Macro
By the end of this year’s second quarter (Q2), central banks of major economies found themselves at different junctures in their monetary policy cycles, at least temporarily. After being the most aggressive to raise interest rates initially, the US Federal Reserve (Fed) paused raises in June. The European Central Bank (ECB) decelerated, with a 0.25% hike in June after several consecutive 0.50% increases in prior meetings, and the Bank of England (BoE) reaccelerated in June with a surprise 0.50% increase. In Asia, Japan has persisted with its ultra-loose monetary policy regime and China has begun to cut interest rates, as their economic recovery from Covid-19 struggled for momentum in Q2.
Whilst at least one more increase is expected from the Fed in July, their recent pause and the slowdown from the ECB suggests those central banks are nearing the end of their rate hiking cycles. Both the US and Europe have now seen three consecutive declines in core Consumer Price Index (CPI) readings, a measure of inflation, whereas the UK has experienced rises of 6.2%, 6.8% and 7.1%, hence the move by the BoE to increase interest rates at a faster pace.
Nonetheless, our analysis still points to a significant deceleration in core inflation by year end as used car prices slow and the effects of big increases in the living wage and minimum wage work their way through the service sector. Producer Price Inflation (PPI) is already decelerating sharply, giving additional support to our thesis.
After a weak month in April, US economic momentum picked up throughout the rest of the quarter. Even with the Fed’s preferred inflation measure, core Personal Consumption Expenditures (PCE) Price Index, slowing to the lowest level since July 2022 and showing cracks in the private consumption story, the housing market and durable goods somewhat surprisingly picked up the slack. More pressure is likely to come on the economy in the second half of the year now that US consumers have used up a greater proportion of the savings they accumulated during the pandemic.
Europe appears to be slowing more quickly and has dipped into a shallow recession, following downward revisions to Q4 2022 growth and a commensurate decline in Q1. Flash Purchasing Manager’s Index (PMI) surveys at the end of June 2023 indicated that the deterioration in economic activity is sharper and broader than expected. This is particularly pronounced in Germany where survey results from the ifo Institute and Growth from Knowledge (GfK), as well as disappointing retail sales and manufacturing figures, suggest that the slump will be extended into the third quarter of 2023.
The contrast between the US and the Eurozone is highlighted in the chart below, as the latter has increasingly seen economic data releases come in below expectations.
Chart 1. Economic surprises are diverging between the US and the rest of the world
Source: Bloomberg and Barclays Research. Data as at 5 July 2023.
Part of the weakness in Europe can be attributed to China’s stuttering economic recovery. Since the unexpectedly rapid lifting of restrictions from late 2022, the Middle Kingdom rebounded strongly at the beginning of the year, but has since seen hindered growth due to lingering COVID-19 implications, a weak property sector and a lack of meaningful economic stimulus. This has prompted a more accommodative stance from Chinese policymakers, who have since cut the policy rate by an underwhelming 0.10%. Premier Li Qiang followed this with a pledge for more effective measures to strengthen domestic demand, boost markets, and support growth.
In Japan, inflation continues to remain above 3%, adding further support to our view that their policy of controlling the levels of bond yields is likely to be scrapped at some point this year, perhaps as early as July.
Markets
One could be forgiven for believing that such a cloudy and uncertain economic outlook would have manifested itself in volatile, most likely declining, equity markets. In truth, quite the opposite has occurred. Volatility is at the lowest levels since just before the onset of the COVID-19 pandemic in early 2020, and with the exception of China, markets have edged upwards during Q2. Even in Germany, where the slowdown has been particularly acute, the main stock market eked out returns north of 3% in the quarter.
Chart 2. Market volatility has fallen to the lowest levels since January 2020
Source: FactSet and Edward Jones. Data as at 30 June 2023.
One explanation for such resilient performance has been the $400bn splurge of liquidity into the US financial system since the problems at US regional bank, Silicon Valley Bank, first emerged in March. In addition, and somewhat ironically, the now resolved impasse on the US debt ceiling also added to market liquidity as additional US debt could not be issued until a resolution was reached. This additional liquidity arrived at a time when the US economy was picking up some steam after a period in the doldrums, especially against European and Chinese peers.
