Market in a nutshell - May 2023

Global share, bond and commodity markets were weaker in May as major central banks pushed ahead with further interest rate hikes amidst the US debt ceiling standoff. The US S&P 500 index only eked out a slight gain on a narrow, large-cap tech stock rally sparked by Nvidia’s earnings surprise.

With prospects of catastrophic American debt default behind it, the market could again fret about disinflation and the timing of future interest rate cuts. The US Federal Reserve has made strides in slowing inflation, but core inflation is still over 5%. The robust US labour market and rising wages prompted the Fed to raise rates to 5.25%. Across the Atlantic, UK and Eurozone inflation is also falling, but not as quickly as the central banks would like — the BOE and ECB each also raised rates by 25bps.

Despite the mixed data, some Fed officials, including Chair Jerome Powell, are now suggesting a possible pause to interest rate hikes at June’s FOMC meeting. Growth investors — already taken with the captivating artificial intelligence (AI) storyline — wasted no time in driving a small group of interest rate sensitive growth stocks to nose-bleed levels.

The narrow US market rally was sparked by the idea that AI will rival the wheel, printing press and internet in terms of its disruption to life as we know it. Tech giant Nvidia — whose chips power AI applications such as ChatGPT — became the poster boy for AI hype as it soared to a $1 trillion valuation. It became the fifth publicly traded US company to exceed a $1 trillion market cap after Apple, Microsoft, Alphabet and Amazon.

Nvidia currently trades at a price-earnings multiple (P/E) of more than 200 times last year’s earnings. In early 2000, another business that traded at a P/E of over 200 for three thrilling months was Cisco Systems Inc. That staggering valuation was also driven by a compelling narrative — namely the massive growth potential of the internet.

But while this turned out to be a #truestory, buyers of Cisco shares in 2000 waited 18 years to break even. Twenty-three years later, their return is a modest 1% per year even as Cisco’s business flourished as expected. As forward-looking investors, we need to consider more than just the prospects of future earnings streams for the businesses we buy. We must also evaluate whether the price we are paying for these future earnings streams stacks the odds of a good investment outcome in our favour.

Even stripping out the most expensive stocks, the US equity market does not offer much upside prospect or downside protection against things going wrong. The forward P/E for the S&P 500 median stock is currently at ~18 times earnings, placing it firmly in the top 15% of its historic range going back to the mid-1990s.

Conversely, Chinese bourses offer the opportunity to invest in growth-oriented businesses at attractive multiples. China’s activity data was weaker than expected in May, which saw its equity markets retrace heavily. However, the fundamentals still reflect an economy that is expanding — particularly in the non-manufacturing space. The Foord global funds own several quality Chinese companies expected to capitalise on economic growth and shifting consumer spending patterns.

Given their low US tech weighting, US market hedges and preference for better valued Asian counters, the Foord global funds underperformed in May. The flagship Foord International Fund remains conservatively positioned against a myriad of market risks with ~30% of the fund in cash or near cash assets to take advantage of market dislocations. The Foord Global Equity Fund is underweight expensive US tech stocks.

South African share, bond and listed property markets were materially weaker. The rand fell precipitously against the US dollar on continued load shedding, sales by foreign investors and prospects that South Africa may lose favoured trading status or even face sanctions over perceived Russian friendship. Currency weakness cushioned the Foord multi-asset funds, while the Foord Equity Fund outperformed in the falling market. The fixed income funds remain conservatively positioned, with the Foord Flex Income Fund outperforming most peers during May's market weakness.

Looking ahead, we caution against placing too much confidence in this year’s US market rally, considering the disconnect between anticipated rate cuts and their economic consequences. In our view, the Fed is only likely to cut rates once inflation moves closer to 3% and this is unlikely to happen without some demand destruction in the economy. Already, the US credit crunch following the US regional banking crisis is accelerating: 46% of US banks are tightening their lending standards — the highest since 2020 and reminiscent of past recessions.

While the US consumer has proven resilient, there are signs that this strength may be fading. Retail sales have fallen by 4.2% in real terms over the last year. All the while, borrowing has continued to surge, with credit card balances having increased by 17% over the last year — the biggest spike since the 2001 recession. It seems that governments are not the only ones struggling to break excessive spending habits. Rising interest rates and rising debt are not a sustainable combination for robust economic growth.

Lastly, while the debt ceiling resolution removes a near-term market risk, renewed Fed balance sheet tapering and sizeable pent-up Treasury issuances could suck hundreds of billions of dollars from the market. This would be a headwind for liquidity and leave the market vulnerable to another correction. Caution remains the watchword.