Video Q2 market outlook webinar: Navigating choppy waters

(00:01): Good afternoon everyone. Thanks for joining us. I'm Anthony McDonald, Head of Portfolio Management at Aegon UK. And I'll be joined later by Dan Matthews, who's a Senior Investment Manager on my team. In the next 30 to 40 minutes, we'll revisit some of the themes and opportunities that we see in markets and how we're navigating the economic and political crosswinds. As always, and this is important, there'll be time for questions at the end. We leave plenty of time for questions, so please do use your Q&A button on the teams screen to put in any questions you've got and we'll answer as many of them as we can at the end of the presentation. Just as importantly as we get towards the end, the CPD certificate link will turn up in the comments section. So do please look out for that. Linked to that CPD, here are our learning outcomes of identifying economic background, market themes and understanding opportunities and our views. And that's broadly what we're going to go through in the next half hour or so.

(01:10): As always, I will very quickly start with our investment philosophy. It does frame, as you'd hope, the way we think about investments and markets and the way we present them. So it is always important to remind you that we do take a long term approach to investing your client's money, it's anchored by our valuation analysis, and we think that the combination of understanding and analysing evaluations and looking to capitalise on opportunities over the medium to long term really are edges in navigating the funds through different market environments.

(01:48): And for me, this is the chart that captures the story of this year so far. After the big bond rate that we saw at the backend of last year, we entered this year with markets implying the interest rates with fall from over 5% in the US to under 4% by the end of 2024. And that's what you see on this chart. So the blue line is the actual level of interest rates and then you see the kind of spaghetti lines kind of branching off from it. Purple is what was implied by the pricing in markets in the end of last year. And then orange is the much more recent what was implied in April. So you can see it in the last year, the purple line, that interest rate of over 5% was expected to come down to under 4%.

(02:44): But most of those rate cuts have now been priced back out as we've moved back towards that orange line. Much flatter trajectory, investors confronting that seeming reality in the first quarter of stickier inflation, healthy US growth, and starting to question the degree to which central banks, in this case, the US Federal Reserve, would want to and feel able to reduce interest rates. We think this is critically important for all markets and asset classes. Jerome Powell Chair of the Federal Reserve, he's told us and we think the data supports this, that interest rates in the US are currently at restrictive levels, meaning essentially that they are weighing on the economy as the authorities try to drag inflation back to target. Now and the longer they stay there, and the orange line is saying that might be longer than many investors hoped at the end of last year. Then we see the higher risk of an economic accident or general downturn. And that would come with implications for equities, credit bonds. So we think the the interest rate that economies can tolerate and how quickly central banks are willing to get there is the key question in markets right now.

(04:10): Now, one of the notable as I say, probably more unexpected developments over the last 12-18 months, and we spoke about this a bit before, has been quite how strong the US economic growth has been in the face of those sharply higher. And as we said, probably restrictive interest rates. What we see here is that the purple and red lines, UK and the Eurozone, those economies have been basically flat lining since the backend of 2022. You know, those growth rates, quarterly growth rates fluctuating broadly around zero. But at the same time, the blue line, the US has been carving its own path, seemingly oblivious to any headwinds to to economic activity. And if anything, you can see on an upward trajectory for most of that period. And the question we think or we've been asking ourselves for over this period is why has that economy been so resilient? Because that's important for us to think about what happens next. And we think there are a few factors that have been at play here.

(05:21): First, there's plenty of evidence that consumers entered the period financially in rude health. Covid restrictions are combined with government support payments straight into many bank accounts to create this combination of higher than usual savings and pent up demand as economies reopened. And what this chart from the San Francisco Feds tried to show is it's their estimate of how much extra money in aggregate that there is in those consumer bank accounts as a result of those stimulus payments. And what you see here is over 2020 into 2021 as people were stuck at home more than they wanted to be, and as they were getting support payments, those excess savings went up. And since then they've been gradually going down as as individuals have been willing to use those savings.

(06:21): And the key point here for us is that you're broadly down here towards a zero level. Actually, the most recent update to San Francisco Fed suggests that number might be actually slightly below zero. Either way, suggesting that stock of additional excess savings has probably been spent. And what we think that means in a nutshell is the US consumer is likely to start finding things just a bit more difficult maybe having to make some of those tough choices that could be postponed before. You know, I say a marginally more difficult backdrop for an economy generally.

