As we speed into the final quarter of 2023, we asked our investment team to wrap up the economic goings on of the last three months.
UK The downward direction of inflation was a welcome development, and while the UK equity market has been out of favour, analysts are pointing to the value of UK assets in the current climate.
US The Federal Reserve reinforced its commitment to keeping inflation trending down by holding policy at a restrictive level.
Europe The effects of monetary tightening are beginning to show and inflation is remaining stubborn.
Asia A mixed picture across the continent, with glimmers of promise after poor economic performance from China.
Alternatives Oil was the standout performer, buoyed by the tightness of the market.
Sustainable The EU has launched a consultation on the implementation of the Sustainable Finance Disclosure Regulation with the aim of improving transparency surrounding the marketing of sustainable funds.
Inflation in the UK continued to trend down in the quarter, somewhat easing the pressure on the Bank of England (BoE). The July inflation figure was of particular importance as the consensus was for a large fall in the headline number following the big drop in energy prices which came in July as the new energy cap from regulator Ofgem was introduced. This seemed to be the case as the July headline inflation rate dropped to 6.8% from 7.9% with the biggest downward contributors being gas and electricity prices. Furthermore, the August headline and core inflation figures were welcome downward surprises, driven by a record (ex-COVID) drop in accommodation prices and misses in transport, furniture, and clothing inflation. These drops in the inflation data as well as signs of a loosening labour market and falling business sentiment prompted The Old Lady to hold its key rate at 5.25%, ending a series of 14 successive interest rate hikes since December 2021. 1 The Bank, however, have highlighted they remain data-dependent, but the hope is that inflationary pressures will respond to these restrictive conditions and continue to trend in the right direction.
UK equity markets finished up slightly with the FTSE All-Share gaining 0.76% 2 over the quarter. Stocks higher up the cap scale benefited from a weaker pound as approximately 77% of FTSE 100 companies generate most of their revenues overseas.
The UK equity market has been out of favour with investors on the back of persistently negative sentiment on the UK economy. It’s not only investors that have turned cold on the UK equity market, but business leaders also continue to favour other major markets to list their companies on with the number of companies listed in the UK falling 17% since 2015. 3 However, there has been an increasing number of analysts and commentators pointing to the value of UK assets right now, none more so than UK equity investment trusts which at the end of July traded on an average discount of 15%. 4
After an aggressive period of monetary tightening, the Federal Reserve decided to leave the policy interest rate unchanged at 5.25%-5.5%. While some suspect no further increases will be seen, Chair Powell stated, ‘We are prepared to raise rates further if appropriate, and we intend to hold policy at a restrictive level until we are confident that inflation is moving down sustainably toward our objective’. 5 Despite these words, attention has shifted to when the Fed might start to reduce rates, with projections showing a reduction in the Federal Funds Rate to 5.1% by the end of 2024 – a more hawkish projection than that of June’s. 6 With inflation still well above target (3.7%) and labour markets remaining tight, looking ahead to any loosening of policy feels slightly premature.
US equities had a poor end to the quarter with the S&P 500 remaining relatively flat over the period, growing by 1.5%. Changes to interest rate projections and talk of ‘higher for longer’ have led to a recent sell-off in equities. As in the previous quarter, a handful of mega caps are helping to drive returns for the index. Nvidia, a multinational technology company, is still up 203% YTD despite falling 10.53% in September. In fixed income, yields pushed higher throughout the quarter, with 2- and 10-year treasuries yielding 5.05% and 4.57% respectively – the 10-year has reached levels not seen since 2007.
The European Central Bank (ECB) increased all three key interest rates by 0.25%, with the main refinancing operations rate reaching 4.5%. The effects of the monetary tightening are now beginning to show. Economic growth has stagnated in the year so far and is likely to remain subdued in the coming months, however, inflation projections have been revised upwards for 2023 and 2024, partly due to a higher path for energy prices. 7 While many expect this to be the final interest rate increase, similar talks of ‘higher for longer’ and being made with inflation proving stubborn.
The MSCI Europe ex-UK fell by -1.92% over the quarter, having previously had a strong start to the year. Sentiment in equity markets continues to worsen following the news above. Expectations of higher US interest rates and ongoing issues in China are also having spillover effects in Europe, creating a tricky environment. The consumer discretionary sector is beginning to struggle, with luxury brands struggling with cooling demand from key markets.
While economic data coming out of China has been morbid, recent figures paint a promising picture for China’s economy. Retail sales, industrial production, and fixed asset investment all witnessed robust year-over-year (YoY) growth in August suggesting the recent monetary and fiscal support from the People’s Bank of China has helped rebuild sentiments of households and businesses. That said, there are still challenges ahead for the second-largest economy. The slowdown in growth among China’s foreign trade partners, especially in their manufacturing sectors, has impacted China’s export delivery value while the housing market and deflationary environment are weighing on market sentiment. The country’s ability to maintain this momentum will be crucial.
