Monthly Market Commentary - July 2023

The second quarter was more or less flat for many UK-based investors with multi-asset portfolios. While it was another positive period for global stock markets, sterling appreciation pared gains for UK based investors to just over 3%, UK equities lagged, and gilts had another poor quarter.  UK bond yields moved higher, pushing gilt prices lower, as inflation is proving stickier than hoped and the Bank of England recently raised its base rate to 5.0% - the highest level since 2008.

Market volatility has notably decreased since March with gauges of volatility on US stocks falling to two-year lows, largely thanks to well-known risks not materialising. Fears around widespread contagion in the US regional banking sector have not come to pass and US politicians reached an 11^th hour deal to avert a US debt default. The first armed uprising in Russia in over three decades serves as a timely reminder of the ongoing instability in the region and the potential for knock-on effects further afield, but for now it seems that while recent events have led to plenty of speculation not much has changed from a financial markets’ viewpoint.

Central banks continue to fret about inflation which has led to a re-pricing of terminal rates from major central banks, with the Bank of England (BoE), European Central Bank (ECB) and Federal Reserve (Fed) all now expected to raise interest rates further than was predicted at the end of March, according to futures markets. Economic data on the whole continues to hold up better than expected with weakness in manufacturing more than offset by services where spending is being supported by solid jobs markets. Forward looking business surveys are flashing warning signs and the Eurozone has entered recession following two consecutive quarters of negative growth, but employment measures remain strong.

This broadening out of driving factors behind high inflation has increased pressure on the Bank of England to tighten policy further and futures markets are now pricing a terminal rate in excess of 6% around the end of the year. UK rate setters displayed their determination to curb inflation by stepping up their efforts following the latest policy decision, voting in favour of a 50 basis point increase of the base rate after 25 basis point raises after the two previous meetings.

This reinvigorated determination to raise interest rates has caused notable moves at the front-end of the yield curve, with the two-year gilt yield rising to 5.28% from 3.47% in the last three months. In doing so the yield has surpassed the highs from last Autumn caused by ex-chancellor Kwasi Kwarteng’s “mini-budget” and has reached a new 15-year high.

An obvious pain point caused by these levels of interest rates are mortgages, many of which are typically set at fixed rates for two-, three- or five-years. Deals where the fixed-term portion is now expiring face sharply higher monthly repayments than when they were initiated as a typical two-year fix now carries an interest rate of more than 6%.

Another by-product of higher interest rates in the UK is the gain in sterling, driven by rate differentials with peers. The pound has risen to around $1.27, up 3% in the quarter. The move up in the currency has weighed on UK large caps which have fallen around 1% since the end of March, although they remain in positive territory for the year.   

Tech in vogue

A trio of factors have combined to boost US stock markets compared to European counterparts over the last three months, with broad-based indices stateside up over 8% in local currency terms. Firstly, economic data points to relative US outperformance, with stronger economic activity and inflation falling more swiftly. Secondly, the Fed appears closer to the end of its tightening cycle, keeping rates unchanged following its latest meeting. Lastly, and most impactfully for financial markets over the last three months, there has been a groundswell of interest in Generative Artificial Intelligence (GenAI) with investors flocking to stocks deemed best positioned to benefit from the potentially transformative technology. GenAI is a type of Artificial Intelligence that can create a wide variety of data – including text, images, audio - by learning patterns from existing data, then using this to generate new and unique outputs. 

US indices with a higher weighting to technology stocks have reflected this, jumping by around 13% in the second quarter. While we recognise the clear potential in the AI space – and already have some exposure to likely ‘winners’ - we are wary of chasing the hot theme of the moment preferring to invest in good quality companies that trade at sensible valuations. The initial hype and subsequent bursting of the dot-com bubble showed that you can be right on the technology but still suffer large losses, if you hold the wrong investment.  

Away from the AI bubble, other companies appear to be coping reasonably well with increased input costs and modest sales growth with profit announcements at least in line with expectations. There is always the risk that consumers are squeezed out of existence before central banks let up on interest rates, but equity valuations are in the middle ground rather than over-extended and investors always like to look through any current challenges to better times ahead.