FidelityConnects: UK and Europe market trends: What they mean for global investors

[00:01:01] Pamela Ritchie: Hello, and welcome to Fidelity Connects. I'm Pamela Richie. Central banks around the globe are set to deliver a series of key policy decisions this week but with the ongoing Middle East crisis expectations of rate cuts have more or less evaporated. What might shifting rate expectations mean for the global economic outlook and what ripple effects could it have on private credit, for instance? Joining us here today live from London to take us through his latest market thesis is Fidelity Investment Director, Tom Stevenson. Warm welcome to you, Tom. Great to see you. How are you?

[00:01:37] Tom Stevenson: I'm very well, thanks, Pamela. Thanks for having me on again.

[00:01:40] Pamela Ritchie: We're delighted to see you. This is a key moment. Let's go into it. We'll ask everyone to send questions in for Tom for the next half hour or so. Let's jump right into what central banks actually are facing. The backdrop, of course, is so different from a couple of weeks ago. The Fed has room to cut. What do you say about that and other central banks?

[00:02:06] Tom Stevenson: I would say it's a bit like London buses. Central banks sort of hunt in packs. This week we've got the Fed, we've got the Bank of England, we've got the Bank Japan, we've got Canada, Australia, you name it. We've got central banks making interest rate decisions all this week. They've had a couple of weeks to really begin to assess what's going on with the crisis in the Middle East. Of course, that is the key driver of their decision-making process at the moment because of what's happening with the oil price and the knock-on impact that's likely to have on inflation. You say that the Fed's got room to cut, they probably have got room to cut, I think a lot of central banks have got room to count. They've pushed their rates higher over recent months. I think it's extremely unlikely that any of them will cut this week, though. I think that it's going to be a wait and see week. Indeed, we have seen a huge swing in expectations just over the last couple of weeks. If you take the UK for, example, a month ago we were expecting two quarter point cuts this year. I think we're now expecting one hike this year. Three-quarters of a percentage point, that's a big swing. Something similar is happening in Europe and, actually, something similar is happening in the US as well. Countries like Canada and Australia, they've already bottomed out, the next moves are likely to be up there.

[00:03:37] Pamela Ritchie: That's right, and they were finished, sort of on hold in Canada, I'll speak for just because I know it better than Australia, and they were finished their cycle. That was the cycle. They got to roughly where they needed to go for an adjustment, tuck in, move needed. They were in the right place, the right zone was sort of the general thought. Inflation itself from oil sometimes can be very transitory. The world is in some serious disruption. How would you compare this to the COVID supply chain shock?

[00:04:12] Tom Stevenson: I think that's a really interesting comparison. If you go back to four years ago, when we had that energy crisis after the Russian invasion of Ukraine it came against a very different backdrop. We were just emerging from the COVID pandemic. The jobs situation was very different. It was a much tighter market. If you look at now, you know, unemployment is higher. Vacancies are lower. It's a much looser market. I think that the upward pressure on inflation is actually much lower this time. You remember, I think you were in the UK at the time, when inflation spiked up to 11% very quickly. I think it's quite unlikely that we have that now. That will be in the calculations of the central banks when they look at this situation. I think they will be hoping that they can look through this. The mistake they're not going to make is the mistake they made four years ago when they talked about this is a transitory thing, this is something that's going to pass, and, of course, it didn't and they were really caught badly out by that. I think that's why they're going to be more cautious this time.

[00:05:34] Pamela Ritchie: It's very interesting to see what the calculations the central banks will have to make. A month later we'll have earnings so you can see CEOs and their teams with their notepads out and their AI strategies out trying to figure out how they get through this, and the margin story, essentially, for all companies that are having to deal with what maybe is a short term shock but otherwise ... do we have much knowledge at this point? Nobody's really saying anything, are they, in terms of companies and how they're handling things at this point.

[00:06:08] Tom Stevenson: In terms of the earnings picture.

[00:06:09] Pamela Ritchie: In terms of sort of margins.

