View From The Top: Who cares about the waiting game?

View from the very top: focus on the bigger picture. The result of the US Presidential Election is highly uncertain and may not be known for some time. Neither candidate may have a clear mandate to govern. Unrest is possible along the way. None of this may matter, beyond the near-term uncertainty. The US economy has continued to exhibit remarkable robustness despite an exceptionally divisive and unpredictable election campaign. The economic data show how growth remains on solid footing, a picture supported by the current corporate earnings season. Crucially, Central Banks have significant flexibility, should they wish to use it. Global liquidity is ample, corporate spreads are tight and debt costs are falling. Any number of factors could disrupt this currently virtuous feedback loop, while high starting points (for equities) imply lower future returns. We see a compelling logic in being both constructive and opportunistic regarding asset allocation, continuing to diversify wherever possible.

Asset Allocation:

• Equities: After its October 2022 low, the equity bull market has now entered its third year. Much of this rally has been driven by mega-cap tech, with the Magnificent-7 making up one-third of the S&P 500 Index’s market cap and accounting for half its returns year-to-date. NVIDIA alone has been responsible for around a quarter of these returns. Against this background, this has been the worst year for active managers since 2009 (all data per Bloomberg). The dominance of the Magnificent-7 has also distorted market multiples. Strip these businesses out of the S&P 500 Index (or the MSCI World Index) and the remaining constituents look markedly cheaper. We believe the rally should broaden over time, helped by improving earnings multiples. Consensus estimates are increasing following third quarter earnings.
• Fixed Income/Credit: Treasury yields have risen markedly in the last month, with US 10-year debt now offering 4.3% versus a September low of 3.6%. Higher yields may be indicative of better growth prospects and a reassessment of the monetary easing cycle. Yields still remain well below their 2024 peak of 4.7%. We see a case for investors to increase duration and to lock in debt (both government and corporate-backed) at elevated levels. Treasuries now yield more than the S&P 500 Index for the first time in over 20 years.    
• Gold: We have been longstanding bulls of the precious metal and see it playing a crucial diversifying role in investors’ portfolios. Even after its 30%+ gain year-to-date, we see a case for further strengthening. Former correlations between gold and rates seem to have broken down. We see gold as a hedge against geopolitics and de-dollarisation. Central Banks are still buyers. Gold could act as an additional hedge against fiscal profligacy.
• Currencies: Consistent with higher yields and revised interest rate assumptions, the US Dollar Index has strengthened and is now up on a year-to-date basis. Both the European Central Bank and the Bank of England appear markedly more dovish than the Federal Reserve currently. In the near-term, a higher Dollar may impact EM currencies adversely.
• Alternative Assets: Owning assets with collateral-based cashflows brings diversification to portfolios. Many benefit from an illiquidity premium too. We advocate being highly selective across this broad and diverse area, favouring differentiated and uncorrelated strategies.

In case you weren’t aware, there’s an Election happening very soon, and quite an important one too. While it would be easy to fill this document with endless speculation about its outcome and ramifications, our consistent counsel about almost all things political is to put them to one side and focus on the bigger picture. We have argued with regularity that it is the direction of travel that matters. Sure, the path forward will not be linear – and it never has been – but put simply, bullish arguments outnumber bearish ones. The economy appears robust, global liquidity is ample and Central Banks remain supportive. This is a time to be both opportunistic and constructive on asset allocation.

First, the obligatory few words on politics. More than anything, be wary of inferring causality. This is a lesson we have learned with time and applied consistently. Polls can be very misleading, per the 2016 US Election and the Brexit vote. There is also the reality that almost all politicians end up toning down their rhetoric once they encounter the practicalities of governing. Sure, Donald Trump is a better-known quantity this time around, but the world too is a different place, both economically and geopolitically. Taxes would probably fall and tariffs rise under a Trump administration, whereas an America led by Kamala Harris may have more similarities with the current government.

However, whoever wins, many things won’t change post November 5. The world will remain characterised by geopolitical rivalries, security of supply chain questions, rising populism and fiscal challenges. The winner’s ‘inheritance’ will be a federal budget deficit equivalent to 9% of US GDP and interest payments that will soon top $1tr annually (per the Congressional Budget Office). This is the problem that neither candidate has been willing to tackle. Spending is popular and so are tax cuts.

