Commentary on July and August 2023

Market Overview

Financial markets closed marginally higher over the summer months, as continued gains in July were met with profit-taking in August as the recovery paused for breath. Global equities and bonds both closed the period 1% higher overall.

The correction in August was concentrated in US technology stocks following their strong rebound this year from lows reached in October 2022. The sell-off was triggered by disappointing earnings results from several key companies. Tesla reported a shortfall in profits with margins squeezed by price cuts, while Microsoft experienced a slowdown in sales growth for its cloud-services business. Apple reported a third straight quarter of declining sales, hurt by an industrywide slump in demand for phones, computers and tablets. This contrasted with upbeat results from three of the largest US banks. Revenues grew strongly at JP Morgan, Citigroup and Wells Fargo, helped by an increase in net interest income following recent rate hikes. The contrast in fortunes between these two key sectors triggered a change of leadership, as the US market rotated back to domestic value and recovery plays in cyclical and defensive sectors. This trend was mirrored across markets in the UK and Europe.

Asian stocks closed broadly flat. After a strong start to the year on optimism over the final removal of draconian zero-covid restrictions, the recovery in the Chinese economy has lost momentum. Official figures showed that GDP quarter-on-quarter growth slowed in Q2 to 0.8%, versus the 2.2% seen in the previous quarter. The economy is also facing fresh risks from a property slump following the bankruptcy of developer Evergrande. The Chinese central bank unexpectedly reduced interest rates to 2.5%, the second cut since June. The slowdown in growth has also reignited calls for more fiscal stimulus to revive spending. Elsewhere, India closed higher on news that Apple’s main supplier, Foxconn, plans to invest in two additional factories. The economy continues to benefit from an influx of investment from companies wishing to diversify from China to mitigate the risks of US economic and technology sanctions, underpinning the longer-term growth story for equities in this region.

Trends in the US economy have been encouraging. Economic growth has continued to outpace expectations even as monetary tightening has become more restrictive and, as a result, policymakers are no longer forecasting a recession. Second quarter GDP rose at an annualised rate of 2.4%. Despite stronger growth, inflation has continued to abate, fuelling hopes for an economic ‘soft landing’. The CPI report for July came in below the consensus estimate, with the annual pace of price increases falling to 3.2%. This represents a significant drop from the 9.1% recorded in June last year, which was the peak in this cycle.

In the UK, inflation finally surprised markets by coming in weaker than expected. The CPI fell to 6.8% for the year to July, down from 8.7% in May and 7.9% in June. The slowdown has been driven by falls in the price of electricity and gas, as the reduction in the energy price cap came into effect. Data from the British Retail Consortium showed that prices in UK stores also fell for the first time in two years; a further sign that the cost-of-living crisis is starting to ease. GDP growth of 0.2% in the second quarter was higher than predicted, driven by a rebound in manufacturing and higher household spending. Although this is a low growth rate by historic standards, it is encouraging that the economy has remained more resilient than expected, avoiding a recession in the face of a surge in the cost of living and interest rates. Some darker clouds are emerging for the housing market, as while prices have held up well in the face of a sharp increase in mortgage repayments, the pace of transactions has slowed more markedly over the summer months. However, the housing market is undeniably more resilient than in the past with fewer mortgages, a greater proportion of fixed rate contracts and tighter market regulations.

Major central banks continued to tighten interest rate policy, with the US Federal Reserve, European Central Bank and the Bank of England all raising rates by a further 0.25%. Federal Reserve Chair Powell did however confirm that that the Fed would start cutting rates before inflation got back to 2%.

One central bank that continues to hold out is the Bank of Japan, which has kept interest rates at 0% or below since 2010, following years of stagnant growth and deflation. However, the latest data suggests that Japan might finally be starting to see the growth and inflation it has been hoping for. While official policy on interest rates has yet to change, the Bank of Japan has once again relaxed its yield curve control policy, effectively doubling its cap on 10-year government bond yields to 1.0% from 0.5%.

Looking Forward

In recent weeks, investors have grown more optimistic that a soft landing is possible for the US economy, and that the most recent rise in interest rates by the US Federal Reserve may be the last, although higher rates are still possible in the UK and elsewhere. Investors have been encouraged that despite the increase in interest rates, growth has remained resilient, and inflation is established on a downwards path. Economists at Goldman Sachs expect the first rate cut to occur in the second quarter of next year.

Trends in UK are also encouraging at last, although there is still work to be done. In inflation terms it is no longer an outlier when compared to Europe. Food and energy should generate further downside over the remainder of this year, with October expected to see the next drop in the energy price cap. With overall economic trends now improving, the uncertainty weighing on financial market prices presents an opportunity for long-term investors to position themselves for future growth.

Our Strategy

Following strong outperformance last year, UK equities have been range bound in 2023. The overall market is exceptionally cheap on both an historic and relative standard and we feel the magnitude of this discount is unwarranted. During August, the UK index drifted back to the lower end of its range, providing the opportunity to add a new position in either Artemis UK Select or GLG Income (according to risk profile) across our standard portfolios. Both funds are well positioned to benefit from a recovery in large cap value stocks. Over the long term we believe that buying undervalued and under-owned assets is one of the best and safest strategies to generate superior returns. The UK, Japan and select Asian and emerging markets, along with gold and commodities, currently fit these criteria.

Bonds are finally starting to reach attractive levels for the first time in over 15 years and should also act as a counterbalance to equities in any economic recession. We have increased the existing position in Royal London Short Duration Credit on low to medium risk standard portfolios, as the yield has increased significantly in line with the higher returns now available on cash. However, while the headline return on cash is looking far more attractive, it does nonetheless remain negative in real terms, especially after accounting for tax. Real assets such as equities, commodities and gold have proven historically to be the best assets to beat inflation over the long term and provide the bedrock across our standard portfolios.