Chart 3. The tick up in central bank liquidity has helped equity markets so far this year, but it has begun to reverse
Source: Bloomberg and Barclays Research. Data as at 5 July 2023.
Another tailwind to markets has come from the frenzy surrounding Artificial Intelligence (AI). After the emergence of ChatGPT as a mainstream tool towards the end of last year, investors surged towards perceived beneficiaries of AI, particularly after US chip giant Nvidia smashed earnings expectations.
Several large US technology and platform names became the anointed few and led the charge in the Nasdaq Index, which posted its strongest first half gain since 1983. So far this year, Nvidia has nearly tripled in value and Apple has reached the staggering valuation of $3trn, only just shy of the entire GDP of the UK economy. Up until the beginning of June 2023, seven stocks accounted for all of the gain in the S&P 500 year-to-date, with the other 493 companies in the index posting an average decline. Since then the market has broadened out somewhat, helping the S&P 500 finish with its strongest quarterly gain since Q4 2021.
Chart 4. Until 1 June 2023, the equal weighted S&P 500 Index was down, but the market-capitalisation weighted index had been buoyed by the performance of large AI-related stocks
Source: Datastream and JP Morgan. Data as at 3 July 2023.
The US outperformance has come despite earnings proving to be weaker on a relative basis compared to Europe, as shown below. This looks to have gone too far and we would expect the disconnect shown below to narrow in the second half of 2023, given the headwinds facing the US economy.
Chart 5. European earnings per share (EPS) momentum has been stronger than that of the US recently, but the market performance has not
Source: Institutional Brokers’ Estimate System (IBES), Refinitiv and Barclays Research. Data as at 5 July 2023.
Elsewhere, Japanese equities posted strong returns in Q2 2023 to cap off the best half-year performance since 2012. They have been buoyed by a weak yen, loose monetary policy, and stock market reforms aimed at urging companies with a Price to Book ratio of less than one to focus on realising shareholder value.
The oil price has weakened despite supply cuts from the Organisation of the Petroleum Exporting Countries (OPEC+) cartel, weighed down by the availability of cheap Russian oil being sold to Asia.
Table 1. Performance table of asset classes and regions in Q2 2023
| Index or Asset Class | Change in Value | Currency and Bond yields | Change in Value |
| FTSE 100 | -0.31% | (EUR) €:£ (GBP) | -2.44% |
| S&P 500 | +8.74% | (EUR) €:$ (USD) | +0.47% |
| CAC 40 | +3.54% | (JPY) ¥:£ (GBP) | -10.68% |
| DAX | +3.32% | (USD) $:£ (GBP) | -2.89% |
| Hang Seng | -7.27% | UK 10 Year Government bond (Gilt) Yield | + 0.90 basis points |
| Nikkei 225 | +18.54% | US 10 Year Treasury Yield | + 0.37 basis points |
| Brent Oil | -6.11% |
Returns were more difficult to come by in fixed income markets, as traders scrambled to reprice expectations for future rate hikes, particularly in the UK. Whilst longer dated bond yields did climb in Q2, it was at the short end where this shift was most pronounced as the UK 2 Year Gilt yield rose above 5% for the first time since 2008 to end Q2 at 5.2%, 1.8% higher than where it started the period.
Chart 6. The yield on 2-Year Gilts since 2006
Source: marketwatch.com. Data as at 5 July 2023.
Positioning and Outlook
It is on the back of that sharp repricing of UK government bond yields that we have moved overweight UK Gilts for the first time in over 10 years as part of an overall overweight position in bonds. We maintain a preference for the short end of the yield curve, as the chart below shows, we are not being commensurately compensated for investing in longer dated bonds at present.
The slope of the yield curve in the following chart shows how government bonds of different maturities yield different amounts. Most of the time it is positively sloped as investors demand more compensation for lending further into the future.
Chart 7. The UK Yield curve is heavily inverted
Source: worldgovernmentbonds.com. Data as at 3 July 2023.
Sticking with the UK, we have rolled back some of our overweight position in the currency after a decent run. We remain overweight UK equities, which are unloved and at a stark discount to historical valuations. These things can change very quickly however, as we have seen recently with US homebuilder stocks who have rallied nearly 40% this year and more than 50% over one year, after previously being in the doldrums without an obvious catalyst other than the Fed approaching the end of their tightening cycle.
