Macro Backdrop
Markets remain keenly attentive to inflation and its implications for interest rates. US headline inflation dropped to 4% in May, predominantly due to lower energy prices. Core inflation, which excludes energy and food, declined to 5.3%, a low not seen since November 2021.
UK inflation decreased in April to 8.7% (surpassing expectations) but remained constant in May. Increases in prices for air travel, recreational goods and services, and second-hand cars counterbalanced falling fuel costs and a deceleration in food inflation, despite the latter still registering a hefty 18.3%. Notably, core inflation hit 7.1%, a peak not reached since March 1992, surpassing market predictions of 6.8%. Eurozone inflation fell to 5.5% in June, down from 6.1% in May, but core inflation increased slightly to 5.4%.
While price increases are slowing in certain sectors, others remain more resistant, rendering the path forward somewhat uncertain. Wage increases could be one contributing factor, backed by tight labour markets. UK wage inflation including bonuses was 6.5% in the three months to April 2023, and 7.3% excluding bonuses. Another potential factor is that some companies, though not all, are leveraging the inflationary environment to raise prices and bolster profit margins.
In response, monetary policy has seen a global rise in interest rates. In June, the Bank of England raised interest rates by 0.5% to 5%, and the European Central Bank by 0.25% to 4%. While the US Federal Reserve paused their rate hikes, they indicated potential for increases later in the year. China, however, remains a significant outlier, as it grapples with deflation and marginally reduced rates in the quarter’s final month.
The complete impact of elevated rates on consumers is yet unclear. Savings accumulated during the pandemic, coupled with wage increases, may counteract some inflationary effects. However, these savings are dwindling, and the latent impact of higher mortgage rates may not be fully felt yet. This could be crucial for the global economy and corporate earnings in upcoming quarters.
Recession worries persist, with the Eurozone in a slight technical recession and UK GDP marginally rising in the year’s first three months. Some cracks are emerging in the US economy, however, robust consumer spending and a stable labour market indicate no immediate recession.
Bond Markets
Despite significant volatility in US Treasuries due to various regional banking issues, global bond markets have yielded positive returns this year, providing a relief after a disappointing 2022. However, the UK government bond market fell due to a discouraging inflationary environment and expectations of higher and/or longer-lasting interest rates.
Currently, central banks remain committed to prioritising the battle against inflation over supporting economic growth. However, we believe the end of the monetary tightening phase is nearing and therefore most of the valuation adjustment has already been seen in bond markets, as reflected by dramatically higher yields. This means there could be benefit in longer dated bonds – these have been hit hard by rises in interest rates, but consequently would benefit were rates to stabilise, or fall. This trend would be expected when markets begin to anticipate that interest rates have peaked and/or need to be cut, and in turn this would be expected if the economic outlook worsens (which in turn might be a negative event for equity markets, as below).
Equity Markets
Overall, returns have been largely positive this year. The Japanese market has been the best performer in local currency terms, bolstered by a weak Yen, which benefits exporting companies but reduces returns for foreign investors. The US market has also performed well, with AI (artificial intelligence) fervour favouring the nation’s largest companies, such as Apple and Amazon. The returns from these few but significant companies have driven the majority of US market returns in 2023.
After a robust first quarter, European markets had a quieter second quarter but are still well up this year. However, a stronger pound, encouraged by the Bank of England’s more assertive approach to monetary policy, has diminished returns from Europe and the US for UK investors. The UK showed a subdued return, with a limited technology-related presence and tepid performance from mining and energy stocks. Asian and emerging market equities have lagged this year, largely due to disappointing Chinese economic data, where a better reopening narrative was anticipated by investors.
While a global recession does not appear imminent, we expect the inflationary and economic journey to be complex, and it could be a matter of a delayed recession rather than an avoided one. Interest rate increases are a blunt tool for curbing inflation as they aim to dampen demand by making life more expensive for consumers and companies. Therefore, there may be more corporate casualties to come, especially for more indebted market segments, such as commercial property; an area we do not directly invest in. This also would make companies with low debt levels more preferable when considering equity holdings. However, consideration needs to be given to the fact that equity valuations have improved and that the growth potential of stock markets makes them one of the few asset classes that can deliver returns ahead of inflation in the medium to long term. Therefore, we do not believe investors should positioned too aggressively in equity markets, but historic data also shows the risk of “missing out” – this suggests a neutral level of exposure in portfolios will be prudent for most investors.
