Quarterly Investment Update

Market Review

Just like the UK weather, a summer in investing can often be hit and miss. The phrase “sell in May, go away, and come back on St Ledger Day” seems to do the rounds every year in late spring, suggesting Q3 has historically had its challenges. As we closed on the end of the first half of the calendar year, economic growth looked ok, inflation was on the back foot and interest rates look set to be reduced for the first time since 2020, so the backdrop was more positive this time around.

As always though, it’s important to stay on your toes, and despite the solid pre summer set up, market volatility came from wobbles in US economic data, a change of direction from Central Banks, and a significant Chinese stimulus package.

Taking those in order, for some time now the US economy has looked remarkably resilient, despite the rise in interest rates. It is worth noting that the last time the US avoided a recession (after a significant increase in interest rates) was during the mid-1990s. Markets have been eagerly anticipating the effects of the current cycle therefore. Will economic data slow, and what will that mean? A hard landing (recession), a soft landing, or even a slowdown before a growth pick-up are all possible, and this dilemma continues to dictate investment returns in addition to the dreadful geopolitical events that continue in the Middle East and Eastern Europe.

Up to the start of Q3, markets weren’t particularly worried about a ‘hard landing’ (significant recession) and were instead positioned for a ‘soft landing’ (no recession’). However, as July closed, employment data turned quite quickly. Job openings in the US reduced and the unemployment rate moved up to 4.2%; a 0.5% increase since the start of the year. It isn’t quite enough yet to be significantly concerned, though it is also fair to say the US economy looks more vulnerable than it did three months ago. August therefore saw significant volatility in equity and bond markets, and not just in the US. On one day the Japanese equity market fell over 10% in 24 hours, as ripples were felt all over. Bond markets initially benefited from the shift in the risk of a hard landing, rallying hard. But then, as further economic data came out looking normal, within 10 days or so, the price movements reverted, and we ended August essentially where we started it.

Positively, Central Banks across the globe started to reduce interest rates as widely expected. The Bank of England reduced the base rate from 5.25% to 5% in August, then voted to hold it static in September. The Federal Reserve (US Central Bank) waited until September, but immediately reduced their rate by 0.5%. Overall, the objective here is to start to provide more support now inflation is lower, though it is only the first step and it looks like they will move slowly and steadily providing the data remains in line with expectations.

Thirdly and only recently, Chinese policymakers announced a raft of measures aimed to stimulate. Their economy has been in the doldrums since Covid, initially held back by much longer restrictions on their population and thereafter the unwinding of a property bubble. However, in the last few weeks it looks like they have now thrown their banking system a financial ‘bazooka’ to support lending and economic growth. Markets have been looking for a strong stimulative for a while, and there is now hope that this policy action will have a positive impact not just for China, but for the global economy as a whole.

All put together it was a mixed quarter for markets. On the equity front, Emerging Markets (and in particular Chinese equities) performed well, as did Europe which is often a beneficiary of Chinese growth (The Chinese are big spenders on some major European Luxury Brands). In contrast, US equities had a rare negative quarter, with the S&P 500 down 0.55% over three months, and the tech-heavy NASDAQ down further.

The real star of the show were bonds. Lower growth tends to mean lower interest rates in time, which benefits bonds, so the US growth wobbles were welcome for low-risk investors. As an example, our bond bucket added 3.4% across the quarter, outperforming any single equity sector.

Portfolio Review

The portfolios produced their fourth positive quarter in a row in Q3, with returns between 1.19% (High Risk) and 3.24% (Very Low Risk). Year to date our portfolios have produced between 5.3% and 11.8%, depending on the risk profile selected.

We often talk about our philosophy being different from the typical investment firm. The background to this is that we are a planning business at heart, which means whether you sit in our investment or planning team, our collective objective is to deliver a journey that clients are comfortable with. In the good times that means trying to make the most of the opportunity set, but always with one eye on the risks ahead.

