Quarterly investment outlook – Q3 2023

Despite higher interest rates and persistent (though falling) inflation, global equity markets continued to err on the side of optimism as consumer spending remained strong and company earnings were better than expected. Global equities returned over 6.5% during the second quarter of the year, albeit for unhedged UK-based investors this was tempered by a stronger Pound meaning returns closer to 3%.

Geographically the US market continued to post strong returns as the enthusiasm for stocks which might benefit from new AI technologies accelerated. This performance however was eclipsed by Japanese equities which benefitted from foreign investors being attracted to a newfound focus on raising the value of listed companies. UK shares, though cheap by most standards posted a slight negative return. Continued interest rate rises in the UK, and the anticipation of more to come pushed returns on Gilts down to over -5%, although this does mean the asset class looks increasingly attractive.

Unsurprisingly, inflation and central banks expected response continues to be the single biggest factor in Western economies and the fortunes of the companies that operate in them. There are signs that in the US, and to some extent in Europe, but far less so in the UK, a combination of ‘base effects’ (inflation numbers are calculated on a rolling twelve-month basis, and therefore high increases in previous months are now starting to fall out of the calculation period), and the actions taken by central banks to raise the cost of credit are bringing inflation down to somewhere in sight of targets. This fall in inflation is occurring despite the resilience of consumer spending which has held up well due to low levels of unemployment and associated wage growth. Even the housing market has avoided a serious downturn, and although economic growth is not exciting, the US has avoided the much-predicted recession, at least for now.

Does this mean that inflation can be brought under control without a recession taking hold? The answer is that it is possible, but probably unlikely. Monetary policy, i.e., interest rate rises, famously works with long and variable lags, meaning that it is very difficult for central banks to know when they have raised rates high enough to slow inflation without causing a deep recession. What we do know is that central bankers have been consistent with their messaging throughout the rate hike cycle and have followed through with actions. We also know that they remain concerned about ‘sticky’ inflation and are more likely to raise rates than cut them at this point, and indeed have given little signal that rates will be cut at all in the short term. If fractures in the financial system occur, they would much prefer to address these by providing targeted liquidity rather than cutting rates for the whole economy.

What then does this higher inflation, higher interest rate environment mean for investment portfolios? First and foremost, it makes investment in bonds much more attractive than has been the case for many years. In the ultra-low interest rate environment, which has persisted for many years, holding bonds has been difficult. Now though, holding bonds is very much back on the radar for most asset allocators, even if the higher-risk end of the market is still viewed with some caution.

For equities, inflation can be less of a headwind for those companies that can exercise some pricing power and control wage costs. For others, the amount of debt built up in the years of easy liquidity could prove to be a major obstacle when that debt needs to be refinanced at higher interest rates and when lenders are being choosier about where they place their money. In theory, at least, the next few years should provide an opportunity for active fund managers to outperform.

David Baker, Chief Investment Officer

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