(07:04): Now, the consumer has not been the only engine of spending. The government's been hard at work too. And we can kind of see that here through the US government deficit. So, you know, when we're below the zero x axis, which basically have been for most of the period since 2000 that means the government is spending more than it's receiving. And what you can see at the end there, I've marked it with that green arrow, is actually over 2022 to 2023, a pretty large expansion in that government deficit you know, from that peak to trough there about an extra five percentage points of GDP in deficit. So that's a lot of government spending going into the economy. If we just eyeball that chart, it's an unusual increase in the deficits outside a recession.

(08:00): And we think that's been really supportive to economic activity. Now, clearly there's a US election later this year, and we may come onto that in the questions later. Please do, as I said, put questions in the q&a part of your teams screen. And with that in mind, we are not suggesting we think there's going to be a sudden government retrenchment and they're going to suddenly stop spending money. But what we do think is it's very unlikely that we see another five percentage points put on this deficit in the next year. Actually we think that's probably close to impossible. And so at the very least, we think the government contribution to growth is likely to slow and could slow quite considerably. And again, that will just create a slightly more difficult economic backdrop to be operating in.

(08:47): And here's the third thing that I wanted to highlight that's been happening. The kind of reality and the impact of it is a little bit more complicated on the economy, but I think it's been very important. And Chair Powell sums it up well by saying - I put it at the top there in the strap line - that the US is a bigger economy. And you know, that's reflected by strong growth without being a tighter economy, it's put it as where inflationary pressures were decreasing. So normally when your kind of growth picks up and gets beyond what people think as trend levels, and you have overheating economies, that comes with inflationary pressures. And he's been highlighting that it has perhaps in the recent past, been possible for the US economy to grow and to grow well, while inflationary pressures are still falling.

(09:32): And a lot of that comes down to the growing supply side. And actually I think particularly immigration. And that's what this chart captures. You know, the purple line is the January, 2023 congressional budget office reality and forecasts on immigration from 2000. They go all the way up to 2053. I've just stopped the chart at 2030. Because you get a steady state from from then on. And then the blue line is the same data updated for January 2024. And just have a look at that difference in the kind of that recent immigration experience compared to previous estimates and forecasts. It really is quite astonishing. And if we take the whole window that's an upward revision of over 8 million people. That's 13.5% percent over 2000 all the way up to 2053.

(10:26): So a really significant upturn in immigration which typically there's lots of different ways it can play out over the short and long term, but economics 101 is good for the potential growth of a country. A higher labour force is a good long-term thing to have. A growing labour force is a good long-term thing to have, all else being equal. But what we're also aware, as I mentioned before, is there is an election this year and immigration as we know is one of the key flash points in the US political discourse at the moment. And we find it unlikely in that context, and particularly if President Trump comes to power, that the kind of upturn in immigration versus previous expectations will easily persist over the coming period. And again, what that means is it may very well be that that concept of a bigger economy, good growth where inflation pressures were decreasing just gets a bit harder. The best may be passed for now from that side of things.

(11:40): And so if I quickly put all that together. US growth has been comfortably stronger than some of the other economies, the UK and Eurozone, where interest rates are also going up that notable exceptionalism. We think there are risks rising to some of those key factors that I've pointed to as potential drivers of it. And we think that'll create higher challenges as this year progresses. But at the same time we think that other parts of the world are on an improving path and none more so actually than here in the UK. This shows the quarterly growth figures as a bar chart instead of a line chart. And I'm sure all of us will know well from the headlines and the hand-ringing that, you know, these see those two negative bars at the end of 2023.

(12:33): Yeah, a slight access label there, sorry, apologies. At the end of 2023 you know, we entered this technical recession two negative quarters of growth. And that's clearly a challenge, economic backdrop, and it was in many ways a manifestation of what we'd seen over the previous 12 to 18 months. You know, that flat down growth just tipped on the wrong side of zero for a couple of quarters. But actually as we'll see in a bit, we think that investors actually understand those challenges and that the UK has been mired in economic challenge, both structural and cyclical for quite some time. And we are much more interested in the signs of life entering 2024. And on the right here, I've shown this chart before but I think it's important, so I put it on here again, it's just showing that kind of the real pay growth, real wages in the economy flipping from deeply negative 2022 into 2023.

