There has been a strong value bias over the past 18 months but this is starting to swing back to growth.

Equity markets started 2023 with a recovery in tech stocks pushing US equities to the best January performance in 20 years. Stocks were lifted by positive sentiment over the opening of China and economic activity that appeared to reduce the chances of a recession. February saw these expectations fall with uncertainty over the path of interest rates and inflation. While March was influenced by the prospect of a new banking crisis with the failure of well-established banks in both the USA and Europe.

Labour markets and inflation continue to be robust but the trend is stalling. The US added 339,000 new jobs in May having created 253,000 new jobs in April and 165,000 new positions in March. At the same time inflation has fallen from 6% to 4.9%. Investors would be hoping for a pause in interest rate rises to see if enough has already been done to bring inflation down further. As it was, rates did rise and the expectation of higher rates being maintained for longer. With this outlook, markets soon lost their January gains although the UK and Europe held up better due to improving business confidence and consumer sentiment.

The Fed position this year has been to fight off persistent inflation and to achieve this aggressively increase interest rates. The Fed has stated that they expect peak interest rates to be higher than they had previously expected at 5.25%. These announcements caused stocks to fall and bonds to start to recover. However, the uncertainty in the Banking sector soon changed the narrative and this drove market sentiment in March. Both Silicon Valley Bank, the 16th largest US bank by asset and Signature Bank went from business as usual to failure within a matter of days. A week later Credit Suisse, a 166-year-old banking institution was forced to merge with rival UBS at a fire sale price. These events led to heightened volatility across the banking sector.

This pressure on the banking sector put the spotlight on liquidity concerns and the central banks aggressive tightening policy. To relieve these concerns, the major central banks announced measures to improve access to US$ liquidity. The Fed did increase interest rates again in March but softened its language over ‘ongoing increases’ being necessary to bring inflation under control. These moves restored stability in the banking sector and led to equity market improvement.

The US super banks are in a strong position for liquidity and after recent events have seen big inflows of deposit money.

The UK avoided recession at the end of Q4 of 2022 and Q1 of 2023 with 0.1% growth in both quarters. The UK is still 0.8% below it pre Covid growth position while both the US and the Eurozone are up 5.1% and 2.4% respectively.

UK inflation at 8.7% is very high and not fallen as rapidly as it has in the US. UK inflation has been driven by high food and services costs. Chancellor Jeremy Hunt described the UK inflation numbers as ‘dangerously high’ and above levels in all other G7 countries. The BoE expect inflation rates to fall to 5% in Q4 which is about half the current rate and in line with Prime Minister Rishi Sunak’s promise. The interest rate rises have led to UK bond yields rising and a corresponding fall in bond prices.

European inflation was 7% in April, up from 6.9% in March. Both figures are down from February’s 8.5% due to a big decline in energy costs. Core inflation that excludes energy and food stood at 5.6%. Despite the concerns over Credit Suisse, and the pressure interest rates are having on the banking system, the ECB put up rates by 0.5% in March and 0.25% in May to 4.00%. Unemployment in Europe is falling and now stands at 6.5%. Business activity in the Eurozone is robust with the PMI index raising to 54.1 points. Generally, the outlook for Europe is encouraging.

European banks due to Basil 3 requirements are much better capitalised than they are in the US. As a comparison, European banks have US$16tn in reserve while US banks have US$13.75tn. Europe will still suffer tighter credit conditions but not as much as the US so the growth risk is higher in the US this year than Europe.

The Bank of Japan (BoJ) believes that their lose money policy has been a success despite it not having sustainably achieved its 2% inflation target. The BoJ maintains its negative interest rate policy and bond buying programme. Inflation is now at last rising in Japan and now stands at 3.2% down from January’s high of 4.3%, which is the highest rate of Japanese inflation since 1982.

Japan’s major employers have all agreed to give a 3.8% pay raise for this financial year. Japan is confronted by post pandemic labour shortages and a heavy reliance upon imported commodities and a weakened Yen. We do think that the BoJ may consider interest rate rises to keep a control upon inflation. However, the recent decline may make life easier for BoJ Governor Kazuo Ueda in trying to control inflation when Japan has wanted to create and retain sensible levels of inflation for so long.

The Chinese economy advanced 4.5% year on year in Q1 of 2023, accelerating from a 2.9% growth in Q4 and topping market estimates of 4%. It was the strongest pace of expansion since Q1 of 2022, amid efforts from Beijing to spur the post-pandemic recovery. Retail sales growth was at a near 2-year high in March, industrial output rose the most in 5 months, and the surveyed jobless rate fell to its lowest in 7 months. However, a complex global environment and insufficient domestic demand mean the foundation for the country’s recovery is “not yet solid.”

Last year, the economy added 3%, missing the government’s goal of about 5.5% despite the zero Covid policy. This year the National People’s Congress have set a growth target of 5%. There is likely to be pent up demand from consumers after years of tight Covid restrictions. Chinese consumers have US$2.5 trillion in excess savings. A long-term recovery in China will be needed and some tax cuts and incentives already in place have helped the lower paid households and small businesses.

The property market in China will need support. China’s banks have increased lending after an injection of liquidity from the state banks to support property development.