In Japan, the Bank of Japan (BoJ) made a surprise adjustment to yield curve control (YCC) by letting the 10-year Japanese Government Bond yield trade up to 1%, thereby limiting short sellers’ ability to make money. YCC was introduced in 2016 to encourage consumers to spend and head off the risk of deflation. 8 From a central bank’s perspective, the range has turned into a price cap thus making price discovery as an important market mechanism redundant. Currently, Japan’s debt-to-GDP ratio is approximately 260% therefore the BoJ doesn’t want interest payments on the bonds to get out of control, so YCC is an imperative tool. Inflation could prove to be a thorn in the BoJ’s side, however. Recent headline and core consumer price index figures show 3.2% and 3.1% YoY growth in August, respectively. These are particularly high levels for historical standards, although the BoJ continues to view these inflationary pressures as temporary, prompting them to keep the short-term policy rate of -0.1%. 9 This commitment to ultra-loose monetary policy sets Japan apart from other developed countries thus it’s no surprise that the Japanese Yen has weakened 3.5% 10 against the US Dollar over the quarter.
The broader Asia-Pacific (ex-Japan) and Emerging Market indices finished the quarter in positive territory with the MSCI Asia-Pacific ex-Japan gaining 0.68% 11 and MSCI Emerging Markets gaining 1.11%. 12 Both indexes were buoyed at the end of the quarter as investors grew more optimistic about China’s economic outlook.
A standout performer in the alternatives bucket over the quarter was oil, buoyed by the tightness in the market following Saudi and Russian supply cuts and an increase in the USA’s Strategic Petroleum Reserve (SPR), the latter of which was the first time we saw four consecutive weeks of reserve increases since they started draining the SPR in 2020. 13 Energy prices are one of the most volatile components in the inflation basket and thus the recent rise in oil prices could pose a threat to headline inflation figures across the globe. While this has the potential to only be a short-term problem, central banks and governments will want to ensure this rise isn’t sustained, especially in two key oil-consuming countries – the US and India – where there are elections next year.
Global infrastructure indices continue to slide on the back of the current macroeconomic environment. Inflationary pressures in the assets supply chains have impacted manufacturer’s margins while higher interest rates have increased project financing costs. The S&P Global Infrastructure Index fell 8.19% 14 over the quarter while the S&P Global Clean Energy Index, a good proxy for clean energy infrastructure, fell a staggering 20.51%.15 It has been a challenging period for renewable infrastructure companies as the ESG tailwind of recent years has abated as well as the macroeconomic drivers that are pertinent for the success of infrastructure companies. An apt example highlighting the challenges for infrastructure companies, in particular renewable infrastructure companies, is Orsted, a renewable energy company whose shares fell 25% in one day in August after it announced it may have to write down the values of its US offshore wind portfolio by nearly £2bn. This comes after the macroeconomic headwinds discussed above as well as setbacks in its discussions with US lawmakers about inflation reduction act tax credits it hoped to secure on a couple of the projects.16
In September, Rishi Sunak announced scrapping a slew of government plans, following leaks announced by the BBC. A ban on new petrol and diesel cars was pushed back from 2030 to 2035 and removing a requirement for landlords to make properties more energy efficient are a couple of examples of changes to policy. The mention of meat taxes, compulsory car sharing for commuters, and sorting household rubbish into seven bins have been touted as political point-scoring. While these plans might appeal to voters, many of whom are struggling with the ongoing cost of living crisis, moving the goalposts does not create the ideal foundations for investment.
Having been introduced over two years ago, the EU has launched a consultation on the implementation of the Sustainable Finance Disclosure Regulation and will review whether any further changes are needed. The regulation, which aims to improve transparency surrounding the marketing of sustainable funds, has come under criticism since its launch. While well intended, the labelling system of Articles 6, 8 and 9 has led to many instances of fund reclassifications and confusion for investors and has perhaps not led to the improved transparency that it aimed to do.
How have portfolios fared?
The markets have continued to be difficult over the course of the quarter, with a range of returns across our portfolios. The lower risk portfolios have fared better with their exposure to shorter duration bonds and cash like investments. We expect shorter duration sterling corporate bonds continue to perform well with L&G Short Dated £ Corporate bonds returning 3.75% of the quarter. Another key performer was Schroder Global Sustainable which returned 3.45%. As we move into the fourth quarter, we start the work into how we set our asset allocation for the beginning of next year, the information of which we will share in due course.
11. Morningstar MSCI AC Asia EX Japan NR USD 01/07/2023-30/09/2023: 0.68%
12. Morningstar MSCI EM NR USD 01/07/2023-30/09/2023: 1.11%