(13:30): And that's the cost of living squeeze that we all remember well. Where when, when pay rises were far from keeping up with the inflation and the cost of living, to where we are now, which is that the inflation has come down a lot faster than all the data on pay. And that's a pretty healthy real wage level that we've had here for a few months now. And we think that's a really much more supportive backdrop for all of us, for consumers, for the economy. What we see on the left is the UK now reports growth estimates on a monthly basis, and the rolling three months of that, you can see a real pickup from the start of the year, really, you know, we've been in that kind of negative period for quite some time, but it's flipped to a reasonable positive area. So we think that is indicative that some of those less difficult backdrop to the UK economy is indeed coming through the way we've been hoping.

(14:35): And it's not just the UK either. We've also seen decent evidence of a stabilisation and kind of progressive improvement in China's economic activity over recent months after, you know, quite a prolonged period of challenge. Here I've tried to capture that with a PMI that's just a widely followed business survey. Anything above 50 aims to represent expansion month to month, anything below 50, contraction. And you can see now from that kind of fading period in over most of 2023, we've had a kind of a stabilisation, a gradual recovery. It looks to be an economy that may be back on the right path again. And there's still plenty of challenges in the Chinese economy, but again, as in the case of the UK we argue that's pretty well understood and predicted by investors. You can see that in some of the valuation metrics we look at. And actually what may be underappreciated is the potential for kind of improvement in recovery in the case of China. You know, the authorities have increasingly shown willingness to provide policy support for the economy directly for equities, actually. And we think that's an interesting backdrop for opportunity.

(15:56): So, big picture, if I summarise that message very quickly. It's really that that US exceptionalism has been an important economic theme for quite some time. It's no surprise that investors would either subconsciously or consciously extrapolate that forward. It's been something that we've really been been living with. But actually we've looked at the pillars that we think have underpinned that over the last 18 months. And we've looked at what's created the difficulties for some of the other economies like the UK and China. And we really think there's an opportunity for much more economic conversions this year. We think that's a little bit against consensus and expectations, and we think it can lead to a change in a broadening out in the market environment. And actually, I'd say since we put these slides together, we've seen the Q1 growth rates for the key economies. That's absolutely what we're starting to see in the first quarter. UK quarterly growth came in at 0.6% it was ahead of the US and we think that there was more to come in terms of convergence and action, particularly compared to expectations, which seem to us to be the other way around. So with that, a bit of a flavour with economic backdrop I'll pass over to Dan who's going to talk a bit about market performance and the areas where we're finding opportunity.

(17:11): Thank you. Great. so I'm going to start. So my slides today are looking a little bit at Q1 performance. So let's start by looking at that chart that's over there on the right. There's a whole bunch of different asset classes represented here. Most of these are held by the funds the exceptions being, we have high yield bonds and oil on this chart, and we hold no position in either of those, but we do hold the rest. You can clearly see that equity performance has been strong over the quarter. So all the equity markets are primarily crowded over there on the left hand side of the chart with the big bars. And then fixed income is of course, mainly over there on the right, with kind of flat to slightly more mixed returns. Special mention there for oil, who's the, the second bar along, which is 15% plus return for the quarter.

(18:01): It's worth highlighting that this chart is in base currency and obviously as you're most likely aware, some currencies in particular, the yen have had some fairly significant moves in recent times. And so, you know, this chart would look different if you were a serving investor or an investor from a different part of the world. But overall, I think most investors in a multi-asset fund, exposed to a range of different asset classes, would've enjoyed positive returns over the quarter, although with a fairly significant return differential as you go up the risk range. So obviously the higher risk funds have a higher proportion equities and therefore they're more exposed to to the left hand side of this chart versus the right. Next slide, so obviously on the back of a pretty good quarter for equities, we're going to talk about our favourite topic, which is valuations.