Investors could, of course, be forgiven for thinking that politics doesn’t matter. The absolute return of the S&P 500 Index has been almost identical over both the 2016-2020 period (Trump 1.0) and during the past four years (Biden). Admittedly, the ~65% return witnessed in each of these periods marks simply the gains achieved across two static points of time. Across the past eight years we have witnessed the pandemic, global instability in Ukraine and the Middle East and the inevitable consequences of both inflation and interest rate policy changes. Market multiples are clearly higher now than they were in either 2016 or 2020 – the result of the AI boom – but ‘expensive’ markets can become even more so.

Any sober assessment of the world might also question the value of forecasting. The art of making predictions in the investing world has surely been undermined by the fact that calls for recession over the last two years have almost all been consistently wrong. At the same time, expectations for interest rates (both the magnitude and the number of rate changes) have been on a round trip over the past 18 months.

Even the bulls have been proven wrong by the robustness of economic data. Optimism about the growth outlook for the US economy has only intensified as the rally has rolled on. It is notable that the S&P 500 Index closed October at a level ~20% higher than where the average sell-side strategist had assumed the market would finish this year, when their forecast was made at the end of 2023 (per Bloomberg). This is an impressive achievement, especially in the context of persistently high interest rates and an exceptionally divisive and unpredictable election campaign.

If there has been an investing lesson for this year, then it is simply look at and care about the economic data. To repeat our earlier observation, it is the direction of travel that matters. The Federal Reserve has emphasised consistently the importance of data dependency. Adhering to the numbers can be hard work, but it is in this light that the Central Bank has had to adjust its messaging, rather than Fedspeak leading the way. It is hard to disagree with Jerome Powell when he notes that the economy is “on solid ground” and policy has “no preset course.” Crucially, CPI inflation is currently 2.4% and the Fed Funds Rate at 5.0%. When inflation was last at this level (pre-2020), the US interest rate was 1.75%. In other words, there is huge Central Bank flexibility, should they wish to use it.

Much has been made of the recent rise in US government bond yields. Ten-year Treasuries now yield over 4.2%, up sharply from their September nadir of 3.6%. The ‘simple’ – and in our view, incorrect – explanation might be that yields have risen in anticipation of a Trump victory. Notwithstanding our scepticism about polling information, current voting intentions would seem to support this outcome. A Trump administration, so the argument goes, would be inflationary (via tariffs and tax cuts), hence the case for higher yields. By contrast, a simpler explanation could be that yields are increasing because economic growth is increasing. Crucially, this is not a bad outcome for equities either, since higher yields are being offset by higher earnings estimates.

Let’s go back to the data. With a 2.8% US GDP print for the third quarter, mid-quarter calls about economic slowdown look clearly to have been incorrect. The US economy seems to have entered a virtuous feedback loop of strong jobs and retail sales driving a better economy (and stock market). The latest Conference Board poll shows the percentage of consumers anticipating recession over the next 12 months is its lowest in 2 years. Ask consumers where they see inflation in a year’s time and the answer is 2.7%. Project out three years and the figure received by the New York Fed of 2.5% is the lowest it has been since polling on this question began ten years ago. Put another way, good news is seen as good news. For further evidence, look at currently tight corporate spreads, falling debt service costs and a generally robust third quarter results season. The average S&P 500 business has beaten consensus earnings estimates for the period by 7.2%, per Bloomberg.

Against this background, the reasonable question to ask is what could undermine the optimism? Near-term, we see prolonged uncertainty as potentially the biggest risk. There is a clear scenario where the results of the US Election may not be known for some time. The fact that the polls are currently pointing to a very close outcome in all three branches of US executive power is, to our minds, indicative of just how divided America currently is. A close result (or potential tie) may result in immediate calls for voter recounts, questions regarding fraud and a reduction of confidence in the democratic system. Insurrection is not impossible. Just because markets have shown a remarkable ability to surmount other recent ‘walls of worry’ does not mean that the trick can be repeated indefinitely.

Optimism about the economic outlook can also potentially bleed into complacency. Sure, the current earnings season – which will not fully end until NVIDIA reports on November 20 – has been broadly robust, but consensus estimates assume an acceleration in growth for the S&P 500 Index in 2025 over 2024. Next year’s predicated ~13% earnings expansion (per Bloomberg) may be a stretch, particularly were tariffs, geopolitics or other potential black swans to alter the growth path. Not even Central Banks can abolish the business cycle. A recession will happen at some stage. Higher starting points for equity markets also, by definition, imply lower future returns. Many would argue that neither corporate margins nor earnings multiples have major room for expansion. This reinforces the logic for diversification across portfolios.

Alex Gunz, Fund Manager, Heptagon Capital