Macro
The global economy outperformed pessimistic expectations during the quarter, helped by unseasonably mild weather in the US and Europe. The unexpected and rapid rebound in Chinese activity also bolstered growth, a development that is expected to continue throughout the year.
Positive surprises were seen in the UK, Europe and the US. For example, Berenberg revised its expectations for a peak to trough fall in the UK economy from -2.4% to -0.4%. The Bank of England has also become less cautious and is no longer predicting a recession lasting for eight quarters.
Europe survived the mild winter without an energy crisis and the re-opening of the Chinese economy is providing further impetus for the export-orientated region.
In the US, services demand remained strong and this has enabled employment and job creation to hold up far better than consensus had expected.
Markets
During most of the quarter, investors in Western markets were fighting the Central Banks by insisting that the end of the rate-hiking cycle was nigh despite repeated actions and words to the contrary by Central Bank officials. The collapse of Silicon Valley Bank in the US and the forced sale of Credit Suisse in Europe have given advantage to “the end is nigh” camp and both Federal Reserve and Bank of England officials have moderated their language with respect to the pace and level of future interest rate rises. The European Central Bank (ECB) has not been quite as circumspect, with their President, Christine Lagarde, insisting the ECB was “ready to respond as necessary” to maintain price stability.
Amidst this standoff, fixed income markets continued to exhibit elevated levels of volatility. We had the best January in 40 years following the release of lower inflation numbers and then one of the worst Februaries in 40 years when the next set of inflation data was higher than expected. March started relatively calmly but post the Silicon Valley Bank collapse bond yields had the sharpest fall since 1987 (post Black Monday).
Despite the volatility, most equity markets finished up for the quarter, with the NASDAQ leading. Unusually, the S&P 500 actually lagged European bourses despite the strength of US technology shares. Hong Kong had a breather after a sharp rally whilst Japan delivered solid mid-single digit returns.
Table 1. Performance table of asset classes and regions in Q1 2023
| Index or Asset Class | Change in value | Currency and Bond yields | Change in value |
| FTSE 100 | +3.55% | (EUR) €:£ (GBP) | -0.57% |
| S&P 500 | +7.03% | (EUR) €:$ (USD) | +1.48% |
| CAC 40 | +11.2% | (JPY) ¥:£ (GBP) | -3.31% |
| DAX | +11.1% | (USD) $:£ (GBP) | -2.02% |
| Hang Seng | +3.13% | UK 10 Year Government bond (Gilt) Yield | -16.2 basis points |
| Nikkei 225 | +7.46% | US 10 Year Treasury yield | -27.4 basis points |
| Brent Oil | -7.12% | ||
Source: Morningstar, FE Analytics and MarketWatch, data as at 31 March 2023. All figures are in base currency.
Oil recovered from a fall of almost 15% to finish the quarter only marginally below where it started. Several factors buffeted the price. Concerns of a recession in the West, a less capital-intensive recovery in China and a milder winter were the negatives, whilst a production cut of 500k barrels per day (bpd) from Russia and stronger than expected hard economic data in Q1 provided support. Immediately post quarter-end, further strong support was provided by an unexpected 1m bpd cut in production from the Organization of the Petroleum Exporting Countries Plus (OPEC+) cartel.
Gold finished a volatile quarter strongly in positive territory as its safe haven status and the collapse in US real interest rates (interest rates adjusted for inflation) following the banking issues in March buoyed demand for the yellow metal.
Despite skittish markets, the dollar finished lower in the quarter whilst the pound was relatively strong versus peers.
Positioning and Outlook
Actions taken during the quarter were executed with the aim of making the portfolios more resilient should the much anticipated economic slowdown, or indeed recession, materialise later this year.
This involved moving some money from equity to fixed income and taking some cyclicality out of our equity positioning. Using the same reasoning, we reduced some high yield bond exposure, switching the money into investment grade bonds. Yields on fixed income, particularly in short duration because of inverted yield curves, now provide an attractive risk-reward as mid-single digit yields can be garnered with only a fraction of the volatility associated with equities. It has been years since such attractive yields have been on offer in short duration fixed income so we took advantage of the opportunity.
Chart 1. The UK 2 Year UK Government Bond (Gilt) Yield has risen back to levels last seen in 2008
Source: MarketWatch, 6 April 2023.
As we have said in previous communiques, this is the most anticipated recession of my 36-year career and once again it has been delayed given the decent Q1 performance. Asset allocation is therefore somewhat more complicated than usual as many small cap and cyclical shares are trading on very low valuations, implying that a good part of the recession is already discounted. However, experience reminds us that stocks seldom bottom before the recession has actually arrived. It is for this reason that we have tempered our economic sensitivity during the strong rally enjoyed by several markets year-to-date. We do, however, retain the view that areas such as UK and Asian equities provide compelling long-term value with underappreciated earnings power and therefore remain overweight.
Table 2. FTSE 350 stocks with 12-month forward dividend yield currently greater than 12-month forward P/E, by sector
Source: Berenberg Research and Eikon, data as at 6 April 2023.
The table above from Berenberg details the number of stocks in the FTSE 350 who have the unusual characteristic of the dividend yield exceeding their Price to Earnings Ratio (P/E). As can be seen from the table, all but two are from cyclical areas. When such occurrences arise, it is usually because investors do not trust the earnings estimates in the Price to Earnings Ratio (i.e. investors think the earnings estimates are too optimistic). This gives credence to our belief that, in some areas of the market, a recession is at least partly discounted.
We think the US has more elevated expectations that are least likely to be met (for instance one reason being the regional bank crisis) and therefore we remain underweight there.
The table below highlights valuations of various equity markets:
Table 3. Many markets are at discounts to historical valuations, the US less so!
*As of close of business 2 November 2022.
Source: JPMorgan Asset Management and IBES, 3 April 2023.
Conclusion
So, in conclusion, the reason we have less cash now than we have had for periods in the past is not because this is the most bullish we have ever been, it is because investment grade bonds now offer much stiffer competition to both cash and equities because of the much higher yields on offer. They can also offer better diversification than cash in periods of economic uncertainty. Therefore our portfolios have morphed to reflect this new reality, whilst retaining our long-standing bias towards small and mid-cap as well as dividend compounding shares.
Kind regards,
Ian Brady, Chief Investment Officer
Important Information
All Index data figures are sourced by Morningstar and correct as at 31 March 2023, unless otherwise stated.
The value of investments or any income arising from them may fluctuate and are not guaranteed. Past performance is not necessarily a guide to future performance.