Q3 review

How to pithily summarise a quarter that began with the attempted assassination of former President Trump and ended with China’s surprise monetary and fiscal blunderbuss? The supposedly sleepiest quarter of the year delivered more than enough thrills and spills in between too.

This week, we review the months in our wake and take a fresh squint at the ever mirky crystal ball for what lies ahead (Figure 1).

(Please note: The performance context shared below is an isolated snapshot for Q3 2024. Past performance is never a guarantee of future performance).

Figure 1: Asset class returns for Q3 2024 and year to date

Source: Bloomberg, Barclays. Data as of September 2024, ATS as of August 2024. Asset classes in GBP and represented by the following indices: Cash & Short Maturity-Bonds, Barclays Sterling Treasury Bills (0-12M) TR GBP; Developed Government Bonds, Barclays Global Treasury TR Hgd GBP (60%), Bloomberg Barclays Global Inflation-Linked TR Hgd GBP (40%); Investment Grade Bonds, Barclays Global Agg Corp TR Hgd GBP; High Yield and Emerging markets Bonds, BofAML US HY Master II Constrnd TR Hgd GBP (40%), JPM EMBI Global Diversified TR Hgd GBP (30%), JPM GBI-EM Global Diversified TR GBP (30%); Developed Markets Equities, MSCI World NR GBP; Emerging Markets Equities, MSCI EM NR GBP; Commodities, Bloomberg Commodity TR GBP; Alternative Trading Strategies (ATS), HFRX Credit Arbitrage TR Hgd GBP (25%), HFRX Merger Arbitrage TR Hgd GBP (25%), HFRX Active Trading TR Hgd GBP (25%), HFRX Systematic Diversified TR Hgd GBP (25%). Past performance is not a reliable guide to future performance.

Emerging markets strike back

Looking at the year so far, returns from emerging market (EM) equities are now neck and neck with their developed world peers. However, that is really only the case because of a barnstorming last few days of the third quarter. Spurred by the dramatic unveiling of a battery of fresh measures to combat the residential property bust by Chinese policymakers, the region’s stock markets spiked.

It had become increasingly clear over the summer months that the deliberately surgical interventions announced up to that point were tantamount to a fisherman shaking his fist at the storm. Data on the economy suggested a further swoon in activity from already disappointing levels.

The measures announced and hinted at so far in a very strongly worded Politburo statement are certainly substantial, but much crucial detail remains absent. The jury remains out as to whether this is the Chinese equivalent of Mario Draghi’s epochal ‘whatever it takes’ moment.

EM assets remain a key player in a typical diversified fund or portfolio. Valuation and diversification appeal have been present and correct for some time. The Politburo’s more visible urgency on some of the Chinese economy’s structural headwinds introduces a little more tactical appeal to the asset class.

Trumped

As noted above, the US campaign trail has so far managed to deliver even more drama and intrigue than usual. Following President Biden’s career-ending debate performance and RFK Jr dropping out of the race, we have seen a levelling of the odds between the options facing the electorate. At the time of writing, the race for the Oval Office remains a coin flip, with the Senate and House of Representatives not far different.

It is always difficult to translate campaign trail speeches directly into actioned policy and invest accordingly. However, mealy-mouthed though it will inevitably sound, diversification across geographies and asset classes is the only real protection against idiosyncratic policy risk.

The US economy has continued to disappoint the doomers. Growth remains considerably stronger than most had forecast and inflation lower. Policy rates have begun their descent, but the point for us remains that the outlook for continued growth is a lot better founded than most realise. The evolving texture of the incoming industrial revolution will likely swamp anything from the next President for investors focused on the next five years.

AI and other wobbles

The impact of this new batch of technologies remains hard to assess while progress remains so brisk. The wider benefits from both machine learning and generative AI could take many different forms¹, from digitally discovered new drugs or materials (such as the AlphaFold² protein structure prediction tool or the new DeepMind materials database³). Conversely, it is already being patchily realised in the form of improved prediction and reduced inventories.

Even so, much of the debate⁴ has zeroed in on the costs over the last few months. The related data centre and wider infrastructure build-out is pricey to say the least. Businesses that were praised for their incredible mixture of giant cash flows derived from very little up-front investment (and awarded premium earnings multiples as a result) are changing.

The question posed is – if these modern technology titans are no longer as different from their rail, energy, and industrial forebears in terms of capital intensity, why do they command such a different valuation?

Time will tell of course, but there was considerable rotation in the stock market, with smaller companies, value stocks, and other unfashionable areas enjoying some support at the expense of some of the titans.

Geopolitics

The world remains peppered with tragedy of many different shades. The sharp escalation in conflict in the Middle East is one such. For investors, assessing the potential for further escalation and what that might mean is a necessary cold calculation. There are a few points to make.

First, the oil intensity of global gross domestic product (GDP) growth has fallen sharply since the 1970s. The barrels linked to a unit of GDP have fallen by around two-thirds over that timeframe. Oil demand was growing at around 10% a year in the 1970s, now it is more or less flat. These facts change how we transpose historical parallels from the 1970s onto today’s economy and capital market.

Second, there remains significant spare capacity amongst the most important producers, particularly Saudi Arabia. So far this has kept a lid on geopolitical risk premia in prices – these are not directly observable of course but inferred.

Third, the revealed preference of the main actors in this latest Middle East trauma has so far been to stay below the threshold for all-out war. Of course, that doesn’t have to remain the case and even if preferences were to continue as such amongst the leadership of the various state and non-state actors, there is always significant room for accident or mis-step.

However, the most important overarching point remains that geopolitical risk has not proven in the past to be a very useful investment indicator and there is no reason why it should be now. Past periods of surging productivity and investment returns, such as the 1950s and 60s have co-existed with much less friendly geopolitical contexts. The answer for the times when that isn’t the case is invariably diversification not disinvestment.

European doldrums (again)

Various nowcasts of the European, and in particular the German economy, are flashing red. The German economy looks to be very troubled right now and on the brink of a recession potentially. Some of this weakness in core Europe has been airbrushed by some of the brighter spots such as Italy and Spain. However, they are simply not big enough to offset the struggling German industrial sector.

One of the most closely watched European Central Bank members is the very highly regarded German economist, Isabel Schnabel. Her recent speech⁵ was seen as possibly opening the door to more forceful cuts in policy rates. As Mario Draghi’s much discussed report on EU competitiveness observed, European policymakers have full in-trays.

And finally Japan

Certainly, the most dramatic moment of the quarter in capital market terms was spurred by better news out of Japan. As central bankers became a little more confident in peeling policy rates off the floor, a whole host of trades which were initially founded on the assumption that Japanese depression would continue forever, wobbled alarmingly. Gunpowder was added briefly by some wobbly (but misleading) US economic data. We covered this in some detail in several podcasts and articles.