Q2 2023 Market Review

Investors came into the second quarter feeling like the worst was behind us. Inflation was falling consistently across the globe, interest rates looked close to peaking, and so far, economies were showing no signs of a recession.

In most regions that story has continued to play out. US inflation is now 4% and expected to fall further in July, and although there is a bit more volatility in the European data, progress is still clear. German inflation data is down to 6.1% from a peak of 8.8%, and if you look over at Spain the annual rate has fallen to 1.9% (what would we give for that here!)

Unfortunately, the UK is taking a slightly different path, and progress on the inflation front has been slower than hoped, with the annual rate still at 8.7%. This ‘stickiness’ has caused a big shift in policy plans and has had a likely short term negative effect on the capital values of UK fixed income markets. Just 3 months ago UK interest rates were expected to peak at 4%, whereas now markets expect them to get to 6.25%. UK Government Bonds fell sharply in Q2, losing 5.5%, and pulling UK corporate bonds with them. That 5.5% loss is added to -24% returns in 2022, and -5% in 2021… saying it has been a challenging environment for lower risk portfolios is the understatement of the year! It should be noted however, that over the same period, the income produced from the same investment has risen from 0.25 to 4.4%, so over the next 10 years the benefit would be significant.

In addition, higher interest rates are likely to attract foreign investors, causing the pound to strengthen against most major currencies, finishing the quarter at $1.27, up from $1.22 on 31^st March. This might not sound like much, but a rising pound is a headwind to UK investors, as any overseas assets they own become less valuable compared to the pound.

Staying on the UK, it’s also worth just touching on the housing market, as that has received a lot of attention given the increases in mortgage rates. Prices are now around 3% down on the same time last year, but the market continues to show surprising resilience, part due to the fact that only a third of UK households have mortgages. UK residential and commercial property prices do continue to trend downwards, but there is no sign of an imminent collapse. We are expecting house prices to decline over the remainder of this year, with Right Move reporting around a 5% price reduction on all properties that have not sold since being added on 31^st March.

Back to markets then – equities did fair slightly better than bonds and property in Q2, but there were still some mixed fortunes. The US market was the lead performer, as it benefited from a greater concentration in large technology businesses. After a torrid time in 2022, the likes of Microsoft, Facebook and Apple have seen an improvement in their reported earnings, whilst also benefiting from the significant attention of the “Artificial Intelligence” newsflow.

Other equity markets were not as solid though – the FTSE 100 lost 1.10%, Emerging Markets also fell, and European equities traded flat. These markets are more correlated to the global growth outlook, given large weightings in energy and banks in the FTSE 100 for example. With investors still grappling over recession risks, investors were more cautious here.

Overall, it was a quarter where we expected to see some progress in returns, though the persistence in UK inflation in particular surprised and upset markets. We think the upshot of the quarter has pushed the anticipated upside from fixed income markets in particular, back by a few months. We will discuss this more in our outlook, but to conclude for now, Q2 was a challenging period.

Q2 2023 Portfolio Review

We came into 2023 with the highest income yields we had seen in over a decade. The interest rate increases of 2022 had caused a significant repricing across all assets, and with inflation having peaked, and income levels high, we were expecting returns to develop as we moved through the year.

In some parts of our portfolio’s, this has happened, notably the higher risk areas such as equity markets, specifically over in the US, have helped to drive returns particularly in higher risk portfolios, though obviously they have also had a positive contribution to our lower risk mandates as well. In addition, we’ve had around 3% in income distributed into our lower risk portfolios over the first 6 months. Unfortunately, further losses on bond markets have held returns in those portfolios back.

Bond markets generally are actually negative in 2023, despite good income levels. Capital values have fallen further as interest rate expectations have moved up once again. The upside of that is yields have risen even further, with our Low Risk Portfolio yielding around 5% at the start of the year, but comfortably above 6% at the time of writing.

The proof is in the pudding as they say, and although the 6 month returns are not where we had anticipated at the start of the year, the fact the Low Risk Portfolio has achieved a 1% return despite bond markets being negative, is support for the benefit of that natural income trickling in.

