Q3 2023 Update
Global economic growth proved to be resilient in the second quarter of 2023 driven by the consumer that was supported by a stable jobs market, falling inflation and wage gains. Investor sentiment remained fragile as interest rate rises continued, albeit at a much slower pace, the psychological overhang from the mini-banking crisis remained, and reliable recession indicators, such as the yield curve inversion, continued to send an ominous signal.
Many of our macro views are firmly playing out, particularly on the continued downtrend in global inflation. US inflation has fallen to 3% from a peak of 9.1%, EU inflation has declined to 5.5% from peak of 10.1% and UK has declined to 7.9% from peak of 11.1%. In the US, headline inflation is now back to normal levels, however we expect further falls in the UK and European inflation. Chinese economic growth is improving, despite the negative media headlines, with Q2 growth delivering year-on-year growth of +6.3%, and there is increasing probability of more aggressive stimulus given inflation is near zero and the Chinese consumer still lacks confidence to freely spend excess savings.
We are now past the halfway mark for the year and some of the economic weakness we previously forecast is underway. Most notably the German economy entered recession after its economic output shrank for two consecutive quarters and the global manufacturing sector has now been in contraction for 10 months. However, the rate of change in new manufacturing orders in the US has improved and key Asian export countries such as Singapore have seen a tentative improvement in export activity from a low base, indicating there is possibility the global manufacturing sector moves back into expansion in the second half of the year. Despite these positive signs, overall, the economic cycle remains tepid, and given the significant monetary tightening we have experienced, with developed market interest rates moving sharply higher in very short order, we feel it still warrants a measured approach to risk taking in investment portfolios.
Household and corporate finances are still relatively robust, and we expect this resilience to limit the depth of any oncoming, more broad-based recession. We expect inflation to trend lower in Europe and UK, an acceleration in Chinese growth, a weaker US dollar and a likely end to central bank rate hikes to support global growth in the latter part of the year and beyond, a view we have held since the start of the year.
At this juncture, we maintain a neutral (N) view on Fixed Interest, an overweight (OW) view to Alternative asset classes and an underweight (UW) view on Equities. Despite this, our centrally managed discretionary portfolios still have ample risk and continue to perform well in risk on markets. We believe that an opportune time to become more positive on equities again will materialise over the course of the year. We continue to see many of the negative macro events of 2022 reverse, giving us confidence that we are moving positively in the right direction.
We believe growth will improve as we progress through 2023, and any recession will be mild and brief, due to:
- Inflation falling (disinflation) supports real disposable incomes and consumer confidence. The recent outbreak of inflation is subsiding relatively quickly, in-line with prior outbreaks that were born out of crises. The pandemic, lockdowns and excessive stimulus are the reasons for the inflationary boom and as we move further and further away from the pandemic, we will likely witness a period of dis-inflation. A falling inflation rate incrementally boosts the purchasing power of consumers and households and we have already seen real disposable incomes in the US start to rise. There has also been a pick-up in consumer confidence in the UK and Europe, albeit from low levels, but a good lead nevertheless, that real incomes are on the cusp of an upturn.
- Interest rates are set to peak in the second half of the year. The US Federal Reserve held rates steady in June (a pause), a clear signal that the aggressive tightening cycle is nearing an end. Current market pricing suggests there is a 79% chance of a further pause at the September meeting and only one more 0.25% interest rate hike this year. Amongst Central Bankers there are now opposing views on future interest rate hikes, a clear shift from the unanimous rate decisions we have seen over the last 18 months, another indication the tightening cycle is nearing an end. The Bank of England’s (BoE) terminal rate of interest has also declined following the better-than-expected inflation reading for June, suggesting the BoE may be closer to peak interest rates also.
- Chinese reopening is supporting global growth and more aggressive stimulus is likely. The Chinese economy registered strong growth in the first half of the year of +6.3% year-on-year at the end of June. The Chinese consumer is spending but is still lacking confidence which has led to a slower pace of consumption growth than we expected. As a result of this, we expect the Chinese government to announce a raft of policies to stimulate the domestic consumer, supporting growth in the world’s second largest economy.
