Commentary on May 2023
Market Overview
May was generally a flat month for equity markets, reflecting mixed global economic data. Japan rose a further 3.3%, as optimism continues to grow that the economy is emerging from its deflationary stagnation of the past three decades. The US gained 2.0% on relief over the debt ceiling agreement and blow-out numbers from NVIDIA, a maker of chips for artificial intelligence, which sent its share price soaring to a lofty multiple of 200X earnings. This was enough to take total gains for the US index since the October low above the 20% level, prompting some commentators to declare a new bull market. Further gains were also seen in India, which rose 4.4%. In contrast, Chinese equities fell by 7.1%, as data indicated that the post zero-covid recovery has stalled, with manufacturing contracting in response to a fall in exports, as global demand has continued to weaken. The People’s Bank of China unexpectedly cut interest rates for the first time in a year. UK equities also declined 5.2%, retracing some of their previous strength as the latest inflation data proved particularly disappointing, causing investors to reassess the forward path of interest rates. Gilts fell by 3.3% while Sterling continued to appreciate.
Negotiations to extend the debt ceiling in the US came down to the wire as expected, with a last-minute agreement reached that resolved the problem until after the next elections in 2024, with Federal spending capped and the debt ceiling suspended until then.
US GDP for the first quarter showed continued growth. Leading indicators for the service sector and consumption both point to continued growth, although momentum is slowing. The extra savings from pandemic stimulus payments have created a buffer against the rising cost of living, leaving consumption stronger than expected. The situation in the manufacturing sector is much gloomier, with the Purchasing Managers Index reading below 50, signalling a contraction in activity. Nonfarm payrolls continued to produce higher than expected growth. However, wage growth is finally slowing, and the unemployment rate has ticked up slightly to 3.7%. Importantly, the gradual downward trend in inflation has continued.
The UK economy has continued to flatline, but gloomier forecasts have failed to materialise. The IMF is the latest thinktank to revise up, now calling for growth of 0.4% this calendar year. Wages grew at an annual pace of 7.2% for the quarter to the end of April, accelerating from 6.7% and adding more pressure on the Bank of England to raise rates. In contrast to the US, UK policymakers have yet to achieve positive interest rates in real terms, with inflation still running higher than the level of interest rates. Consumer prices rose 8.7% in April on an annual basis, sharply lower than the 10.1% recorded in March but still considerably above target. Any cuts in rates are therefore unlikely to occur before 2024. UK gilts are now yielding higher than when Prime Minister Liz Truss left office following a disastrous mini budget. The impact of this in terms of higher borrowing costs is starting to take effect on the UK housing market, where prices recorded their first annual decline in May since 2012.
The Federal Reserve, ECB and Bank of England all continued with further rate hikes as expected. Markets were surprised with additional hikes by Australia and Canada, following previous expectations that rates in these economies had peaked for the current cycle.
Looking Forward
The overall economic narrative remains largely unchanged. Data continues to move in the right direction as central banks act to quell inflation, but progress is slow. The US is leading the way: interest rates here are now positive in real terms, following a total 500 basis points of monetary tightening in just over a year. The Federal Reserve is now expected to pause to assess the combined impact of these hikes, as they work with a long and variable lag. Markets still expect US rates to be cut by the year end, but forecasts have been scaled back. As long as GDP growth remains positive it’s hard to imagine they will proceed with cuts while inflation remains above target. The risk of higher for longer therefore remains a distinct possibility.
The UK remains an outlier in the global battle to cut inflation. However, much of this discrepancy can be explained by energy prices. Since June 2020, this portion has risen by 114%, compared to 60% for the Eurozone and just 32% for the US. Excluding this factor, the data would be quite similar. This means that the figures should start to converge later in the year, as last year’s lumpy energy price rises fall out, with big drops expected in July and October. Food prices are also set to fall over the coming months. This should hopefully allow UK interest rate expectations to cool off.
Our Strategy
The overall macroeconomic backdrop for stocks is improving but progress is slow. There remains a dichotomy between trends in the US and the rest of the world, largely driven by the unique dominance of technology shares in the case of the former. Recent gains have enhanced the technical position of the US market, as this sector has recovered some ground following a savage sell-off last year. However, the move has been narrowly driven by a handful of mega cap stocks following exuberance around artificially intelligence. As a result, the year-to-date gains in the overall US index have been driven by just seven stocks, while the remaining 493 are flat on average. Breadth will need to improve markedly going forward to signal more widespread strength.
Elsewhere the dynamic is different. Markets outside of the US are far less reliant on technology stocks, with cheaper valuations and much greater recovery potential. In past monthly commentaries we have highlighted opportunities in UK and Japanese stocks. Emerging markets are another area of interest, having markedly underperformed over the past decade. They also fell harder in 2022 thanks to the negative effect of a stronger dollar, which makes borrowing conditions tougher for the region. As a result, valuations are depressed, trading at a 30% discount relative to the rest of the world. Growth potential is also higher: the latest forecast from the IMF expects emerging market economies to expand by 3.9% in 2023, compared with just 1.3% for the developed world. In China, policymakers are ramping up stimulus to boost the economy. Stronger Chinese growth will provide a positive multiplier effect across the region. Elsewhere, India could be poised to emerge from China’s shadow as a key driver of growth. The tougher geopolitical environment for China is providing a tailwind for the Indian economy, illustrated by Apple’s recent move to set up a key production base there. The Modi government is keen to implement policies that incentivise other multi-nationals to follow suit. The demographic profile is also more supportive. Between 2020 and 2040, India will add 40 million workers with a secondary education to its workforce, in marked contrast to the shrinking trend across developed nations. Overall, there is much potential for India’s $3.4 trillion stock market to catch up with China’s $10.3 trillion one.