This is one of the reasons we prefer assets that give us some form of predictability in their return stream. When you buy an equity, you are hoping for share price increases in the future. When you buy a bond, you know you are getting a fixed income return over a set duration of time. These are very different investment decisions, with the former more relevant to the higher risk portfolios, and the latter to the lower. Across the board though, one of our biggest active positions in the last 24 months (all the way back to Lizz Truss’ short reign) has been an overweight position to bonds. The reason was we could comfortably lock in 7-8% per annum for several years. Over the last two years this has provided a great underpin to returns. Our bond allocation is also a great hedge against a recession, as we have seen more latterly with the returns delivered when US data deteriorated.

Even within our equity bucket we have a strong focus on diversification. We were asked, in the last Question the Committee blog , about whether we should have invested in US tech with greater conviction. Our short answer is that we do have some exposure, though Tech remains a highly risky sector, and so it is not an ideal partner for lower risk portfolios. It instead has a greater allocation up the risk range, though even where it is owned, we have a strong eye on diversification. Pleasingly, when we monitor our portfolios versus benchmarks, our blended approach to risk has still allows us to significantly outperform.

In terms of portfolio activity, bonds still look good value and provide a hedge to some of the key risks. We sold some bonds on the back of the August rally and bought them back when priced reverted. Volatility can be used to your advantage if you are active enough, and we continue to try to ensure we add value this way. We don’t always get it right of course…in hindsight we should have held more US bonds than UK, though this may still play out in our favour, particularly if the UK economy stutters, which we see as having a strong probability.

So, ending the quarter, parts of our equity exposures look between fair value (UK / Europe / Far East) and expensive (US Tech). Opportunities still remain in fixed income, and we feel we can continue to generate over 4% pa net of fees from cash, at least for the next few months.

Put together the portfolios have had another good quarter, and we are pleased with our consistency and outperformance versus our benchmarks. Most importantly, after a tough 2022 for markets (including our portfolios), we continue to deliver a positive journey for our clients which is our core objective.

As we will argue in the next section, the outlook remains positive for returns over the next 12 months, but as always there are things to watch.

Market Outlook

Providing none of the key risks surface, we expect our portfolios to continue to grow ahead of our target returns. That assumes global economic growth remains slow (but ok), inflation remains contained, and interest rates are gradually reduced. In this world, cash will get less attractive over time, and money will gradually flow into investment assets as people are incentivised to spend and invest over save. Indeed, there is still a huge amount of wealth tied up in cash and cash-like investments which had previously locked in 5% and will be rolling into a lower rate environment.

At the same time, the backdrop for companies and the consumer looks ok. The UK household savings ratio is at its highest level in decades, and wage rises are still happening at levels ahead of inflation. Challenges remain in the UK, mostly due to budget uncertainty, with the Governments black hole rhetoric doing nothing other than to spook markets and defer investment decisions. That said, if the Government can set a clear and rational directive that supports growth, then the UK looks well placed. Once we get October out the way we can have more conviction with regards our thoughts on UK potential.

Key risks for our portfolios will emerge if inflation reverts and starts to increase on a consistent basis, with interest rate cuts being priced out of current forecasts. In this respect we do expect a blip in October data in the UK, as the energy price cap is removed, though we do not see anything that suggests there is a broad-based trend at this point. For inflation to rear its ugly head again, it would need to be supported by a significant pick-up in economic growth, which we are not seeing especially with interest rates at such high levels. It will become something we need to watch closer as they are reduced, so as always, it’s important we can react quickly to change direction as required.

The other key risk is that the US economic slowdown becomes a recession. Again, this is not our base case, but it would be a significant risk for equity markets and is another reason we feel comfortable with our overweight position to bonds, which would benefit in this situation.

Our central case remains a positive one for markets, with Central Banks likely to continue to reduce interest rates slowly, not risking a second inflation wave, and not needing to worry about an impending recession. This is the perfect policy stance for a soft landing and should result in steady forward growth for our portfolios. Around that scenario we have a keen eye on the risks, though we are positioned with an elevated level of portfolio diversification as a starting point and will continue to adjust positioning as the environment shifts.