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Investors were very worried that 2023 would see an economic slowdown. But so far, global activity has held up well.

The US and Japanese economies posted annualised quarterly growth of 2.1% and 4.8% respectively in the second quarter. In the eurozone, despite a bout of weakness in Germany, the fact that recession has so far been avoided is a welcome surprise. China is bogged down in a serious property crisis and seeing its growth prospects deteriorate once again. The country’s authorities are currently refusing to consider a large-scale stimulus plan. Admittedly, the effects of a debt-led recovery tend to lack substance.

Although the risks arising from high interest rates and geopolitical events are ever present, we cannot ignore the fact that inflationary pressures are being reduced by much tighter monetary policies and the normalisation of supply chains. With labour markets still sufficiently robust, there is an increasing likelihood of a 'soft landing' for the global economy as the buoyant job scene is supporting household incomes and boosting consumer confidence.

The artificial intelligence frenzy has been a shot in the arm for the world's equity markets and they have clearly embraced these positive macroeconomic developments. The global equity index has gained almost 13% in euros since the start of the year, an excellent performance that inevitably raises the question of whether these gains are sustainable?

In our view, the greatest danger currently facing the financial markets is excessive optimism.

Persistent vulnerabilities

We fear that the euphoria surrounding artificial intelligence that gripped the markets at the start of the year is not sustainable. The multiples of AI companies have risen hugely while, with a few exceptions (Nvidia being the most visible), their impact on profitability is still only at the ‘pipe dream’ stage. In addition to valuation, other signs of ‘investor fatigue’ are emerging. Nvidia's share price has more than tripled this year but its exceptional results did not trigger a further surge in the company's share price. The technology-focused Nasdaq Composite index fell by 2.1% in August, its worst month since the end of last year.

The markets currently seem to be ruling out the possibility of further interest rate hikes, particularly in the US. Inflation rates are starting to ease at a slower pace as the comparison bases become less favourable in the second half of the year. In the United States, inflation rose from 3.0% in June to 3.2% in July. In the eurozone, the inflation rate was unchanged at 5.3% in August. Nevertheless, the markets are expecting the US Federal Reserve to leave its key interest rates unchanged at their highest level for 22 years at its meeting next week.

Equity risk premiums are falling

Meanwhile, Fed Chairman Jerome Powell has indicated that if the economy does not slow sufficiently to bring inflation down, the Federal Reserve will consider raising interest rates again later in the year. At the Jackson Hole summit, Christine Lagarde, President of the European Central Bank, also stressed that interest rates could remain considerably higher than they were pre-Covid. Although this year has proved to be an exception, higher interest rates tend to be detrimental to risk assets such as equities since they offer investors safer alternatives, Currently, the yield on the 10-year US Treasury note is over 4.2%, a level not seen since the great financial crisis of 2008-2009. As a result, equity risk premiums are contracting sharply, reducing the relative attractiveness of equities compared to US bonds.

Chinese growth in danger

The biggest disappointment of the year has probably come from China, and it is worth recognising the risks associated with its property and financial sectors. Its property sector crisis shows no sign of abating, with financial problems affecting new developers. The meltdown in housing sales and the liquidity crisis at Country Garden, one of China's biggest property development companies, could ripple through to other sectors, with the risk of contagion.

Diversification to mitigate risk

In conclusion, we are seeing excessive optimism in the markets. In this context, we believe that a well-diversified portfolio invested in the shares of high-quality companies and in low-credit-risk bonds is more critical than ever.

Michael Barclay
Senior Investment Advisor
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