[00:06:13] Tom Stevenson: I think as it stands at the moment, and we are some way off the next earnings round, we're kind of in the middle between earnings rounds, but I think the expectation is that the earnings outlook remains pretty strong and the margins remain pretty strong. Now, of course, that can change completely depending on what happens in the Middle East. The longer that this goes on the longer that there is pressure on the oil price and pressure on inflation, pressure on margins, then I think that earnings picture changes. That is therefore the key question at the moment. The key question is how long does this go on for?

[00:06:54] Pamela Ritchie: I know, and because we can't really answer that, lots of people are working on that at high levels, it is interesting to know how other countries are in terms of their energy security. I mean, this is one of the things that has been discussed for some time. It's been an underlying theme and, of course, it's different this time for the US because they're a net exporter and we know that. In terms of energy shocks around the world I'm sort of curious to ask you about how countries are handling that to get to the point of the rest of the world trade, the global trade that was competing with the so-called US exceptionalism all through last year, through the beginning of this year, who is in sort of an energy security spot that looks good, that can help underpin this global rotation to international equities, essentially.

[00:07:45] Tom Stevenson: There are lots of questions there because that whole rotation out of the US, which seemed like such a sensible, positive story at the beginning of the year, has been completely upended by what's happened. One of the reasons, of course, it's been upended is that the US in recent years has become one of the largest, if not the largest, exporter of oil and gas to the world. It's the countries, the likes of emerging markets in Japan, big importers of energy which have been hit particularly hard. The Japanese stock market down 8 or 9% just in the last couple of weeks. Interestingly, though, I was on the phone this morning to our Tokyo office talking about what's going on in Japan and I was told some things which I didn't realize, actually, about Japan, which is that it learned an enormous amount from the 1970s oil shocks, which were so damaging all around the world but in particular to the Japanese economy. They have learned to adapt and to protect themselves from that dependence on Middle Eastern oil. For example, Japan holds 250 days of demand of oil in inventory. That's about three times the OECD average. They really are extremely cautious on making sure that they've got that buffer.

[00:09:19] Another thing I learned, I think 98% of Japanese electricity does not come from oil, it comes from LNG, most of which comes from Australia and a number of other producing countries outside the Middle East. In all sorts of ways Japan has sought to protect itself. You have to take that into consideration when you think is that 8 or 9% fall in the Japanese market a bit of an overreaction? Quite possibly it is but again, it is dependent on how long this goes on for. If there's a quick resolution then I think we see quite a positive bounceback in markets like Japan.

[00:10:03] Pamela Ritchie: Let's broaden out, because you said I asked you a question with a lot of pieces in it, to this international rotation which had strong winds behind it. Is it contingent on the oil price?

[00:10:17] Tom Stevenson: I think to an extent it is. I think it's contingent on a resolution of the crisis in the Middle East. What we've seen is a classic sort of return to the sort of perceived safe haven status of the US underpinned by the fact that it does have energy independence. The whole thesis, which made sense in January, that we had an overvalued US market, we had investors looking to diversify themselves away from that dependence on technology towards better valued markets in the rest of the world, made complete sense in January. It's been turned on its head by what's happened. If we do get this resolution, maybe it's too soon to say that this is just a blip in an ongoing bull market, I don't think it is because I think that the oil situation persists even once the bombing ends. I don't think this just disappears. It's not an immediate revert back to the status quo ante. I think if we do get a quick resolution then those markets which have been very heavily hit, I mean, you look at Japan but also Korea, big, big sell-off in Korea, Taiwan, some emerging markets, I think we see a big rally in those markets.

[00:11:50] Pamela Ritchie: Yes, that's really interesting. A lot of people are sort of waiting for that, essentially, and trying to position with maybe dry powder or some version of that to take advantage of that when that comes through. Just as we're on this piece, the Canadian Prime Minister, Mark Carney, is actually in the UK today. He's been travelling to visit Nordic countries. New alliances being formed. This has been going on for several months now. The allies that are sort of reorganizing themselves are also trying to respond to the blockages in the Strait of Hormuz due to the Iran-US-Israeli war. It's an interesting lack of response on some level. I just wonder if you could comment on it because it's just interesting that Mark Carney happens to actually be in the U.K. today speaking to your Prime Minister.