(18:49): So, you know, you might anticipate that valuation backdrop has shifted. Anthony's talked a bit about the macro backdrop for the US. So now I'm going to sort of take a step back and look at where the valuations are. So if you think back to our philosophy, we always try and have this dual mandate where we start with a view of whether an asset is cheap or expensive, and then we place that in the macro context. It's never one without the other, but you can always expect our team to have a view on both the valuation as well as kind of the macro context for all of our assets. So this is long-term valuations in the US. We've looked at this chart before, I'm sure some of you recognise it. It's a chart of the US CAPE ratio. So just a reminder, CAPE is the cyclically adjusted price earnings ratio which is a version of the PE ratio. So the PE ratio is the ratio of a stock price relative to its earnings. The CAPE is a similar thing, but what you do is you smooth out the earnings component. So the idea is that this would remove some of the economic noise from the earnings, and it's a better measure when you are doing a longer term chart or a longer term view of valuation.

(19:56): Obviously in terms of longer term views, this is about as long term as we get. This chart starts in 1900. We're pushing ever closer to having 125 years on this chart. And you know, when the cap is high, what we can say is that US shares are expensive versus their history. The inverse, of course, therefore being that when it's low, we can suggest that they might be cheap. Some pretty big prominent spikes on this chart. One being kind of the roaring twenties, the late twenties, and the second being the .com boom. And you will notice, of course, if you look to the right on the chart, that we are within a third one of those large spikes. So we're back to very elevated valuation levels as measured by the CAPE. Obviously, we don't kid ourselves that the US market today is directly comparable to the past. You know, the 1900s was a long time ago. We take it with a pinch of salt. But even when you do that, this provides some useful context as to whether or not the US is expensive versus its prior history. So we think it serves as a good starting point for for our analysis. Next slide, please.

(21:04): So why does high valuation matter? Again, this is a chart that some of you would've seen before. We're very fond of this chart. We're looking at the CAPE ratio again, so similar data to before, but plotted slightly differently this time. So this time we've got around 30 years of data on the chart, and we're looking at the CAPE across the bottom here, but we've plotted it against the next 10 years return on the left hand side. So the CAPE ranges from around 10 at its worse to around 40 at its best. And then during the same sort of period, you get a return for the next 10 years of between minus five and plus 17 ish. Obviously the chart has a pretty clear slope showing you pretty good relationship between the two. The r squared there is on the line is on the chart 0.87.

(21:50): So r squared a sort of a measure of correlation, and it measures the strength of that relationship. And 0.87 is a very strong relationship between these two things. So this means that, you know, in almost all cases there is a strong link between a lower CAPE ratio and future returns being good, and a higher CAPE ratio, and then future returns being poorer. So, on the data alone, it suggests that the CAPE ratio is something that's worth paying attention to. The purple line shows where we were towards the back end of Q1. CAPE was 36.12. Look at that on the other axis. And you end up with a forward projection for the next 10 years return of zero. Do we expect exactly zero. Probably not. We aren't in building mathematical models through our work. We're using this to inform a wider view. There's a lot of real world change going on AI, productivity, different management practices, but regardless of the exact accuracy of the number, the chart and the strong relationship there suggests that on a long-term basis, the US has a poorer-looking, forward looking return when you start with valuations where they are.

(23:05): So I guess the core point and the point that we push a lot is that, you know, when we say that we think valuations matter and that there are key determinants of those longer term returns, the data kind of backs it up. Last point in this chart, and again, one that we always make, we show this, this is the relationship between the CAPE and the next 10 years return. It's not the relationship between the CAPE and the next one year's return. And I think this is an important distinction. The CAPE is a good predictor of longer term, under or outperformance. But it doesn't tell you a huge amount about the path that you take to get there. And this links back to our investment philosophy and the idea that that long-term view is crucial to being successful.

(23:45): You know, the US could continue to outperform on the back of the AI led boom that we're seeing. And if that did, if that happened, we would continue to see that as a tailwind for our portfolios. Doesn't necessarily mean we'd look form, you know, we are underweight in the US we would not participate in that boom as much as others might. But you know, this is not the only position we have on. We have, you know, we believe there's lots of other opportunities elsewhere we're taking advantage of, but a boom in the US would continue to be a drag on performance. But we're not aiming to be the sort of products that would buy into a bubble simply because it's going upwards. You know, we start with those valuation. Our philosophy is about providing investors with a safe place to put their money over the longer term. And with that in mind, when you look at a chart like this, the longer term suggests that underweight in the US is entirely appropriate. Next slide please.

