The Great Escape: How did the world get away with it?

Evelyn Partners chief investment strategist Daniel Casali Picture supplied by EVELYN PARTNERS

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A year ago, all the indicators were pointing to recession, but, as Evelyn Partners’ Daniel Casali tells Emily Moore, that scenario was not realised

WHAT do Steve McQueen’s The Great Escape, the American comedy 9 to 5, the Alfred Hitchcock thriller Rear Window and The Magnificent Seven have in common?

While they are all classic films of yesteryear, their lesser-known claim to fame is that their titles also formed the basis of Evelyn Partners chief investment strategist Daniel Casali’s recent presentation to Jersey-based fund managers.

Why? Because, in Mr Casali’s words, “we have got away with it”. After predictions of global recessions and market crashes in response to the “massive correction needed following the sharp rise in interest rates”, instead the world enjoyed a “great escape” as markets rallied, partly – and somewhat ironically – as a result of the same factors which initially wrought chaos across the world.

“Covid itself had a short, sharp impact on the markets, and the UK economy saw its worst contraction since The Great Frost of 1709,” he said. “However, the ramifications of the pandemic remain today, with inflation and a strong labour demand having a significant effect in driving markets.”

It is no surprise, therefore, that this theme featured strongly in Mr Casali’s presentation.

“The reason that the markets have recovered and started the year so strongly is that the whole concern about higher interest rates and higher inflation leading to recession didn’t materialise,” he said. “From October 2022 to January 2023, Bloomberg’s economic model said that the chance of the US entering a recession was 100%. Economists across the world were convinced that recession was inevitable because we were seeing the biggest rate increase for 40 years. Instead, the US, Europe and China did alright, and that’s why the presentation is titled The Great Escape For Equities.”

And one of the main reasons for the economies’ Houdini-esque performance, says Mr Casali, is the labour market or, in keeping with the presentation’s cinematic references, the 9 to 5.

“If you go back to 2020, when Covid hit, a lot of people left the workforce for health or lifestyle reasons,” he explained. “That mass exodus of staff left companies panicking about the supply of labour and, with supply significantly down, job openings absolutely rocketed. In the US alone, there were just over 12 million job vacancies advertised.

“While that figure has come down, it is still high and that explains why the unemployment rate hasn’t gone up. Last year, the US created three million new jobs. How can you have a recession when companies are adding more and more workers? Added to this, people’s disposable income rose by more than 4%, despite the rise in inflation.”

The second film which Mr Casali drew upon to explain markets’ resilience was Rear Window.

“This is all about interest rates and inflation,” he said. “Central banks didn’t predict that the response to Covid would drive inflation. But as China shut down its manufacturing industry and we all hoarded goods and saved money because there was nothing to spend it on; it was natural that, as the world opened up again and people’s desire to spend money outstripped the supply of goods, inflation would soar.

“Central banks saw this through the rear window and had to jackknife interest rates really aggressively to try and bring that inflation down again. At the same time, there was lots of talk about a ‘mortgage time bomb’ but because a lot of people were able to extend their maturities or had five- or ten-year fixed-term mortgages, that didn’t happen.

“Weirdly, many companies, particularly in the US, also profited from the higher interest rates, as they put money into market funds at 5%, extended their borrowing into longer maturities and made money, a scenario which has never been seen before.

“This combination of smart borrowing and a resilient labour market meant that higher rates and inflation levels didn’t impact economic growth.”

And the third reason – which Mr Casali says was only possible because of the first two factors – was The Magnificent Seven.

“These seven US stocks, led by Nvidia, have given the markets a storming start to the year, and the key theme linking these high-performing stocks is AI,” he said. “These three things have enabled the great escape and are influencing our predictions about the equities, countries and sectors in which fund managers should be investing.”

But does this trio of box-office hits mean that the risk has passed?

“The events of the past four years are continuing to have an impact this year, but we have now passed the peak of inflation and interest rates, and interest rates are likely to be cut later this year,” Mr Casali said. “However, when you look at the headwinds and tailwinds facing us, there is still plenty going on.

“Is there likely to be a second round of inflation? Probably, but we think that risk is fairly low and more transitory, mainly because wage rates in the US are slowing. Other factors to consider include US public debt. This is rising by around a trillion dollars every three months, something which cannot continue. And, of course, you have the moving feast of geopolitics to consider. While the US and China are the key players to watch here, as the US is desperate to defend its ‘top dog’ position, you also have the situation in the Middle East and Russia’s invasion of Ukraine to consider.

“We also cannot ignore the US election, although, looking at this purely from a market perspective, the risks may not be as high as some people think. The biggest risk is social unrest ahead of the election, and the other risk is a very close result. Markets like certainty, so the best-case scenario from that perspective is a clear victory.

“On a more positive note, though, there is tremendous momentum behind stocks; AI has the potential to go a long way and the labour market shows no signs of weakening, which means we are in a very different situation from the global financial crisis of 2008.”

Combining all of these factors, Mr Casali has four pieces of advice for investors.

“We prefer equities to bonds, as companies have stronger earnings growth and lots of share buyback, whereas government debt is soaring,” he said. “We also see the US equity rally broadening out, so would recommend that people ‘hedge their bets’ and don’t place all their money in AI. The financial sector is actually the best-performing area at the moment.

“When looking at UK companies, we would favour those with an international footprint, as 75% of sales from the top FTSE100 companies happen overseas, so international companies such as BP and Anglo American are likely to deliver stronger growth.

“Finally, the US dollar is falling in value because Americans are living beyond their means, the country has a huge external deficit and government debt keeps rising. This is having a positive effect on gold, as countries such as China, Saudi Arabia and India are buying fewer dollars and more gold knowing that this is something they can keep within their borders should a conflict arise. This goes back to the Russian invasion of Ukraine, when western governments confiscated 80% of Russia’s central bank reserves.”

Overall, says Mr Casali, while existential risks are ever-present, and difficult to predict, and elections will “grab headlines”, there are plenty of opportunities to drive returns.

“And that’s the story,” he said. “We got away with it. The higher interest rates didn’t plunge us into recession, but our great escape was all to do with the lingering effects of the pandemic rather than the response of central banks.”

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