AI is exciting, but patience will be rewarded

We are halfway through 2023 - a year that’s followed the worst for equity and bond markets since 1928 - and equity markets are on a tear. We, on the other hand, as investors of long-term family capital, have taken a more cautious stance. Which means that this commentary is at risk of being exactly what Lewis Caroll warned about; we haven’t been on the adventure, and we’re going to explain exactly why that is. We’ll do our best to keep it brief, clear and thoroughly un-dreadful.

Perhaps at first glance it doesn’t seem strange that we’re seeing market strength; 2022 was a weak year for risk assets, so you might expect them to bounce back in 2023. The strange thing is, the prospect of recession that loomed so heavily over investors last year hasn’t even happened yet – we are still on the cusp of global slowdown. In our view, the pendulum of probability is still poised towards the downside, and that’s because the economic cycle we’re in now is getting very long in the tooth. We might be benefitting from inflation coming down at the moment, but it’s still moderate, which means that if growth really were to take off again, we’d see tighter policy coming through, and that’s the real pinch point. Growth has been stronger than economists expected because labour markets have supported consumption, but as soon as we start to see unemployment rise, that support is likely to weaken considerably. What’s interesting, is that for most of the year so far, the vast majority of stocks have reflected this economic conundrum; most have been flat, mildly positive or negative. Up until June, it has only been a small number of AI and tech stocks that have done extraordinarily well, singlehandedly driving broader equity indices into positive territory.

In a sense, we don’t think this enthusiasm is wrong; AI, we believe, will be completely transformational. It’s one of the key secular themes that we have been working on for the past couple of years. But just like with the internet boom in 1999, it’s easy to pay the wrong price, at the wrong time, for the right piece of innovation. Price is still ultimately the main driver of returns. Take Cisco as an example. If you’d bought Cisco stock in March 2000, you’d have an annualised return today of 0.8%. Today, it’s easy to look back at the excesses of 1999 and laugh at what investors were buying; internet stocks with no revenue, that went nowhere, for stratospheric prices. But you don’t need to look very far to see some extraordinary activity today. There’s Mistral, for example, the French AI company that raised over 100 million euros, a month into its existence. The business isn’t only untested, it’s still being built. Who knows, it may prove to be a Microsoft and not one of the hundreds of forgotten tech names lost to the last century, but the strength of the market response to this, and many similar launches, does suggest to us that investors might be getting overexcited.

If we’re sounding pessimistic at this point (or Scrooge like, to borrow from another Victorian literary mind), then the good news is that we are in fact quite optimistic about a few areas of the market today. This is a difficult market and economic environment, but the picture is nuanced, and there are pockets of opportunity. For one thing, after over a decade of broad-based equity market strength, we’re now firmly back in an era of market dislocations and distortions; an era in which great stock-pickers and active managers can really show their skill. There are also more idiosyncratic opportunities; take Japan for example. While most major economies battle with inflation, Japan is finally moving out of its multi-decade long disinflationary spiral. That, combined with a cheap currency, cheap stocks, earnings growth, corporate governance improvements and capital flow, makes for a very interesting proposition indeed. Tech stocks might be taking the lion’s share of commentary at the moment, but Japanese equities are moving towards record highs for the first time since the 1980s. These are the kind of rare, structural opportunities that we like to tap into.

All things considered, we think that long-term investors today are best served by protecting their capital, looking for relative value opportunities through active management, and keeping enough powder dry to deploy capital when market start to weaken. It might not make for an adventure, per se, but for those who want to enjoy a smoother ride over the long term, we think it’s the right approach.

We now face a materially more complex investment environment than most investors working today have experienced in their lifetimes. While China’s reopening could have been a major boon to the global economy, any resulting positive sentiment is being more than outweighed by fears over rising geopolitical risk. In the same vein, falling inflation figures should be good news for markets, but equities have arguably taken this good news too far, pricing in a near-perfect scenario of a soft landing from central banks and a modest hit to corporate earnings as economic growth slows. Our view is that the market is not pricing in the very real possibility of a 15-20% fall in earnings as recessions hit key economies.

The good news is that distortions between economic reality and investor sentiment create opportunities for long term investors. By maintaining a carefully hedged allocation to equities with an active management tilt and long/short strategies, we are still positioning portfolios to capture some of the benefit from sharp upside swings without taking on the full extent of the downside risk, which we think is significant. Recessions across the globe have yet to bite, equities are still not that cheap on a historical basis, and inflation is coming down – but is still high - all of which makes a further leg down in equities more likely than not. Where we do have direct equity exposure, it is tilted firmly towards areas that have a greater margin of safety in terms of valuation: value strategies, and equities outside of the US.

Another key question to explore, is whether now is the time to buy bonds. On the one hand, yields have risen to pre 2008 Financial Crisis levels, which means that for the first time in well over a decade, investors might be adequately rewarded for taking on duration risk. On the other hand, there is still a risk of capital erosion in real terms for long-term holders of bonds, given the apparent return to an inflationary environment. Right now, given both the risk of recessions, and the valuations that longer dated bonds have fallen to, we think that 30-year US Treasuries look attractive as portfolio protection. Macro data have been weakening in the US - with high frequency and leading indicators pointing to a reduction in activity - but equity markets have not priced in the increased risk of a deep recession. Longer duration bonds should act as portfolio ballast in the wake of a sell-off in risk assets caused by a recession.

Ultimately, we think that the market and economic environment still warrants caution. We continue to favour the use of active management and hedge fund strategies, that can take advantage of heightened volatility and market dislocation. Hedging strategies, allocation to alternative strategies, and careful equity positioning should provide a buffer to sharp market swings, essentially smoothing the ride for investors.

All information and opinions expressed are subject to change without notice. Advice is given and services are supplied by Capital Generation Partners LLP and its affiliates (“CapGen”) on the basis of our terms and conditions of business, which are available upon request. No liability is accepted or responsibility assumed in respect of persons who are not clients of CapGen, unless expressly agreed in writing.

This does not constitute investment advice or an offer, contract or other solicitation to purchase any assets or investment solutions or a recommendation to buy or sell any particular asset, security, strategy or investment product.