February Performance Update

2023 closed with bond and equity markets moving notably higher on the back of falling inflation data and the prospect of interest rate cuts. This was something we had anticipated would happen earlier in 2023, though our thoughts played out, and the returns we expected all came in somewhat of a rush in the final two months of the year.

However, as we discussed in January, expectations often overshoot, and markets got too excited in the fourth quarter about how quickly interest rates would come down. We took some profit in January before markets sold off, and we are now adding back in as we look towards a positive few months for inflation, global growth and interest rates.

Fast forward two months to today, and market expectations are now much more measured. Instead of thinking interest rates will go from 5.25% to 4% this year in the UK, markets are pricing in a year end rate of 4.5%. Similarly in the US the first reduction is now expected in June not March, which provides a more realistic timeline for inflation to get back to target.

A consequence of that shift in view has been an increase in market volatility. Bond yields have backed out quite some way, increasing by around 0.6% so far this year, 0.3% of which came in February. As bond yields move up their capital value falls, so to put that in return terms that’s an average loss of around 3.5% on a standard bond exposure so far in 2024. Equity markets have also been mixed, with certain markets performing well (the US and Japan), and others struggling (the UK and China).

Despite the volatility, our portfolios have navigated the start of the year well. Given the selloff in bonds, we have managed to avoid much of the downside, and are now looking to add back into what looks like excellent value especially in UK government bonds. Equity markets have performed well in the US, and we will likely look to reduce our positions here as we move further into the year. Overall, so far this year our portfolios have performed better at the higher risk end, benefiting more from our equity allocations and with less drag from bonds.

One important point to make on the equity exposures is that despite the good results we remain heavily diversified. The reason that is important is because a large portion of global equity returns year-to-date have come from two stocks – Nvidia and Meta – both of whom have ridden the AI investment wave. We have some exposure here but it’s not significant. We are reassured by the various contributions from other sectors, for example we have a thematical equity exposure to the insurance sector which is up 9% year to date.

Looking forward the investment backdrop remains positive for our return forecasts. A consequence of the rise in bond yields since the turn of the year is that the income yield on the portfolios has risen further. Low Risk for example has an overall yield of more than 5.5% per annum, with High Risk even at 3.5%. This will continue to underpin returns and contribute consistently across the year. We expect our yield story to benefit us with capital upside particularly as inflation comes down significantly in the UK into the early summer months. Indeed, the optimistic end of our forecasts suggest that UK annual inflation starts with a ‘1’ by May. That sounds like a big statement, but when you include the fact that energy prices are predicted to fall by 12% in April, and that last year’s big inflation months are about to fall out of the annual numbers, you can quickly get to a figure below 2%. That naturally gives the Bank of England a lot more headroom to start reducing interest rates, which will be positive for UK bonds. Then, as inflation falls and interest rates are cut, this should help economic growth pick up. That’s then supportive for equity markets, which require a growth backdrop.

There are no doubt potential stumbling blocks. The UK budget is likely to include tax cuts which markets will likely deem as inflationary, and wage inflation is still quite high, which reduces the likelihood of interest rates being cut quickly.  For these reasons we expect bond markets to stumble around a little for now, and maybe sell off a little more. We will be looking to add into these movements, to maximise the opportunity down the line.

So in short, a steady start to the year, and we believe there is significant opportunity around the corner. Of course, there’s a lot of election activity globally over the next 12 months, and geopolitical tensions can ignite problems quite quickly. Our bond holdings will benefit in that environment, so we feel well positioned as we look at the road ahead.