Q2 Investment Update

Market Review

Our outlook at the start of Q2 was that inflation would prove stickier than the market anticipated, and interest rates would remain higher for longer. Inflation has tracked down slowly in the Western world, though interest rates have been slow to follow, with just 0.25% being shaved off EU rates in June.

Economic data suggests that growth is slowing in the US, though some data points remain stubborn, such as wage increases which remain higher than inflation rates in both the UK and the US. As a result, the respective Central Banks have yet to give clear guidance on when they might cut rates, though on both committees, there are a rising number where the preference is moving towards cutting sooner rather than later. It is a game of trying to ensure the inflation genie is well and truly in the bottle.

The fact that we are still anticipating interest rate cuts into July has slowed the progress of expected positive capital returns from bonds. The income produced has provided an overall positive return over the quarter, though again bond values fell meaning that bonds look even better value than they did at the start of this year.

Equities have enjoyed a good spell. They did benefit from low profit forecasts being set for Q2, which in the main, companies hurdled over by some distance. The resilience of the economy in the US, and (though to a lesser extent) in the UK, meant that companies reported earnings were well ahead of estimated profits, so equity performance (in the main) was positive, benefiting our portfolios.

Interestingly, nearly all the UK equity market return came after the UK election was announced. It certainly wasn’t the only factor, but it is worth highlighting that when you look at the global political landscape, the UK for once looks more balanced politically comparative to both Europe and the US. The Labour administration are likely to need two terms to make a significant positive difference, and hence their need to remain in office in 5 years’ time should keep them focused on the centre ground.

What does all that mean then? Well to summarise, overall, it was a positive quarter for our portfolios despite the bond market struggling to add capital gains to the income produced. Equity markets weighed in with some positive numbers and overall returns in combination were solid. This leaves us in a very good position. Bond valuations still look compelling from here, though some equity markets do look very stretched, notably the US technology sector. Care is required here, as although returns have been strong, they can quickly revert.

Q2 Portfolio Review

Following on from the detail above, we are pleased that the second quarter was once again positive for the portfolios, building on the returns delivered in the fourth quarter of last year and first of this. Depending on the risk profile selected they delivered between 0.93% (Very Low Risk) and 2.35% (High Risk) in Q2, with 2024 to date returns between 2.02% (Very Low) and 10.44% (High Risk). We are now comfortably ahead of our benchmark’s year to date, and on track to deliver the target returns for each of our risk profiles.

A year is a long time in markets, and it is easy to forget that just 12 months ago we were sat on the back of a very challenging 2022 and first half of 2023, writing blog after blog about why it was important to remain patient. Today, things are a lot easier, though the returns being delivered now are in a large part due to all the work completed in those tough times. In 2023 for example, portfolio turnover was around 50%, meaning we made changes to around half of our holdings. The benefits of those changes often take years to play out, which we are starting to see now. For example, the gross of fees return from our Low Risk Portfolio over the last 12 months has been 12.79%, versus the industry benchmark at 9.22%. Both nice returns, though it is good to see our added value coming through.

To zoom in on the second quarter, although it was great to see a strong period for the higher risk portfolios, in many ways the performance of those lower down the risk scale was more encouraging. This is because, as noted before, it has been a tough year so far for bonds. Low Risk as an example has around 65% allocated here, and despite bond markets in aggregate being down so far this year, it has returned 3.78%.

Moving onto our equity bucket, this has naturally benefited from the general trends in equity markets. To touch on a couple, we have seen continued growth in AI-related technology names such as Nvidia where we have exposure. At the same time, it was a quarter where other regions also performed well, such as the UK and Emerging Markets which bounced back for different reasons. When added to the returns delivered in the racier part of the market, this provided a good backdrop for another solid quarter of returns.

One final thing we have talked about in recent years, is the re-emergence of income as a key source of returns. In this respect it is naturally a lot easier to provide a total annualised return of 5-6% per annum when you have 5-6% coming from regular income, than when you only have 1-2%. As bond yields have once again increased, the income yields on the portfolios have risen marginally since the start of the year, and overall remain between 3% (High Risk) and 6% (Very Low Risk).

All put together it has been a strong start to the year and sets us up nicely for the second half of 2024.

Market Outlook

One of the biggest challenges of investing is trying to ignore the noise. Put differently, there is always stuff happening, data points are subject to policymaker and media scrutiny, and the markets move quickly on comments made by prominent parties. The real value is often not in understanding everything, but understanding what really matters.

Aside from geopolitical events that cannot be predicted, the investment world is driven by an interconnected set of variables, though mostly this distils down to inflation, interest rates and economic growth. When any of those variables is too high or too low, there are often issues, and really what you want is a middle ground, where they are all stable.

As we sit today, we are close to that middle ground. Interest rates are high (5.25% here) but will soon start coming down, and inflation is low (2% here). That means that for taking very little risk, you are now paid around 3% more than inflation, which as a starting point is very attractive. On the growth front, our base case is that we are in a bumble along world. The effects of interest rate increases in 2022 and 2023 are still being felt, so although they will soon start coming down, we don’t think that will cause a big growth and inflation rebound. Put together, our best estimate of the next 12-18 months is that interest rates progressively come down to 4%, inflation sticks around 2%, and growth is ok but not brilliant. For investors that’s a great environment, and one that should continue to underpin returns.

What could go wrong then? Well as always there are several risks, but again, let’s try and cancel out the noise and focus on three. The first and least predictable is geopolitics. After talking earlier about the UK being a political safe zone for the coming years, we have to worry about a number of other key elections this year, most notably in the US in November. Here it isn’t necessarily about the domestic policy agenda but more the foreign one i.e. how the next President approaches Ukraine, Israel and China. We have spent a lot of time already thinking this through with no conclusions yet worth highlighting, other than to say we are preparing a number of potential scenarios.

The second risk is a roll over in equity earnings, most likely driven by a disappointment in AI outputs. We have seen incredible levels of investment here, and for that to be shown to be profit making and not loss making we need to see some outputs. Our current sense is that in the long term this technology will be transformative, but in the short term there will be some significant breakthroughs and quite a bit of disappointment. As such we have shifted our exposures to be much more active over the recent quarter.

The final risk is the economic backdrop. Europe and the UK have already been through their tough phase, with the cost-of-living squeeze here and subsequent technical recession. The US as noted earlier was far more resilient for far longer and is now clearly slowing. Again, we do not forecast it will head into a significant recession, though it would be wrong to ignore it as a risk and so we feel comforted by having a good portion of our equity allocation, and much of our bond allocation in the UK where the momentum is more positive.

Despite those risks, we remain close to fully invested across the portfolio range with low cash levels. This reflects the fact that we remain positive, this view driven both by the trends in the main economic variables alongside the high levels of income we continue to receive. If and when things do change, we are prepared to move quickly, but for now ‘its keep calm and remain invested’.