At this point it is also worth saying that we continue to see bonds as extremely attractive. The market is pricing interest rates to go to 6.25% now, so we would have to see the Bank of England go higher than that for any further capital losses. Even if they do that, which for reasons we will argue in our outlook is a stretch, then capital values will be flat and returns for the rest of the year will be driven by income (another 3% over 6 months).

There is also every chance that capital values increase as inflation falls back, which is still our baseline expectation. In that world the portfolios benefit from the high level of income and capital growth, which is the ideal environment for returns.

In many of these quarterly updates we talk about how active we have been, though it is worth saying that in 2023 we have made the least changes for 5 years. That’s because a lot of the activity and opportunities were taken advantage of in 2022, and although we’ve topped up some of those positions, the portfolios are close to fully invested to take advantage.

Finally, just a note on benchmarks, which is not something we try to stick to but is always a valuable barometer in how we are doing compared to others. It is pleasing to say that all portfolios are performing above their benchmarks in 2023, and we continue to focus on adding value even in challenging markets such as the last 18 months.

It isn’t an overstatement to say the investment opportunity set today is extremely attractive. It is even more attractive than at the start of the year, and although it has taken longer than we wanted for the story to play out, we remain confident it will, just 4-5 months later than we expected.

Market Outlook

The investment opportunity set remains as good as we have ever seen it. Interest rate increases have caused a huge repricing of all assets, with cash rates now at around 4%, the income on bonds around 6-7%, and equity valuations in many sectors leaving lots of room for capital growth. For those returns to be realised a few key things need to fall into place.

The first and more important is that inflation continues to come down, in particular to a level below current interest rates (currently 5% in the UK for example). Now although markets are currently worried about ‘sticky’ UK inflation, we think there are some key reasons why it will surprise to the downside from here.

The first is that producer prices (input costs) have been falling since October last year. Commodities such as oil, lumber, copper, grains, and many more are significantly lower over 12 months. Supermarkets and retailers alike have been using this period to cover wage costs and re-establish their margins, though the focus of UK policymakers and regulators alike is now quite clear. Just today legislation has changed so that supermarkets need to publish fuel prices, and there are a number of ongoing investigations into fair pricing in supermarkets and other retail sectors. This should start to feed through into lower goods prices over the next 3-6 months, and with food inflation alone 1.9% of the 8.7% overall CPI rate, this would make a material difference.

Then we have energy prices, which on 1^st July fell 17% as the Ofgem energy price cap was reduced. This will pull July’s inflation number into negative territory, with prices set to fall further in October. Overall, this should pull around 2% off the current inflation rate, which when twinned with food prices, should get us close to 5% by October.

This would be a significant positive for bond markets, as it would allow the Bank of England to temper interest rate increases. The income yield alone is 7% on our bond bucket, so even if all that happens is that prices stabilise, returns can then start to come in. If prices rise, which we think is likely from here, then returns will be in excess of that income yield over the coming 12 months. To provide some perspective, if over the next 12 months the UK 10 year gilt goes back to the value it was at the end of January this year, that would provide a total return of around 18%.

The second key factor we need to watch for is a recession, and that’s not just a UK based one but over in the US and Europe too. The current data supports economies being robust, with strong jobs markets doing enough to offset the mortgage and inflation squeeze. Any signs of the data rolling over would be bad for equity markets though, so we need to watch this closely as it is especially important to the higher risk portfolios.

As discussed in the portfolio review, when it comes to positioning we haven’t changed a huge amount over the last quarter. We have added further to our overweight position to bonds, and selectively to some equity opportunities. Overall, the portfolios are fully invested, with a focus on high quality assets with strong income yields. We have little to no exposure to commercial property now, and are light on infrastructure as well, holding a preference for equity and bonds where we see the risk-reward balance as more attractive.

There is no doubt the first six months have been a tougher investment environment than we had hoped, but despite that portfolio returns have been solid. The main cause of the challenges we expect to abate over the coming months, which would allow the income we’ve been talking about for over 6 months to really make a difference to the overall return outcome. Good things come to those who wait they say, and we believe that will ring true over the coming 6-12 months.