(24:39): So we're still on CAPEs here. But following the theme that that Anthony used, we're now looking at the UK having looked at the US and this time we've combined two CAPEs into a single chart. So this is the relative CAPE between UK mid-cap and UK large cap. So it's a chart of the cheapness of smaller companies compared to their, their larger counterparts. When the line is lower, smaller companies are cheaper than their larger peers. Inverse is true when the line is higher, that means that, larger companies are probably more attractively valued. If you think back to what Anthony said about the UK economy, that sort of growth in real wages that we're seeing, you combine this with those smaller companies, they're typically more exposed to that domestic economy. And then you look at this chart and you say, okay, the smaller companies are also historically cheap versus their larger peers. You can start to see why we're becoming more constructive on mid-caps. And indeed the fund has added some positions there over the recent periods. We don't have a chart on it in this deck. But if we were to just look at the valuations of mid-caps in isolation you would see a similar chart. You would see that the mid-caps, even on an absolute basis without being compared to the large caps, are also very cheap versus their own history. Next slide please.

(25:58): So here we're turning to fixed income. And as we saw in the very first slide in the deck today, Anthony showed us that the market has kind of entered a period of disagreement around the size and speed of those interest rate cuts. We've seen the expectations shifting over time. But you know, whilst there's volatility there, what's worth noting is that almost all of this debate now relates to cutting, and very few participants are calling for a hike. We agree with this consensus. We believe that, you know, absent and unseen surge in inflation caused by something that we can't yet predict, it is likely that rates have peaked and therefore the direction of travel for interest rates is, you know, at worst, sideways and most likely downwards. So this means that once again, bonds can play that diversifying role within multi-asset portfolios.

(26:48): You know, they're likely to offer some downside protection whilst at the moment they also offer a pretty reasonable yield on an absolute basis. Because of this, the fund sort of currently holds an overweight position in duration with a preference for UK government bonds. Whilst we have become more constructive on duration as a whole we have seen significant tightening in investment grade spreads. So this is the chart over here on the left, you know, the spread being the amount of extra income that investors demand in order to lend to a company versus lending to a government. So if you are concerned about a company's ability to repay you would demand a higher spread. So a higher overall interest payment on the chart here, the blue line is the US the purple line is the UK. You see spikes there at times of distress.

(27:36): So during Covid you see that the spreads go higher. That's because the market's concerned about company's ability to pay during these periods. But what you can see is that currently we are very much not in one of those times. And in fact the blue line there, which is the US, is about as low as it goes within the time period we're showing here. So because of this timing, we believe that investors are no longer being compensated as well as they perhaps ought to be for the additional risk that comes from the investment grade bonds. And therefore, we've begun to trim our exposures in this area. Just to be clear, that's not to say that we think investment grade bonds are still not an attractive asset class, overall the yields are still pretty good. It's just that their relative merit versus other assets have decreased and therefore we becoming less constructive on the asset class. Next slide please.

(28:28): Finally, we're going to turn to equities. I'm not going to say a huge amount about the valuation here. I think we covered a lot of valuation in the US. Obviously the US is such a large part of diversity markets that that therefore translates into a relatively high valuation overall for global equity markets. And as such, our equity positioning remains neutral. We do see pockets of value. We still have overweights in emerging markets in Japan. We've recently initiated that position in UK mid-cap stocks. And so we think there are, there are some good opportunities there, but we think are cautious in our approach, and the overall equity level is appropriate given the valuation levels that we're seeing. The chart on the right here is just for fun, depending on your definition of fun. But what we're looking at here is, is an index of companies that have been deemed to have exposure to AI. So that's the purple line and then the blue line we're comparing it to is the S&P 500. So the broader US stock market. And it just serves to remind us that we are currently seeing a very narrative driven market. And so again, some caution seems appropriate given, given the valuations and what's been driving a lot of the performance. Next slide please.

