Commentary on October 2023
The headlines in October were dominated by the tragic events in the Middle East. An initial
rally in markets was abruptly halted as the outbreak of violence prompted a shift away from
risk assets. Global equities closed 2% lower for the month. The oil price surged 3% amid
concerns of rising tensions across the region, which accounts for over one third of the global
supply. Airlines and other transportation stocks led equity markets lower, with the sector
falling 5% overall as the rise in oil prices threatened to erode profits. Gold put in a strong
performance, rising 10% to a new all-time high for the sterling-based investor, as demand
for a safe haven surged.
Bond markets initially sold off. The yield on the 10-year US Treasury rose to cross the 5% mark for the first time since 2007, fuelled by surprisingly strong US economic data and concern over the ballooning fiscal deficit, before retreating to close the month flat at 4.7%. Two of the most high-profile bond investors, hedge fund billionaire Bill Ackman and Bill Gross, the founder of PIMCO, separately announced on social media that they were buying bonds, providing the catalyst for a recovery.
The US economy continued to surprise on the upside, with GDP growth for the third quarter recording a robust 4.9%, well above its typical level of 2-3%. Job gains continued, with September payrolls +336,000 versus estimates for +170,000. Retail sales also came in stronger than expected, growing 3.8% year-on-year. The stronger growth picture was reflected in a slight miss in the inflation data, with core CPI, which excludes food and energy costs, rising 0.3% over the month. However, the data is inflated by housing costs, a lagging indicator that is still rising above 7%. Once this is excluded, core inflation drops below 3%, within the upper end of the Federal Reserve’s target range. Moreover, forward looking indicators are signalling a potential slowdown ahead. Consumer confidence dropped to a five-month low, while the ISM manufacturing index came in much lower than expectations. The US Federal Reserve continued to reiterate its stance of “higher for longer” on interest rate policy but chose to keep rates unchanged once again, observing that the recent rise in bond yields is acting as an unofficial tightening of monetary policy, reducing the pressure on the authorities to raise rates any further.
The stronger than expected economic performance was reflected in third quarter US corporate earnings, which came in mostly ahead of expectations. Overall results are on course to reach a new all-time high, with consensus estimates for earnings to grow by a respectable 12.1% in 2024. Investors were reassured by strong figures from major banks such as Bank of America, which reported their best results in more than a decade as net interest income surged on the back of higher interest rates. Mega cap technology company Meta also beat estimates but cautioned on the outlook for advertising spending going forward. UK-based advertising group WPP made similar comments.
Data for the UK economy in September showed little change. Retail sales came in weaker, down 1.2%. However, this followed strong figures in August, with both months affected by unseasonal weather patterns. Growth in wages showed no signs of decelerating overall, although starting salaries rose at their slowest pace in 2 years, suggesting that the labour market could finally be cooling. Inflation was unchanged, with the CPI at 6.7% versus estimates for a slight fall to 6.6%; a rise in petrol prices was offset by weakness in food prices, which saw their first fall in two years. House prices continued to prove resilient given the recent jump in mortgage rates, rising in October by 0.9%, and thus reducing the annual rate of decline to just 3.3%. However, the rate of transactions was 17% lower over the year. The Bank of England also chose to keep the level of interest rates unchanged for the second time in a row, adding to hopes that rates may finally have peaked.
Conflicts are often a negative for markets immediately, but not generally over a longer-term time horizon. The war between Israel and Hamas is unlikely to have a major impact so long as it doesn’t broaden to engulf the region. In the short term, markets are once again approaching deeply oversold conditions that have historically been associated with a market low. Seasonal aspects are also turning positive. Both factors support the idea of a potential rally into the year-end period.
It’s been quite a journey for the global economy over the past few years, from pandemic upheaval to the battle by central banks against inflation. The US economy has been a standout performer relative to other major developed economies. It has unquestionably been stronger than expected for longer than expected, but the blowout numbers for third quarter growth are likely to have marked a peak, with leading indicators signalling a slowdown ahead. The cumulative impact of past rate hikes has yet to be fully felt and many of the factors that have bolstered the economy, such as excessive stimulus, are now waning. It makes sense to expect growth to decelerate from here. However, Wall Street expectations of a soft landing remain alive and well. Consumers are supported by healthy balance sheets and a robust labour market. Any downturn is expected to be mild so long as this remains the case.
Major central banks have now held rates constant over the summer period and have recently hinted that they may now be finished with what has been the most aggressive tightening cycle in four decades. The outlook for inflation has continued to improve. Weaker economic data would reinforce the consensus view that, bar any shocks, we are now at the peak of the interest rate cycle and are unlikely to see rates move higher. Any further confirmation of this could be viewed as bullish by both equity and bond markets, allowing the focus to switch to the likelihood of cuts in 2024.
The correction in bond markets over the past two years has been one of the most extreme in history. As a result, yields have finally returned to a more attractive level, where UK investors can once again achieve a rate above 4% from risk-free government bonds and approaching 6% for high quality corporate bonds. Moreover, if rates do start to come down, unlike cash, bonds offer the additional potential for capital gains, as yields and prices move in opposite directions. As interest rates come down and yields fall, the price of bonds will rise accordingly. Our portfolios have held minimal exposure to bonds in recent years. However, over the summer we increased the overall position across low to medium risk standard portfolios and did so again during the annual rebalance in October, where both bond and equity weightings were raised by reducing cash.
A falling rate environment would also be positive for equities, assuming it’s not accompanied by an economic hard landing. Dividend yields in the UK have been at an attractive level for some time and have the additional advantage of providing an income that will grow over time. Growth of earnings and dividends will always be the big advantage of equities and is an investor’s primary defence against the corrosive effects of inflation, along with real assets such as gold and commodities that form an additional source of diversification on our portfolios. Gold has recorded an annualised return of 10% over the past 40 years in sterling terms and its correlation with equities is close to zero.
The sudden escalation of conflict in the Middle East serves to highlight the merits of effective diversification, as once again our standard portfolios have weathered an unexpected shock and delivered first quartile performance, outperforming their respective benchmarks. As managers, it’s impossible to predict such events, hence we employ strategies to ensure that portfolios are likely to be robust across a range of outcomes and chart a smoother path through the ups and downs of the market cycle. In this case, while traditional risk assets such as equities sold off, our positions in energy, gold and absolute return funds performed well, adding a layer of resilience. The objective is to help protect capital during periods of uncertainty and then participate in the upside once a positive trend resumes.