Welcome to our latest investment commentary covering the third quarter of 2023. We hope you and your family are well.
We recently held our quarterly investment webinar and are delighted to have been joined by Tim Carr, who is an Investment Director in the multi asset solutions team at Schroders. Tim shared the current thinking at Schroders and how they are positioned.
If you were unable to join Tommy and I, or you would like to revisit what we discussed, please click on the image below:-
Our webinars are produced for information purposes only and do not constitute financial advice.
Q3 2023 turned out to be a tough quarter for markets. Portfolios were generally flat to marginally negative, with Government Bonds, Equities and Gold falling.
We have previously mentioned our thinking in relation to the trajectory of economic growth, where we expected more of a slowdown than has been realised. Whilst we have carried slightly less risk in the portfolios due to our views, we have remained invested to ensure we benefit from a better than expected outcome. This has meant our relative performance has been good over the past 18 months or so, despite the challenges in markets.
It has been encouraging to see inflation levels continuing to fall which in turn should alleviate the pressures from higher interest rates going into the end of the year and into next year. Seasonally, the end of the year is positive for markets more often than not. We believe the conditions are there for a positive end to the year.
Much of the quarter was dominated by Central Bank noise.
This started with the Bank of England (BofE), where deteriorating economic data led investors to begin pricing in a pause/interest rate cuts, particularly following the more dovish comments from Governor Bailey. However, this was then overshadowed by the US Federal Reserve, which pushed the ‘higher for longer’ narrative, as economic data has fared better than expected and employment data remains relatively resilient. The response was a rise in longer term bond yields. US Treasuries were initially in the cross hairs, but the negative sentiment spread into other assets and eventually Gilts too, which had held up for most of the quarter due to the BofE comments.
Equities were also under pressure, especially those that are more sensitive to interest rates. For us, the falls were cushioned by two factors; the US Dollar and the oil price.
Conversely to the previous quarters, the Pound saw a material fall against the US Dollar due to the expectations of a more dovish BofE (causing Sterling weakness) and a more hawkish US Fed (causing US Dollar strength). This helped to cushion the falls seen in our US Dollar denominated investments by as much as 5%.
Due to oil supply cuts coming from Saudi Arabia and Russia, the oil price saw a substantial 25% increase in value over the quarter. This favoured the likes of the FTSE 100, which has a large exposure to Energy and Resource companies. Since we own the FTSE All Share (strong overlap with the FTSE 100) in most of our portfolios, this was an additional benefit.
We made no changes over the quarter. As previously mentioned, we made many of the changes last year and earlier this year. We have confidence in the current portfolio composition which has been working relatively well for some time now. We continue to look for opportunities that develop as a result of the market conditions.
Once again, the direction of travel for headline inflation data was in the right direction, with year on year US CPI (inflation) falling to 3.7%. This is in part due to base effects but was nonetheless encouraging. Core inflation components also eased back in the recent data releases, which are more of a focus for the US Fed. However, the headline rate has fallen more quickly than the core, resulting in the core rate now being higher than the headline. This illustrates how difficult it has been for Central Banks to bring down inflation more broadly and confirms how labour markets continue to be resilient. In the UK, CPI is finally showing signs of falling more substantially, with the latest reading at 6.7%. Whilst still high, this is a material fall from the figures seen last year.
Equities and bonds moved in tandem over the quarter, with most equity and bond markets delivering flat to negative returns. As mentioned, the FTSE 100 was one of the better performers along with the Topix in Japan, which is the more domestically focussed market. The Nikkei in Japan was down in Sterling terms as the Yen continued to weaken. US markets managed to eke out a small gain due to currency effects; in US Dollar terms, they too were down. At the sector level, we continued to see sector dispersions with Energy being the outright winner due to the
ue to the prospect of better than expected economic growth, corporate bonds performed well over the quarter. Conversely, it was Government bonds that came under pressure, especially those with longer durations. We have been building exposures to a range of Government bonds because they can add a lot of value when the current interest rate hikes are finally behind us. The consensus at this stage is that we are close to the end of the interest rate hikes, with the potential for cuts to come through at some stage next year. In light of the range of outcomes from different parts of the bond markets, we have favoured having exposures to both corporate and Government bonds.
