Commentary on June 2023 

Market Overview

Global equity markets were broadly flat during June, with further gains in the US and Japan offsetting a pullback in the UK. News flow in the US was generally positive. The month opened with Congress approving a debt-limit suspension that averted a potential default. Wall Street’s biggest banks all passed the Federal Reserve’s annual stress test, while the central bank’s decision to keep rates on hold was also greeted with enthusiasm. After decades of disappointing returns, June saw yet another month of gains for Japanese equities. Warren Buffet’s Berkshire Hathaway raised its stake in five of the leading trading houses to an average of over 8.5%. The billionaire investor’s endorsement, combined with signs of stable inflation and improving shareholders returns helped propel Japanese stocks to a 33-year high.

The UK market traded weaker, as the ongoing rise in bond yields weighed on sentiment, particularly for interest rate sensitive sectors such as housebuilders, REITs and financials. The manufacturing sector is also experiencing a slowdown. This month saw a fresh profit warning from building materials distributor Travis Perkins, a trend echoed among industrial companies across Europe. General retailers fared better as strong trading updates from Next, Primark and WH Smith suggested that it was not all doom and gloom. Consumer confidence improved more than expected, reaching its strongest level in 17 months despite elevated inflation and the sharp increase in interest rates. On another positive note, a takeover bid for Lookers was agreed at a premium to the current share price of 35%, but still representing a price to earnings multiple of just 7X, which served to highlight the underlying value that currently exists in domestic UK stocks.

On the macroeconomic front bond yields have continued to move higher, as core inflation has generally proved sticky and central bankers have maintained a hawkish tone. The price move in bonds has been most extreme in the UK, where the CPI rose by 8.7% for the 12 months to May, defying expectations for a fall. In a clear demonstration that the fight against inflation is far from over, the Bank of England raised rates for the 13th time in a row, with an increase of 50 basis points instead of the widely expected 25. This sparked a fresh round of turbulence on bond and currency markets, with a sharp sell-off in bonds and a rise in the value of the pound.

The US economy is decelerating but continues to grow at a reasonable pace, while inflation has continued to moderate, falling to 3%, its slowest pace since March 2021. Employment is the ultimate lagging indicator and there are some signs that it is finally starting to respond to the recent sharp rise in interest rates. The non-farm payroll for June was slightly less than expected but was accompanied by a much more significant downward revision to the previous two months. As a result, the US Federal Reserve finally chose to keep interest rates unchanged, the first time it has paused since the current hiking cycle began in early 2022. However, it also cautioned that there will not be any cuts while the rate of inflation remains above the 2% official target.

Looking Forward

We are now through the mid-point of the year, and it has been a relatively sound six months for financial markets despite predictions of recession, multiple bank failures and continued geopolitical concerns.

The Federal Reserve’s decision to pause was probably the right one. Headline inflation has fallen sharply, which would suggest that policy tightening is working. The full impact of rate hikes likely hasn’t had a chance to work through to the economy yet, so taking a breather at this point makes sense. The good news is that much of the heavy lifting has now been done. Looking forward, traders expect one final hike in July, taking the US benchmark rate to 5.5%, although the Fed itself is still signalling 2 further increases.

Optimism that the Fed is approaching the end of its tightening campaign has boosted stock prices in the US. As a result, US equities appear significantly overvalued versus other markets, in some cases being almost twice as expensive. The recent rally has been concentrated in a handful of stocks, primarily mega-cap technology issues, where the share price premium is not supported by current fundamentals in terms of relatively higher earnings growth, with companies such as Alphabet and Meta seeing weaker growth from ad spending. Valuations have moved back to the top of their historic range. The overall price to earnings multiple is currently at 19.4X, with technology at 27.3X and non-technology at a more reasonable 17.4X. This has risen notably from the lows last October, where these levels were 15.3X, 18.1X and 14.5X, respectively.

In the UK the higher inflation data has resulted in a further move up in expectations for interest rates, which are now forecast to peak above 6%. This is a huge move from the start of the year, when markets were pricing in aggressive cuts in the second half of 2023. It has understandably weighed heavily on the price of financial assets. However, it is not all doom and gloom on inflation: producer prices are falling sharply, energy costs have unwound, and food is starting to roll over. A key moment will be the July CPI figures released in late August, which will factor in lower energy prices from July. Inflation will also be helped by a resurgent pound.

Our Strategy

As markets continue to myopically focus on the latest data points and extract the trend into the future, we are minded to look through the short-term noise and focus on valuations as a more reliable guide to future returns. The UK market remains cheap in absolute and relative terms. Equities trade on a discount of 30% versus global equities on both price to book and price to earnings multiples. There has been an even sharper derating of small and mid-cap companies. We remain of the view that patience will ultimately be rewarded. Moreover, high dividend yields mean that investors continue to get paid while waiting.

The latest annual 123-year Equity Gilt Study is also a timely reminder of the power of UK shares to outperform UK cash over the long term and give the better chance of beating inflation. The 2023 report gives a probability of UK equities outperforming cash over any 10-year period in the past 123 years of 90%. For periods between 2 and 5 years the equivalent probability is 70% or above. These statistics strongly support the message that sticking with equities over the long term gives the greatest chance of beating inflation.

Our investment philosophy remains that buying undervalued and under-owned assets in an uptrend is one of the best and safest strategies for returns. Japan, the UK and select emerging markets, along with gold and commodities currently fit these criteria. Bond yields are also starting to reach attractive levels for the first time in over 15 years. This means that they should once again start to act as a counterbalance against economic uncertainty, adding diversification and resilience to balanced portfolios.