Pros highlight reasons why this bull market is on thin ice

Most funds that invest in equities have made positive returns since the start of 2023. But some professionals are cautious over how markets will fare in the months ahead. Kyle Caldwell explains why. 

While there’s no shortage of headwinds threatening to blow stock markets off course, most funds investing in equities have made positive returns year-to-date.

Technology funds are leading the pack, with an average return of 25.8%. The biggest stocks in the sector, referred to by some as the ‘magnificent seven’, have seen their share prices soar in 2023 amid excitement over advancements in artificial intelligence (AI).

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As a result, investors with exposure to US and global funds will also have benefited, although to a lesser extent. The average US fund is up 10.1%, while the global sector is up 7.9%.

However, some professional investors are concerned that a small number of stocks are driving the performance of US markets. There are also fears of over-exuberance due to how sharply those seven share prices have risen over a short time period. So far in 2023 (to 27 July 2023), chipmaker Nvidia is up 227%, Facebook-owner Meta Platforms is up 155%, Tesla is up 146%, Apple is up 57%, Amazon has risen 54%, Alphabet is up 48%, and Microsoft has risen 40%.

Earlier this week it was announced that on the back of those surging share prices the Nasdaq index would undergo a ‘special rebalance’ to address overconcentration. The index posted its best-ever first six months to a year in its 52-year history, up over 30%. In addition, as a note from Deutsche Bank pointed out, the Dow Jones index just matched its best-ever streak of 13 days of consecutive increases. 

Some commentators are concerned over AI mania. Cameron McCrimmon, investment specialist at Aegon Asset Management, is in this camp. He says: “The breadth of returns on the S&P 500 has become increasingly narrow, driven by a few mega-cap tech stocks on AI optimism, which is a classic sign of an ageing bull. Earnings per share estimates on the broader index have continued to decline.”

Rather than talking up their own books, it is interesting to see that technology fund managers are also urging caution in the short term.

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Hyun Ho Sohn, portfolio manager of the Fidelity Global Technology fund, acknowledges that it has been a “very narrow, thematically driven market, the ‘hot’ theme of the moment being generative AI”. He adds that it is important to “remain cautious” rather than getting carried away.

“AI is not new and has been used in many areas for some time now. However, ChatGPT and other large language models are new, and an important breakthrough. More importantly, this has made people believe in an inflexion in AI technology and [that there is] a massive investment opportunity ahead; similar in some respects to the sentiment around the then emerging internet in the 1990s.

“However, it is important to remain cautious - or perhaps realistic. Every technology company seems to be pitching an AI angle. While some stand to make tangible near-term gains from AI, most firms seem to be trying to promote AI-related products, with limited and likely near-term customer traction.

“For now, companies are having to spend to support AI roll-out. It should become clearer over the next 18 months or so whether businesses will start to accrue gains from this spending.”

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Mike Seidenberg, fund manager ofAllianz Technology Trust (LSE:ATT), has also urged circumspection in the short term. In a recent episode of our On The Money podcast, Seidenberg said that he would “encourage investors to be cautious, as Wall Street tends to get really excited about things and really upset about things”.

He added: “I would approach it with a cautious view near term because there’s so much excitement, but it is definitely a real theme and you’re going to see billions and billions of dollars spent as companies learn to implement it and use it to their competitive advantage.”

Other reasons why some pros are cautious

The prospect of a recession, which is expected to be mild rather than severe, is also giving some cause for concern. The fear is that if and when a recession comes, central bankers’ hands may be tied in terms of cutting interest rates if inflation remains stubbornly high.

In the US, this is less of concern at present, given that its inflation rate is 3%. However, in the UK, with inflation running at 7.9%, higher-for-longer interest rates look more likely.

McCrimmon adds: “The market seems to be forgetting that monetary tightening hasn’t gone away.”

He points out that the Federal Reserve is pushing on with its quantitative tightening – this week raising interest rates to between 5.25% and 5.5%. McCrimmon notes that rate rises result in “corporates and consumers facing more pressure in the months to come”.

He adds: “The sudden change in market sentiment in the second quarter following the solution to the US regional banking crisis has left many investors understandably scratching their heads. We think returns in the second quarter of 2023 are overdone, given that the US is still likely heading for a mild recession, which we expect to start in the fourth quarter of this year.”

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Duncan MacInnes, fund manager of Ruffer Investment Company (LSE:RICA), also argues that there’s complacency over interest rates remaining higher for longer.

He says: “The past 18 months has seen the largest globally synchronised monetary-tightening cycle for over a generation – and it isn’t over yet. There are more hikes to come. Furthermore, the market has yet to price in the higher-for-longer rates that policymakers are now promising.”

On the prospect of a recession materialising, MacInnes expects stock markets to react much more negatively than some commentators are predicting.

“The recession, when it comes, will arrive with a sudden thud. Sentiment, valuation and market narratives are akin to an echo-bubble of 2021. The pessimism of 2022 has been forgotten and the markets are pricing a soft landing fuelled by AI-driven productivity improvements,” he says.

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Mark Harries, chief investment officer at Square Mile, the fund research firm, adds that “markets remain fixated on inflation and what this means for interest rates”.

While Harries does not think a global recession is imminent, he also doesn't expect the inflationary or economic journey to be a straightforward one.

“It may be a case of a recession delayed rather than avoided. This is particularly because interest rate increases are a fairly blunt tool with which to tame inflation, aiming to cool demand by making life increasingly expensive for consumers and companies alike.

“As such, there may be further corporate casualties to come, especially for the more indebted parts of the market, such as commercial property; not an area we are directly invested in. This is one of the reasons why low levels of debt are important characteristics to look for in equity holdings.”

Nonetheless, Harries notes that equity valuations have improved, and that the growth potential of stock markets means they are one of the few asset classes that can deliver returns ahead of inflation over the medium to longer term.