Inflation & Central Banks
In aggregate, inflation in the developed world continues to fall but the inflation picture is Geographically dependent. Each region increasingly has its own idiosyncratic reasons behind its respective inflation story. For Japan, inflation is starting to come through more meaningfully after decades of deflation, with the latest CPI print coming in at 3.2%.
The rally in energy prices may feed through to the more volatile components of inflation data, presenting a short term upside risk to inflation. Furthermore, the core components are proving to be sticky.
We are starting to see some dispersion between the major Central Banks, with the UK less hawkish and the US Fed more so (although in the past few days, they too appear to be softening their stance). In the UK, economic data is deteriorating, helping to explain the softer BofE approach. For the US, monetary policy so far has not had the desired effect on the labour markets. Labour markets remain robust across the Developed world and unemployment low. For inflation to well and truly abate, the Fed need to see some deterioration in the labour markets and are therefore pushing the ‘higher for longer’ narrative. Due to the uncertainty here, the environment could remain volatile and certain industries could come under pressure as conditions continue to tighten.
We believe our focus on higher quality, large cap companies, should help to navigate such an environment along with our Government bond exposures.
In aggregate, economic data has not been as bad as feared so far. We believe this is now likely to be the case for the next quarter or two. We continue to expect a broader deterioration next year as the effects of higher interest rates continue to filter through.
Recessions do not always spell bad news for the markets because it depends on the type of recession experienced. We have positioned the portfolios relatively defensively as mentioned earlier, with plenty of protective strategies in place where possible, and do not expect to increase the risk levels until the outlook improves.
Recessions are typically characterised by a cut in interest rates, as Central Banks try to limit any damage and promote economic growth. This will be a trigger for us to begin considering adding risk to portfolios, where we have some exciting funds in the pipeline.
As mentioned at the start of the update, we have remained fully invested. Some points to note around our thinking moving forwards, which generally follow the comments in our previous updates:
- We continue to believe elevated volatility levels are likely to become a feature of markets over the next few years and so we will maintain a lower volatility approach more frequently. We are patiently waiting for a more supportive environment in which we expect to add risk to capture more of any positive returns.
- We have already leaned into a range of bonds with a greater focus on Government bonds, which can act as an effective hedge against equity market volatility. We have now completed this process and are now waiting for the payoff, likely next year. Once this comes through, we expect to sell our Government bond exposure in favour of other alternative strategies.
- Outside of Government Bonds, we have concentrated our exposure in short-dated investment grade bonds, which are the safest corporate bonds to invest in. The yields remain attractive and this part of the bond markets has been performing well.
- In terms of our equity allocations, our largest equity exposure remains towards US markets however, we are maintaining good allocations to other markets such as Asia. Diversification is key in this environment. With diversification in mind, we have been researching different parts of the US equity markets with an idea being to introduce a US smaller companies fund when the next economic cycle begins in conjunction with interest rate cuts.
- We continue to have no direct exposure to Europe due to the ongoing war in Ukraine. On a look through basis, some of our global funds have select European exposures and these are typically in the high-quality international companies.
- We have no direct exposure to Japan at this stage but are monitoring the markets and are seeking an entry point. We believe Japan’s longer term outlook looks attractive.
- We are not changing the allocation to the UK and have maintained a focus on the large, international FTSE businesses. We remain concerned with the domestic outlook and feel there are risks that may not be obvious. We are therefore avoiding small and mid-sized businesses where possible, however, we do believe an opportunity will come along eventually to add to smaller companies and have earmarked a fund to come into the portfolios.
- We continue to hold a reasonable amount of Asian equities and are thinking to expand into other Emerging Markets. Valuations are very compelling and they generally do not face the same inflation/interest rate policy headwinds. In fact, many Emerging Market Central Banks were quick to tame inflation and are now in a position to begin cutting interest rates, which can be a major positive.
You should note that when we see signs of improvement and the potential for interest rates to fall, we are likely to increase our risk levels and focus on areas that typically do well during the recovery periods such as Financials, Industrials and Materials businesses.
We continue to monitor the fast-changing developments. We are patiently waiting to see how things play out and are avoiding being drawn into volatile swings for short term gain because this often does not end well.
We will continue to look for new opportunities for the portfolios whilst trying to navigate the environment the best we can.
We hope you find this review informative and look forward to hearing from you if you have any questions.
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