to offset rising petroleum and electricity prices as well as support for businesses to raise wages. “Under the slogan of ‘economy, economy, economy,’ I will prioritise economy above all else,” Kishida said during a policy speech last week. “We will first ‘return’ to the people in a fair and appropriate manner a portion of increased tax revenue.” Inspiring stuff from the Japanese Premier.

Elsewhere the team continue to focus on value offered in the current rate environment – high inflation has led to high interest rates that we are now led to believe will be kept higher for longer – statements backed up by the US Federal Reserve and the bank of England when they maintained their interest rates this week. However, if rates aren’t going higher, certain assets that have been under significant pressure in recent times, such as Fixed Income bonds, can recover, and probably very quickly.

In the face of rising interest rates, corporations have reduced their debt, house prices have fallen, and banks have struggled with fiscal frugality. Can the economy cope? The probable answer is yes, on the assumption that rates have risen for the right reason. Economists typically think that interest rates are determined in the long term by the balance between the world’s desire to save and to invest. The most popular explanation for the rock-bottom rates of the 2010s was that ageing populations were stashing away more money for retirement, while insipid long-term growth prospects had sapped companies of the desire to expand—a phenomenon sometimes called “secular stagnation”.

For rates to have shifted permanently, that outlook must have changed. One possible reason it might have is the anticipation of faster economic growth, driven perhaps by recent advances in artificial intelligence (AI). In the long term, growth and interest rates are intimately linked. When people’s incomes rise over time, they have less need to save. Companies, expecting higher sales, become keener to invest. Central banks have to keep rates higher to stop economies from overheating. The interesting question though is higher rates compared to the last 15 years can still be some way below where they stand today (5.25% in the UK).

It might seem farfetched to say that optimism about AI is pushing up bond yields. Yet it would explain why the prospect of higher-for-longer has not caused stock markets to fall too much. In theory, higher bond yields should reduce the value of companies’ future earnings, an effect that bites hardest for technology firms, since they tend to promise jam tomorrow. In fact, as optimism about AI has spread, the value of big tech firms such as Microsoft and Nvidia has soared. We feel this might have moved too far and we have been reducing our exposure to this area.

To the extent that productivity growth explains higher rates, the new era could be a happy one. Set against the rise in debt-service costs, households will have higher real incomes, firms will have higher revenues, financial institutions will enjoy low default rates and governments will collect more tax. Healthy competition for capital might even bring benefits of its own. Some economists long suspected that the low-rate era of the 2010s made the economy less dynamic. “It was easy for relatively inefficient companies to stay afloat, so there wasn’t much creative destruction,” says Kristin Forbes of MIT. In a higher-rate world underpinned by faster growth, there would be plenty of dynamism.

We must not forget that a key target of indebted governments is a healthy level of inflation to erode away the real value of government debts, as it has in the past after moments of economic crisis. In that case, though nominal interest rates might be higher-for-longer, the real interest rate would not have risen as much. Companies and governments would survive high rates because their incomes would be strong in cash terms.

A realistic possibility is that high rates push the world economy into a mild recession, which in turn causes central banks to cut rates – then fixed income bonds become very interesting and we have started to increase exposure in this area. In line with this thesis, on October 23rd Bill Ackman of Pershing Square Capital announced that his fund was no longer betting that rates would keep rising. “There is too much risk in the world to remain short bonds at current long-term rates,” he wrote. “The economy is slowing faster than recent data suggests.” If he is right, higher may not be for that much longer.

As always, we have much to be keeping our eyes on. We will continue to do this on your behalf, so once the storm recedes you can enjoy the fruits of your labour. Market volatility seems intense right now, but this is very often the time that things start to get better and quite often, much quicker than we would have expected. Do have a good weekend.

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