Macro
Quarter 2 started with US employment numbers, retail sales and Consumer Price Index (CPI) inflation data coming in higher than expected. However, all abated as the quarter progressed. As of May, UK inflation data had dropped all the way back to the Bank of England’s (BoE) 2% target but now commentators and the central bank are worried about sticky service and wage inflation.
The European Central Bank (ECB) became the first major western central bank to cut interest rates but the cut came with commentary reigning in market expectations of a series of further rate cuts.
In our Q1 commentary, we highlighted that the number of interest rate cuts the market expected the Federal Reserve (Fed) to enact had been reduced from at least six to three. Market expectations now stand at one. The reason this is so important is that the actions of the Fed impact what other central banks can do. Furthermore, a strong dollar can act as a depressant on global liquidity and thus negatively impact economic growth and financial markets, especially emerging countries.
Our assessment is that the market has now become too cautious with regards the scope for rate cuts in the West and we would not be surprised if the US, UK and Europeans all cut interest rates twice by year-end and would be amazed if this didn’t happen by the end of Q1 2025.
Inflation below 3%, a slowdown in trend growth in China and a cyclical slowdown in the US, should combine to facilitate such cuts.
The other aspect that has played out is the upgrading of the economic outlook for the UK (albeit from a low base). Q1 Gross Domestic Product (GDP) growth came in materially higher than expected at +0.7% versus 0.4% forecast and real incomes in the UK are accelerating as per the chart below.
China continues to ease policy and support the housing market but not to the extent that satisfied investors. Latest support efforts include supplying local governments with finance which will enable them to buy a portion of the stock of unsold homes from property companies and use them for social housing.
Markets
As expectations of rate cuts eroded, government bond yields rose in Western markets. However, they did finish off the highs following a sharp rally in June that was due to a confluence of weaker US data and a “flight to quality” following the results of European elections. Another natural consequence of the latter was that the interest rate spreads of French and peripheral European countries over German Bunds (bonds) rose to reflect a higher chance of fiscal largesse by populist parties in France especially but also in other Mediterranean countries. Such parties stand to gain influence in the aftermath of national election called by President Macron, even if the far right do not win an absolute majority.
Continued yen weakness was another noteworthy feature of the period and is another example of the influence Fed policy exerts over other markets. A big factor in the yen’s weakness, despite the currency being incredibly cheap versus the dollar, is that the Fed’s reticence to cut rates year to date has meant the interest rate differential between the two countries remains large. If we are correct about the Fed cutting twice over the next few quarters then the situation should reverse. This view is bolstered by the fact that Japanese authorities themselves have stated recently that they are concerned about the extent of the weakness and stand ready to take action.
Within equities, Artificial Intelligence (AI) related stocks led the way hence the Nasdaq was the best performing large index, closely followed by the recovering Hang Seng Index. Other technology heavy Asian indices such as Korea and Taiwan also enjoyed gains, as did Japan (aided by the yen’s weakness) and the UK, where both large and small-caps rose. European indices, on the other hand, fell over the quarter with French shares being particularly weak.
UK economic news was better for choice in Q2, so it seems political and interest rate concerns were the culprits with regards muted (but still positive) returns. However, it was pleasing that several of our widely held UK facing funds such as JO Hambro UK Equity Income, GAM UK Equity Income, Montanaro UK Equity Income and Unicorn UK Income managed to deliver positive returns in the mid-single digits, much better than the overall indices.
In commodity markets, oil fell on worries about US growth and OPEC+ deciding to bring back some of the supply held off the market whilst gold continued its move up despite both nominal and real yields climbing in the West.
Within fixed income, spreads over the highest rated (and hence lowest risk) government bonds are currently very narrow, and this is why we see little point in taking on additional risk within this asset class at present.
Positioning & Outlook
We retain our optimism through year-end as the back of the inflationary cycle has been broken, the US economy is slowing but so far looks like avoiding a recession, economies outside the US are recovering, the manufacturing recession has troughed and, importantly, profit expectations are rising. These points are evidenced on the following two charts.
This was yet another quarter where globally small-caps underperformed large-caps. This was especially pronounced in the US and China but was a widespread phenomenon. We used such weakness to pick up Chelverton European Select in our Wayfarer Model Portfolios Risk 6-8 i.e. the ones with higher equity content.
We made very few other changes in the quarter as we feel comfortable with the way our models are set up. Our models will benefit from the gradual recovery in the world excluding the US.
We have deliberately foregone the possibility of higher returns via longer-dated bonds because we think the risk reward is better on shorter-dated bonds which, unusually, offer higher yields to begin with.
The same phenomenon exists in the UK.
We therefore continue to expect positive returns between now and year-end, short-term volatility notwithstanding. A change from the recent past is that post-election, and at least in the short term, the UK is far less likely to be the epicentre of the volatility a la Brexit and the Truss – Kwarteng budget. This can only be good for investor confidence towards British assets, at least on a relative basis.
Kind Regards,
Ian Brady, Chief Investment Officer
Important Information:
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All Index data figures are sourced by Morningstar and correct as at 30 June 2024, 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.