MARKET SEASONALITY

In our note this month, we wanted to write to you regarding the well-documented slowdown in the US economy, the potential Artificial Intelligence (AI) bubble and how we are responding to these fears in client portfolios. I remember starting my career in finance shortly after the 9/11 terrorist attack in New York in 2001. The financial crisis, the effects of which were felt throughout 2007-09, Took place less than a decade later. That we have been broadly without other systemic crises (which, to a degree, rule out the 2013 European debt crises and the Covid-19 crisis) since 2009 has led financial commentators to suggest another is due, and some of the more pessimistic amongst them have been scouring and reporting any data they can find to support this thesis. Some of the more unscrupulous amongst them may well be ‘talking up their book’, i.e. they will actively benefit from another crisis.

We have written a few paragraphs on AI and China later in this article to provide some greater detail regarding AI’s potential future benefits and drawbacks. This dovetails into another narrative about China’s resurgence, and its desire to usurp US technological hegemony by being at the vanguard in the development and implementation of AI.

Both periods remain highly relevant when trying to make sense of today’s financial environment. Before the 2001 attacks, markets had been inflated by the notorious technology bubble in which company valuations became detached from any reasonable correlation to profitability and earnings growth. One could argue that 9/11 simply accelerated what was already inevitable – a necessary return to realism and a more grounded assessment of what companies could truly deliver to shareholders.

During the 2007–09 financial crisis, a time when regulation was lax, financial and property-based derivatives had reached dangerous levels of complexity and over-valuation. Many retail investors were complacent about risk after a five-year bull market following the nadir of 2002 following the tech crash.

Whilst we do not wish to cause clients undue alarm, there are echoes of those earlier market peaks today. For that reason, we have been gradually reducing risk within the portfolios and taking profits from assets that have performed strongly. One area we have not reduced significantly is gold, which last week reached a new record high of around $4,250 per ounce – although it has exhibited some volatility in recent days.

It is worth remembering that past market declines, including 1987, 2001 and the 2007–09 crisis, all now appear as blips in the robustly rising market when viewed against the longer-term rise of global equities.

Our guiding principle remains safety first. This has developed over years of managing the wealth of high net-worth individuals and families who value intergenerational stability over short-term speculation. While fashionable assets such as Bitcoin and other cryptocurrencies remain in vogue (despite last week’s sell-off), we continue to favour assets with real, demonstrable value rather than those built on the hope of finding a buyer willing to pay a higher price for something with limited underlying worth (called the ‘greater fool’ theory).

We appear to be in one of those curious phases when every warning light on the economic dashboard is flashing red, yet the car (market) continues to race forward. These moments are rare and difficult to interpret with any precision.

A Wall Street strategist once described this as a ‘meltup’; a phenomenon observed after the European debt crisis in 2013, when, despite Greece’s economic collapse, risk assets rallied simply because catastrophe had been postponed rather than avoided. A similar pattern of misplaced optimism is being widely championed today – even the Bank of England has expressed concerns about overly-exuberant markets.

REGIONAL OVERVIEW

In the United States, employment data continues to soften, and the risk of a mild recession is Increasing. Inflation remains persistent, but the Federal Reserve has started to ease monetary Policy, cutting rates by 0.25 per cent, with at least one further reduction expected by year-end. At the same time, political rhetoric ahead of the election cycle has reignited trade tensions with China.

In Japan, the election of Sanae Takaichi, the country’s first female Prime Minister, sparked a surge of optimism and pushed the Nikkei index to new highs. However, her plan to stimulate growth Through higher borrowing has renewed concern about Japan’s already high debt levels, leading to greater volatility across Asian markets. We remain confident about the prospects for Japanese equities.

In Europe, France continues to face both political and fiscal instability. The most recent Prime Minister, Sébastien Lecornu resigned after just a month in office following revelations about the poor state of public finances (he has since been reinstated). This has left President Emmanuel Macron in a fragile position. According to a recent Aberdeen webinar, France is now viewed as part of “peripheral Europe”, with borrowing costs exceeding those of Germany, Italy, Spain and even
Greece.

Across the Eurozone more broadly, growth remains subdued and the European Central Bank has indicated that rate cuts may proceed more slowly than markets expect.

LAST WEEK

Last week’s volatility had been building for some time. Technology stocks, precious metals and digital assets such as Bitcoin had rallied relentlessly for months. In our previous note, we indicated that such momentum was unlikely to continue indefinitely, and indeed markets have now paused for breath.

Whilst it is never a pleasant experience to see markets fall sharply, it is the inevitable corollary of a runaway bull market in risk assets – these are the red lights flashing on our dashboard.

We appreciate that these adjustments can cause concern, but we remain confident in our diversified positioning and our focus on quality. If conditions deteriorate further, we have no compunction in continuing to strengthen our defensive allocation, continuing to increase our high-quality, cash proxy investments. This allows us to look for opportunity when there is a downturn and volatility, this is part of the strategy that has provided the pleasing returns we have delivered, so even a fall is also an opportunity.

ARTIFICIAL INTELLIGENCE

AI has been the dominant theme driving global equity markets over the past year. Its supposed potential to transform productivity across industries from healthcare and logistics to finance and manufacturing has generated extraordinary investor enthusiasm (and some FOMO, which we mentioned above).

The world’s largest technology firms now trade at enormous market capitalisations. Companies such as Nvidia, Microsoft, Apple, Alphabet and Amazon together account for more than a quarter of the entire US stock market. Their rise has been powered by the belief that AI will revolutionise how businesses operate, create technological efficiencies and investor value.

However, there is growing concern that the AI boom is running ahead of itself. Several factors suggest caution may be warranted.

Firstly, valuations are becoming stretched. Many AI-related companies are trading at multiples reminiscent of the 2000 technology bubble. Even if AI continues to spread rapidly, it is uncertain whether the profits generated will justify current share prices. Secondly, AI development is highly capital intensive. Training large models requires vast computing power, expensive semiconductors and immense data infrastructure. As competition increases, profit margins could be narrower than investors expect. It may only be the larger incumbents, mentioned above, who can sustain the high
costs of production and implementation (or indeed, a large state-sponsored and state-owned enterprise – for example, China).

In addition, regulatory scrutiny is mounting. The EU now has an AI Act and similar proposals in the United States and Asia are likely to impose new compliance costs, as countries seek to shore up their own ailing finances, which could reduce innovation and make the entry to market financially prohibitive for smaller companies.

This could exacerbate another concern, market concentration. A small group of American technology giants currently dominate the AI ecosystem. This had led to fears of an oligopoly Between the aforementioned US companies and could lead to a wider market correction should their current positive momentum be derailed.

China’s entrance to the AI fray cannot be ignored. Its ‘Belt and Road’ initiative has given them significant influence in countries where there is a preponderance of ‘rare earth’ metals – they also have significant stores of their own. Its fractious relationship with the US, and broader western world, has led it to develop its own state-sponsored AI ecosystem which could have some real benefits for its own (and regional south Asian) growth. However, this too should be of some concern – perhaps not to investors per se, but certainly to the technological capabilities of an AI system which is not vulnerable to the vacillations of western markets.

OUTLOOK AND COMMITMENT

The months ahead are likely to be shaped by three main themes: the balance between AI optimism and realistic valuations, the direction of relations between the United States and China and the longer term effects of the trade tariffs, and the pace at which central banks reduce interest rates.

Each of these has the potential to influence markets significantly, both positively and negatively. What will remain constant is our disciplined approach. We will continue to endeavour to protect and grow our clients’ portfolios prudently, avoiding the temptations of short-term speculation.

We are grateful for your continued trust with the stewardship of your investments.