[00:12:35] Tom Stevenson: Absolutely. I think that you're right to point to these new alliances and this realignment of the so-called middle powers. I think that's an interesting development. I think it's happened quite quickly. If you look even a month or so ago I don't think our Prime Minister, Keir Starmer, would have been so openly critical of the US president in the way that he has been in the last couple of weeks. I think there's been a real shift and I think that's partly a reflection of the goodwill which has been destroyed over the last year with the whole tariff situation and the sort of undermining of old alliances. I think that represents a significant shift. It's not just the U.K., France, Germany, and others, are being very tepid in their response to calls to sort out what's going on in the Strait of Hormuz. I think what many countries are thinking is they would prefer that the ownership of this situation remains with the US and Israel. I think that's where they would prefer to be.

[00:14:00] Pamela Ritchie: How best to respond if that is sort of to respond in some way but without having to take on that sort of response. I think that's what a lot of people seem to be discussing. One thing that's going on in the market, certainly, this is prior to the war that's going on right now, is the rotation, that very strong rotation, we've spoken about that. We've also got the AI discussion, how it has been invested, ultimately how it's being used within firms. There's the is it accretive yet? In some cases it really is, it seems that started to happen. The other question is the debt funding this, much of it in the private credit markets. There's been some unravelings there. There's a lot of opaqueness and there's probably some bits that are absolutely fine, those are the other big pieces that seem to be moving in the market right now. How would you weight them at this point?

[00:14:57] Tom Stevenson: I mentioned a conversation I had earlier today with my Japanese colleagues. I also had a conversation with my fixed income colleagues and we were talking about precisely this issue. He was saying something quite interesting to me, one of the things which concerns him is that when you read stories about private credit everyone says oh, it's not a problem. That concerned him, and I think he's right to be concerned because there are real echoes of the early part of the financial crisis in ... I'd say it's not 2008, we're probably going back to 2006. I remember when I was working in in journalism at the time and and my editor then said, you know, if you don't know what collateralized loan obligations, collateralized debt obligations are, you need to find out because this is going to be really important. Two years later it was very important. It just feels to me ...  it's not my area of expertise, private credit, but it feels like it's possible to hide a whole multitude of sins in the private markets which is not possible to hide so easily in the public markets. It does feel to me like we've had a big expansion in lending in the private credit markets. I think the credit quality is sometimes a bit doubtful and I think we will begin to see the consequences of that. We're beginning to see the consequences now.

[00:16:46] Pamela Ritchie: It's really fascinating to watch that and, as you say, there's sort of cracks there that one will watch. You've mentioned it in some of your articles, and you are still very much in the world of journalism when you're not doing your main job at Fidelity. You can find Tom's articles at The Telegraph, they're excellent reads. Question rolling in for you here, Tom, can you speak to the trade and defence cooperation between Canada and the U.K.? There has been some of that and, as you say, our Prime Minister is with your Prime Minister today, is there any sort of thing to note there at this stage?

[00:17:21] Tom Stevenson: I think it's early days yet, isn't it? I think that it comes back to what we were saying about this realignment of the middle powers. I think it's absolutely crucial that we get our heads around that and we start to work towards it. This is a big shock which the global trading framework has had in the last 12 months so we need to do it with some sense of urgency but it is still early days yet.

[00:17:55] Pamela Ritchie: Everything's an ancillary, I guess, to what we're discussing right now  but one piece of the new alliances that seem to be forming or reforming is the discussion of Russia. We saw last week on Thursday that Russian oil that's been floating around, some of it shadow fleet, was released onto the international market and sanctions were lifted from them. What do you think about that as sort of the reaction to allies? There's a lot of allies that are trying to make sure the Ukraine war goes in one direction and not another so the lifting of sanctions was not taken well by many. It can help the oil price for a while, that's obviously the reason it was done, but just sort of a comment there because it does seem to be a little bit backwards from what we expected.

[00:18:47] Tom Stevenson: I think it is. It's very difficult to discuss many of these issues because they are...