The general outlook for the global economy is one where the real economy seems to be in reasonable health despite such high inflation and aggressive interest rate hikes. The condition of easy money led to asset price inflation and goods price deflation. We now have the opposite. The move from ‘free money’ to ‘expensive’ money has led to the re-pricing of assets. Breakages are beginning to emerge in the system such as the spike in the UK gilt yields last September and the failure of US and Swiss banks. The impact of higher interest rates may yet not have been fully felt and further breakages will unsettle markets and investors. So far, the institutions who have created the pressure are dealing with the damage sufficiently.

The banking capital adequacy rules that were introduced in 2008 have ensured that the capital position of most banking institutions remain very strong and therefore credit quality remains sound. Silicon Valley Bank and Credit Suisse for example faced their own unique issues and their problems were responded to swiftly to reduce the chance of contagion. The overall impact is a reduction of risk appetite and a likely tightening of lending criteria so that liquidity in markets falls leading to a slowing of growth.

Amid this environment the attraction of gilts and treasuries will rise. We can now expect government bonds to fare better. With interest rates rising, bond investors can benefit from higher yields.

Corporate earnings could be a concern with the slowdown in consumer spending. Earnings expectations in the S&P 500 have reduced and potentially decline further. This is an issue as stock prices often follow earnings. Some sectors have taken advantage of the excuse of inflation and put-up prices by far more than needed and taken advantage of the consumer. While others it is far harder to pass on costs. The health of the consumer will be a key issue over the next 6 to 12 months while inflation reduces significantly.

Our general view is to slightly underweight our previous positions in the US, as earnings expectations are not reflecting a potential recession. We will hold our positions in the UK, but increase our allocation to Japan and Europe. We are expecting growth in China and consequently the emerging markets but as yet this has not materialised in investment returns. Concerns over China’s lacklustre reopening recovery have been weighing heavily on China’s stock market and have been one of the major recent risks in the hope for a global economic soft landing. The news that Beijing is working on a sizeable property sector support package seems to be precisely what investors are looking for.

It is good to see how much more as compared to last year, that equity markets are taking the return to higher yield levels in their stride. Particularly notable is that the growth companies of the tech sector, whose valuations suffered substantially last year under rising yields, seem to no longer be seen as growth companies this year, but safe-haven investments. Markets appear to accept that rates and yields are unlikely to come down in the very near future as inflation proves stickier than anticipated. Yet with a still booming services sector compensating for the slowdown in manufacturing, the notion that the global economy will avoid a painful inflation-busting recession has become the new narrative.

We have increased our tech exposure on the back of the advances in AI companies and as a reaction to growth orientated companies making a recovery. We have redirected allocations to tech from property, sustainable energy and infrastructure as these sectors have been more affected by interest rate rises.

Investors were pleased to see a resolution to the standoff over the US debt ceiling vote and that the solvency of US banks has fallen from the headlines but not gone away. US interest rate rises are now expected to be paused so that further pressure is not placed upon lenders. US new job numbers remain both strong but showing signs of slowing which suits the Fed. Inflation figures in Europe have also declined faster than expected

Investors are now starting to feel a bit more optimistic. To justify this, they would point towards the wider market expectation that yields will fall in the medium term, making equities more attractive against bonds. As for the already expensive US stock market, those optimists would argue this is mainly driven by those companies that will shape our society’s future, and therefore justify the premium.

Pessimists will point to the higher-for-longer risks emanating from high interest rates and lending costs eventually driving down demand and profits, causing a recession that starts a debt default cycle. They might also point out that US tech firms will have to generate high profits in the future to justify the current valuations. We are mindful of liquidity concerns in the market in future through the banks’ tighter lending conditions and capital adequacy requirements.

As we are unsure as to what is ahead of us, we do need to prepare portfolios for a range of outcomes. A fully diversified portfolio including alternative assets will prove more resilient risk adjusted returns than a conventional equity and bond only portfolio.

We will maintain a fully diversified portfolio built on a combination of passive low-cost index trackers and actively managed funds. We are maintaining our weighting in equities but with an improved emphasis on markets such as Europe and Japan. As far as bonds are concerned, we will remain short on duration with an emphasis on quality.

Within Edition 39 we have continued to hold conventional government and corporate bonds. We have continued to select short dated credit and continue with strategically managed bond funds in the form of the Dodge and Cox Global Bond Fund, the Royal London Diversified Asset Backed Securities Fund and M&G Global Floating Rate High Yield Fund. We have retained the Aegon Short Dated High Yield Bond Fund.

As far as the specialist sectors are concerned, we have been happy to maintain our holdings in the Polar Capital Global Insurance Fund, the Guinness Sustainable Energy Fund, but have removed the Gravis Clean Energy Income Fund on performance grounds. We have reduced our iShares Global Property Securities Index Fund and M&G Global Listed Infrastructure holdings as we feel that higher borrowing and mortgage costs will impact returns and values. We have also removed our holdings in the JP Morgan Natural Resources Fund. This fund has been a useful holding and with commodity prices falling, inflation starting to decline and a recession forecast then this capital can be deployed better elsewhere.

We feel that a year of heavy re-pricing of values in almost every asset class and sector is coming to an end and while a recession can bring further sensitive volatility, we can more confident about bond yields stabilising and an improving environment for investors. There has been a strong value style bias over the past 18 months but this is starting to swing back to growth and hence we have re-introduced some growth focused assets.

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