Elsewhere, the risk of a policy mistake from central banks is high and we are wary of complacency within stock markets. As such, we have tilted more towards defensive parts of the market throughout the first half of 2023. The chart below illustrates how unusual it has been this year to see such strong relative performance of cyclical companies in a period of deteriorating economic growth. Indeed, we are now faced with an unusual scenario where some cyclical sectors have discounted a recession and some appear priced for perfection. However, these disconnects rarely persist for long and we have moved to position accordingly.
Chart 8. European cyclicals have performed relatively stronger than defensive stocks, but weak Purchasing Managers’ Indices would imply a reversal is likely
Source: IBES, S&P Global and JP Morgan. Data as at 3 July 2023.
Additionally, the reversal of the temporary liquidity boost referred to earlier and displayed in Chart 3 could also precede a more difficult environment for equities. This deteriorating liquidity positioning is another of the reasons we have pulled back a little on risk of late.
We are also somewhat concerned about the recent lack of patience exhibited by central bankers. At the start of the inflation surge in the second half of 2020 they were telling investors it was all temporary. Initially, investors believed them. Then, as inflation proved stickier than expected, Western central banks went on the most draconian tightening cycle in 50 years by raising interest rates. A key economic principle to highlight here is that interest rate changes work with variable lags, lasting between six and 18 months. Given the much higher proportion of fixed rate mortgages currently out there compared to history, and with corporate debt also extended, logically the lags this cycle are going to be on the longer side. However, because inflation is not falling as quickly as central bankers expected, they are continuing to raise interest rates even though less than half the impact of all rises to date have hit the economy.
As I live in Henley and it is Regatta and Festival Season, the following analogy is top of mind… It is like being at a party, feeling fine after a couple of drinks and deciding to have a couple more. Caught up in the merriment another couple are imbibed until it gets late and it is time for “just one for the road”. Arriving home, the full impact of seven drinks is hitting, not just the incremental impact of the additional ones – making the hangover worse than it would have been otherwise. I do fear now that the economic hangover in the West could now be worse than it needed to be. However, when the Federal Reserve over tightened in 2018 they quickly reversed course and I anticipate central bankers will act in a similar fashion this time round. So, as at the end of June 2023 and whilst we wait to see what happens, we are receiving over 5% from 2 Year UK Gilts, the highest returns since 2007, therefore we consider this investment a very good risk-reward.
Conclusion
We have resisted temptation to indulge in the euphoria that has engulfed AI related shares so far this year. As we’ve stated previously, we would prefer to forgo upside on occasions where fundamentals detach from reality. Global technology earnings are expected to decline this year, yet the sector has continued to re-rate higher, even beyond relative highs reached in 2000 and 2020. Given the weakening fundamentals and expensive valuations, our research suggests future outperformance will be more difficult to come by.
Chart 9. Performance of the technology sector relative to the rest of the S&P 500 has exceeded previous peaks in 2000 and 2020
Source: Datastream and JP Morgan. Data as at 3 July 2023.
Therefore, we are focussed on how best to insulate portfolios from potential volatility. There is a notable disconnect between the story being told by bond and equity markets. Inverted yield curves (where short-dated bond yields exceed longer dated bond yields) have historically been a reliable recession indicator. Whereas equity markets, led by technology and cyclical stocks have climbed higher, implying that central bankers will manage to achieve the unprecedented task of taming inflation without causing significant economic damage along the way. History would suggest avoiding such a downturn is unlikely.
Even if our fears that central banks are on the verge of over-tightening materialise, we will be presented with opportunities to put cash to work and add to risk. In the meantime, there are pockets of equity markets that continue to look attractive, such as UK and Asian equities, the latter of which will benefit from China progressing with more supportive policies to boost growth. Nevertheless, we are grateful to have a place to shelter in fixed income that hasn’t been there for nearly 15 years.
Kind regards,
Ian Brady, Chief Investment Officer
Important Information
All Index data figures are sourced by Morningstar and correct as at 30 June 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.