- Global financial conditions are improving, driven by lower commodity prices and a weaker US dollar. Future interest rate expectations have come down from high levels and corporate credit markets remain relatively calm. The US dollar has weakened over 10% from its peak and aggregate commodities have declined sharply from their peak in 2022. Therefore, the cost of “doing business” is now easier than it was 6-12 months ago, which usually positively impacts growth with a lag of around 6-9 months.
Equity and bond markets are well supported, despite prospect of recession in short-term
We continue to expect any recession to be mild and relatively brief, however, market volatility will remain elevated until the Central Banks finally change course on monetary policy. We believe bonds are well supported in this environment with the prospect of lower inflation and interest rate pauses and cuts on the horizon, supporting fixed rate paying assets. Additionally, bonds are offering the best absolute yields in over a decade. Non-US equity valuations including the UK, Europe, Emerging Markets and Japan are attractive and below their long-term average valuation levels, and significantly below the valuation of the US equity market. The US laregcap index – the S&P 500 – has hoovered up a lot of capital over the last decade, and the recent AI frenzy has amplified this. For example, Apple in isolation now has a larger market capitalisation than the whole of the FTSE 100 or the whole of the US Smallcap Index – the Russell 2000 – which is unsustainable in our view.
Long-term return prospects are attractive, after a tough market environment in 2022 significantly cheapened asset values. Forward looking return forecasts from Schroders and JP Morgan highlight that the return potential for equities has risen by c.3.8% per annum to above 9% on average, whilst expected bond returns have risen by c.2.9% per annum to over 5%. Investor sentiment has improved but remains fragile, hedge funds remain net-short and fund managers have raised cash levels suggesting that when investors finally turn bullish, the return from markets can be powerful as investors re-invest their capital. According to BlackRock there is c.$7 trillion sitting in money market funds, most of which will likely try to find a home in bonds and equities once the peak in interest rates is confirmed.
We believe a relatively cautious approach is still warranted at this stage given interest rates remain in restrictive territory. However, an opportunity to increase equities will materialise over the course of the second half of the year. Probabilities, history and valuations remain on our side as we move through 2023. If we look at decades of market data, the probability of a better return year for markets is very high after such a terrible previous year. On this basis, we are confident the full year will be positive for portfolio returns.
Top-3 Risks to Outlook
- Interest Rate Risk and Policy Error – the full economic impact of higher interest rates occurs with a variable lag. A rate hike typically takes between 6-18 months to impact the economy. Therefore, economies are still absorbing interest rate rises that occurred many months ago. Interest rate rises eventually slow down an economy and there is a risk that Central Banks have gone too far. Also, higher interest rates often unearth stress points in the economy, such as the regional bank issue that we saw this year in the US, and there are genuine risks in residential housing markets across Europe and the UK given the rising mortgage costs. We remain on alert for further issues emerging.
- Recession Risk – the recession is now well anticipated which gives us confidence that it will be mild, and some growth weakness has now passed without any major issues. We believe recession is likely to occur if we look at indicators that have a high predictive power of forecasting recessions, such as the shape of the US government bond yield curve, money supply growth and bank lending standards. All indicators still suggest a recession is likely in the US as well as Europe over the next 12 months.
- Geopolitical Risk – any escalation of the Russia-Ukraine War remains an economic risk. The failed mutiny by the Wagner group, an affiliate group of the Russian military, has weakened Putin, however he is unlikely to back down. The West, notably the US, has significant sway in how this plays out and as we approach the US Presidential election, we may start to see some movement if a resolution is beneficial to Democrats and/ or Republicans. The China-Taiwan issue will be an ever-present risk for markets for many years to come, however should it occur, it would be highly damaging to the Chinese economy and a risk to the authority of the Chinese Communist Party within China, and for that reason we believe the risk is low.
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Past performance is not a reliable indicator of future performance.
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Information was obtained from proprietary and non-proprietary sources deemed reliable by Chase de Vere.
Where the qualified Investment Manager has expressed views and opinions, they are based on current market conditions and their professional judgement and are subject to change.
The information contained within this update is for guidance only and does not constitute advice which should be sought before taking any action or inaction.
Prices were correct at the time of writing.