[00:18:54] Pamela Ritchie: We don't know.

[00:18:57] Tom Stevenson: We don't know. They're deeply political things. I can give you my personal opinion, I share the opinion of many of the people that you just referenced, that really they think that was a retrograde step. I think that the US's commitment to Ukraine is pretty lukewarm and I think we see things differently on this side of the Atlantic. I think opening up those oil sales was a negative development, I would say.

[00:19:43] Pamela Ritchie: It's a different negotiating tactic and hard to sort of figure out exactly how that works. Let's speak to diversification within investors' portfolios for those that often have looked at the 60/40. Much of that still works. I think there's just a different calculation of risks probably that you might outline. For those who maybe haven't diversified on the equity side of things to either international do you think the 60/40 is still a good way to look at things. We've been talking about this for a while, I just wonder if it comes into a different leitmotif now.

[00:20:18] Tom Stevenson: We talked about 2022, four years ago being a different world but in some ways it was a similar world with regard to that 60/40. We had both equities and bonds underperforming at the same time. That traditional diversification through the 60/40 portfolio didn't work for a 12-month period. Now, I think if you fast forward to today we have another situation where, frankly, it feels like the correlations between bonds and equities are going to be positive again because the factors which are driving bond yields higher, the higher oil price, higher inflation, are also negative for the equity market. I think we are going see a period of time when bonds are not a great diversifier against equities. Now, bonds do have some attractions. Self-evidently higher bond yields is attractive to a bond investor. You look at the 10-year bond yield in the U.K., 4.75%. That's a very attractive yield.

[00:21:33] I'm not sort of dismissing bonds within a portfolio but I think that they are going to struggle to perform their traditional function of being a counterpoint to equities. I think investors are going to have to work harder to get that diversification. They're going to have to look at things like infrastructure, precious metals, absolute return funds. I think for a personal investor that poses some issues because those more illiquid markets can be quite difficult to get into as a private investor. It's not as simple as just buying 60% equities and 40% bonds. That's a nice, simple thing. I think that simplistic diversification isn't going to work anymore, or at least for the time being.

[00:22:22] Pamela Ritchie: It's interesting because some of the diversifiers, you mentioned precious metals, gold is obviously sort of the obvious one and it's had huge run-ups and actually has also had moments of levelling off. You're wondering if it's sort of touching its high levels and needs a breather like much of the US equity market, parts of it anyway. So I just wonder about some of diversifiers. Are there new diversifiers, I guess, is the question.

[00:22:48] Tom Stevenson: You mentioned gold and I think that's an interesting one. Gold has done a really good job for a couple of years, a really good job, but when I look at the history of the gold price it does tend to go in sort of periodic moments when it when it spikes higher and then you can have many years, even decades, when it just does nothing or goes sideways or goes backwards. It feels to me at $5,000 an ounce gold has had a really strong run. Just as I'm slightly cautious about bonds as a diversifier for an equity-heavy portfolio I'm also a bit cautious about gold as a diversifier. I'm looking hard at other things like infrastructure, like some sort of absolute return funds. But you know you're running out of diversifiers, actually, it becomes more difficult.

[00:23:47] Pamela Ritchie: It's interesting the role of alts, for instance, in portfolios where you have the ability to short parts of the equity market, for instance, if that's appropriate in the time ahead. There are some others that have been created for, as you say, an average investor can go ahead and invest in some of these. When we're in the eye of the storm you can almost forget just far the equity market has run, and it has been extraordinary for a lot of investors recently. There's been slides, there's no question, and there's concerns right now but, as you say, over that two-year period, or whatever it is, depending on where you've been invested it's been quite life altering, literally, for some.

[00:24:35] Tom Stevenson: I'm glad you mentioned that, actually, because it's very easy when you're in the thick of the situation that we find ourselves in at the moment to take a sort of negative position on investments but you do have to put it in in context. I just happen to have the numbers in my head, we were talking about Japan earlier on, the Japanese market down 8 or 9% in the past couple of weeks, it's up 6% year-to-ate, it's up 36% over the last 12 months. That's quite an extreme example but it's not uncommon. The U.K. market has been very ... most markets have been very strong over the last couple of years. I do think it's important to look at that context and to accept that when you do get a correction like we've had that is part and parcel of investing in stock markets. That volatility is the price that we pay for the long term outperformance of equities over bonds and cash and other safer asset classes. I do think the context is really important.

