Financial Update from Brewin Dolphin - 8 September 2023

September 2023

The Weekly Round-up

Friday 8 September 2023

In his latest weekly round-up, Guy Foster, our Chief Strategist, discusses why the economy has been performing better than feared this year, and the impact of artificial intelligence on the longer-term outlook.

The market has stumbled a bit over recent weeks. After a really strong run, the momentum has ebbed. This week sees major markets weaker, but only marginally, after a succession of days with neither the bulls nor the bears able to wrestle control of the market’s direction.

The story of the year so far has been one of good news on both the inflation and the growth front. That growth positivity has been driven by two factors. In the short term, the most anticipated recession in living memory has failed to materialise. There has also been a boost to the longer-term growth outlook. This reflects the anticipated adoption of artificial intelligence (AI) with knock-on effects on economic growth and profitability.

The cyclical argument

Looking first at the cyclical arguments supporting growth, this year has seen the economy performing better than many had feared. That is particularly surprising in the context of the sharp increase in interest rates. However, as we have discussed in these notes previously, economies do not have a linear sensitivity to interest rates.

Even in the UK, it will take time for higher interest rates to be reflected in higher mortgage payments and to begin to weigh on economic output. In the US, where mortgages run for 30-year terms, the impact of higher mortgage rates is felt through non-mortgage costs, such as car loans and credit cards. This has muted the impact of interest rate hikes. During 2023, the decline in

oil prices has lowered living expenses, partially offsetting the rise in interest costs. Crucially, of course, this year has continued to see employment increase, meaning that even as individuals see their income squeezed, in aggregate incomes have risen. One final factor has been the sharp increase in cash balances which households accumulated during the pandemic.

Several of these factors are set to change. The San Fransisco Fed believes that most of these savings have now been spent and that the remainder will be exhausted this month. This comes at a time when the oil price has begun to increase again, whilst last week’s US employment data did suggest a continual trend of decelerating jobs growth.

Is this evident in the data yet? Far from it. Whilst the purchasing managers’ indices (PMIs) suggest a slowing expansion of services activity, the more explicit signal from the Atlanta Fed’s GDPnow series has been extraordinarily strong. Whilst it is almost certain that GDPnow is overestimating activity levels, the gauge suggests that growth during the current third quarter will be above 5%, driven by an improvement in consumption but also a rebuild of inventories. During second quarter earnings season, we saw that many companies were running down their stock levels which had ballooned amid unpredictable demand and supply. We can also observe that manufacturing cycles tend to follow a three-year rotation, which is often considered to reflect cycles of stocking and destocking. These cycles can be seen in PMIs which would imply they may recover from recent falls.

To summarise, the economy seems to be doing ok for now, but there is limited room to grow employment and some households will have to moderate their spending over the coming months as their excess savings dwindle. Our cyclical perspective, therefore, is that growth seems very likely to slow.

The secular argument

This year, however, also saw an unusually sudden increase in investors’ assessments of the long-term or secular growth outlook. The driver of this has been estimations of the value of the adoption of AI, which have been made flesh by the launch of ChatGPT and AI-enabled search engines such as Bard or Bing following hot on its heels. AI seems to be having some effect on business investment already, and we continue to have good exposure to some of the enabling companies.

More broadly, AI has the scope to enhance economic growth, but the impact on profits more generally is more contentious. A company successfully enabling an AI-driven customer services experience, for example, may save costs by driving an improvement in profitability. However, if it operates in a competitive industry, peers will likely follow its lead and cut prices to gain or retain market share. In such circumstances, AI drives a reduction in inflation, which is good news from a growth perspective and is reflected in high standards of living, but does not lead to enduring gains in profitability. Identifying how AI will drive sustainably higher profits, beyond the specific enablers with cloud computing and semi-conductor sales, is very challenging.

Technology is supported by strong secular themes and is less cyclical than many sectors. It is therefore an attractive area as growth seems set to slow. However, average valuations within the sector are relatively high, which is likely to limit the gains which can be made from them in the future.

Technology shares have also tended to move inversely with bond yields as investors value the long-term growth these shares offer as a function of long-term interest rates. They have managed to overcome the headwind of higher bond yields so far this year because of the big increase in growth expectations due to secular and cyclical factors. But the rise in energy prices serves as a warning that headline inflation could start to rise once more. The current deep cuts to interest rates, which are expected by the markets but denied by central banks, could mean still more upside to bond yields.With this in mind, we remain relatively cautiously positioned with underweights to both equities and bonds.