(29:43): I'm going to pretty much skip over this slide. I think we've covered most of the asset classes throughout the presentation. I would just note that the funds are positioned to take advantage of the views that we've explained. The one thing that you would see here is, you can see that downgrade of the investment grade credit due to those tighter spreads, that is from an overweight to a neutral. So, back to the point that I made that we still think that asset class has merit. This is not an underweight, but we are becoming less constructive there. And otherwise just generally we remain patient investors. And we believe that the fund is very well positioned to take advantage of those longer term visitations that we're we're seeing in the market. Next slide.

(30:22): So last slide in the deck, we've made it. So just to conclude today and before we move on to questions. So please put any into the chat. This is where we are. We believe the US exceptionalism is very much priced into markets. You know, that they're very keenly valued and indeed Anthony talked a bit about it. We see that maybe some of that exceptionalism might in fact be failing. We do see pockets of value outside of the US. So for example, the mid-caps, but also also Japan. We've reduced our corporate bond exposure because the asset class is becoming more expensive. So if we've made some changes there and then overall we share the view that others have, that interest rates have probably peaked and we think this is likely supportive for government bonds on a forward looking basis. I'd like to thank you all for listening to what we have to say and we'll take any questions that you might have. Thank you. Alright, I've got a question for you Anthony. I'm going to pinch it from the chat here. Any thoughts on the UK election in the context of our midcap position?

(31:41): Oh, that's a good one. If you've seen the local elections and the polls are pretty clear. It'd be surprising if Labour weren't the next government. I suppose the way we think about it is it would likely be a transition from a centrist conservative government to a centrist Labour government. And so in itself we don't expect significant political noise or negative ramifications. We think that the financial position of the country will be pretty similar either way. And if anything, you might unlock a little bit of consumer confidence by having what's perceived to be a slightly less dysfunctional, is that the word? Government and political systems. So at the margin we are quite hopeful that the election might drive a little bit of sentiment, but big picture we don't expect it to be one of those more one of the more market moving elections, either this year, I mean the US or probably take that crown, or compared to kind of the recent past of UK elections when we've had options like Jeremy Corbyn's more left wing policy platform at play.

(33:09): Anything you'd add there, Dan?

(33:13): I largely agree. I think the risk, not the risk, but I think the polls show that Labour is most likely to win. I think that will be the outcome. I suspect as we go through an election campaign, some of those polls tighten a little bit and some of the projections for Labour are perhaps a bit overdone which we'll see, but, historic history shows the incumbent normally does a little bit better as campaigning progresses in part because when you are the incumbent, you are in power and power allows you to act. When your opponent is criticising you for something, you have the ability to change it. And that normally provides a bit of headway for them. But I suspect whatever happens, Starmer will be the next prime minister in the UK. So I agree, I think broadly speaking, the UK political landscape, it would be uncomfortable with any major deficit-extending policies. And so we're likely to see a fairly sort of, slightly more socially-left, but not materially economically different set policies from Labour that we're going to see from the Conservatives. But we shall see.

(34:29): And one more question here for you, Dan. Are you too complacent on interest rates and government bonds? Inflation still looks pretty high. Well why aren't interest rates going higher, at least in the US?

(34:48): I'll take that. I think that we're seeing it in the market, we're seeing it in the chart that we had at the start there, which is, you hear from both the Bank of England and from the Fed, that they believe that policy is restrictive. Policy has a lag. We looked at the charts of the consumer savings in the US and things. And so I think even if inflation continues to be stubborn, policy is probably the appropriate level of tightness. And then we just keep it tight for longer. I think that the amount of inflation we need to see for there to be a meaningful move upwards in rates, I think is, at this stage, unlikely given the underlying dynamics.

(35:35): I do think there's a question around how long they stay at current levels in order to squash that last bit of inflation. But we have definitely, at least for now, moved past the idea that rate hikes would be the next move. I absent some data that we cannot predict and therefore we should not be positioning funds based upon. I struggle to see that the next move would be a hike. And I don't think it would be appropriate. I do think policy is tight, especially in the UK. I think policy is particularly tight because we have a very different housing market dynamic here. And so I think the most likely response to an uptick inflation would be to say, let's stay the course at current rates and sort of slow that path of cuts rather than raising them from here.

(36:24): Thank you Dan. Thank you everybody for joining us. We hope you've found that a helpful update and we look forward to speaking to you again next quarter for our next update on markets and our views. Thanks again for joining us and we hope to see you soon.