[00:25:47] Pamela Ritchie: You mentioned, I think just off-line we were talking about this, the tariff discussion, what went on on so-called Liberation Day, this is back last year in April, it was a very short period where it was truly awful. I mean, there are lots of concerns for economies, Canada being massive in some of the concerns there, but in terms of the stock market reaction it was deep and very quick, actually. Any analogies to what we're going through now? How different are they, I guess, is the question, the strength of the markets.

[00:26:16] Tom Stevenson: I think they are different. For one thing the stock market is much higher now than it was in February to April last year. I think that it's a salutary reminder, actually, to be very careful about trying to time the market. I can remember, in fact, I recently looked back at some of the things that I wrote in March, April last year, very easy to get sucked into a sort of negative mindset. Actually, it turned out to be a really good time for getting back into the market because the fundamentals were still strong, earnings growth was strong. Valuations, okay, they were high in the US but they weren't high in the rest of the world at all. The fundamentals were actually quite attractive last year. Maybe they're a bit less attractive now than they were then but there are still lots of opportunities in markets. Underlying growth in the economy is not bad. I think be careful to be too cautious.

[00:27:27] Pamela Ritchie: When you speak with investors and you speak with analysts and so on, any discussion just sort of on how it looks like certainly there are some less tariffs to worry about, there are others coming and being put on that we do need to worry about, and there are trade deals that North America needs to get through and so on, but in a word or two the tariff situation is what at this stage? Better?

[00:27:53] Tom Stevenson: I think the tariff situation is worse than it was before they were introduced. What I take away from tariffs is that businesses are good at handling these things. They adapt. Companies and individuals are very adaptable, that is what we saw last year. In investment, as in life, things are rarely as good as you hope they'll be and they're rarely as bad as you fear they'll be. We tend to muddle along in the middle and I think that's what we've got with tariffs.

[00:28:36] Pamela Ritchie: Very interesting, but it is sort of a better landscape and it has been an extraordinary couple of years. We're very grateful to have you at the beginning of this particular week and we'll be thinking of you as all the interest rate decisions come out on what you said. Tom Stevenson, thank you for joining us live from London.

[00:28:51] Tom Stevenson: Thanks Pamela.

[00:28:52] Pamela Ritchie: All the very best. Thank you for joining us here on Fidelity Connects. Let's lay out part of the week ahead for you. Tomorrow, Tuesday, you don't want to miss our conversation with Ellen Bessner. She's leading defence lawyer for advisors and dealers. Ellen is going to be identifying tangible tools and strategies that advisors can implement to build trust and better business relationships with newer generations of investors. This broadcast will have live French audio interpretation.

[00:29:19] On Wednesday, Étienne Joncas-Bouchard, he is Fidelity Director of ETF and Alternative Strategy. He joins us for his analysis on the current ETF landscape including an update on Fidelity's All-in-One ETFs. It is the monthly discussion, it's usually extraordinary to get some of the numbers there. Now, Étienne is going to be joining us first en français, that's at 10:30 a.m. Eastern time, then at the regular time for Fidelity Connects, 11:30, you can get that conversation in English and that will be discussed.

[00:29:47] On Thursday, put this in your calendar, if you put anything in your calendar. You don't want to miss our live conversation with the Honourable François-Philippe Champagne. He is Minister of Finance and National Review. He'll be joining us here, I think in studio, from Ottawa as policy continues to drive market performance in Canada and globally. We're going to be discussing the state of the Canadian economy and ways to make Canada more investable and how that connects to the federal government. This webcast will feature live French, Mandarin and Cantonese audio interpretation. Do join us for that. We look forward to seeing you throughout this week. Thanks for watching. I'm Pamela Ritchie.