This August/September 2023 market update is brought to you by LGT Wealth Management

August was a challenging month overall for both equities and fixed income. The first half of the month saw a selloff in equities, with the second half of the month seeing markets recover, but still ending in negative territory.

Chinese equities were a particularly poor performer in August, with concerns that the recovery was faltering. Concerns about supply weighed on fixed income markets, with government bonds and investment grade closing in negative territory and high yield close to flat.

Central bankers gathered at Jackson Hole for the annual economic symposium in August. Market participants were fixated on what message Federal Reserve (Fed) Chair Powell would deliver.

In previous years, Chair Powell delivered some market moving speeches. For example, last year he used his speech at Jackson Hole to send a direct message on the importance of price stability, which left little doubt about the Fed’s determination to get inflation down.

However, given materially higher real yields, Powell opted to reiterate the need for flexibility and reaffirmed the higher for longer message.

On the inflation front, US CPI for August came in at 0.6% month on month, bringing the year-on-year figure to 3.7% (July’s yearly figure was 3.2%). The uptick in CPI was driven by a sharp rise in gasoline prices, which were up 10.6% on the month.

Core inflation data was more encouraging, with core CPI rising 4.4% year on year, down from 4.7% in July. This is the smallest annual rise in core inflation since September 2021. The improving core inflation trajectory over the past few months might give grounds for the Fed to pause in September.

The Fed will hope that slowing economic data, a looser labour market and moderating wage growth will support a further deceleration in inflation, allowing the Fed to keep policy steady until it begins to gradually cut rates.

Speaking in front of MPs at the start of September, Bank of England (BoE) Governor Andrew Bailey suggested that UK interest rates are now much nearer the peak and that judgements on rate rises are now much more finely balanced than before.

This was echoed by its Chief Economist, Huw Pill, who compared his favoured rate trajectory akin to “Table Mountain”, providing the clearest visual of higher for longer. Nonetheless, markets are currently pricing in a hike at the September meeting, with UK wage pressure still strong.

UK inflation data for August is set to be released the day before the September MPC, which may shape the eventual outcome. A September hike would likely be the last for the BoE, as the previous resilience of the labour market appears to be eroding and there has been further evidence of slowing economic activity.

The European Central Bank (ECB) voted to raise rates by 0.25% at its September meeting, bringing the deposit rate to 4.0%: the highest level to date.

The ECB provided its clearest signal that the hiking cycle is over. By raising its near-term inflation outlook, while downgrading its growth forecast, this suggests that the Eurozone will face “stagflationary” conditions.

Recent economic indicators are showing a sharper decline in economic momentum. However, with core inflation trending above 5% for nearly a year, it can’t rule out further increases should the economy prove more resilient.

Despite continuing weak economic data coming out of China, stimulus policies have been incremental and specific, rather than large and broad based. This should be seen as a continuation of its efforts to avoid further pockets of financial vulnerability.

Early in September, The People’s Bank of China reduced its one-year loan rate by 0.1% to encourage further consumption. In addition, it has cut stamp duty on stocks and reduced reserve requirements to shore up confidence. At the same time, its intervention in currency markets to announce a higher fix shows a desire to stop the currency from depreciating further and prevent capital flight.

While the re-opening has disappointed so far, there are signs of green shoots starting to form. We would note that sentiment surrounding China has been dire and its stock market valuations remain some of the cheapest across the globe.

September is a hugely important month for economic data and all central banks will remain data dependent. That said, it is clear that major central banks are all at or near the end of the hiking cycle, as the impact of previous hikes are now showing signs of slowing the economy.

While core inflation is still too high for comfort, central banks will have to balance price stability with financial stability. In this environment, stock selection remains key and we maintain a preference towards quality companies that have the ability to compound over the long term.

Market View Changes

• No changes

Currencies

The US Dollar remains the reserve currency of the world and continues to benefit from its safe haven status. The growing belief of US resilience versus elsewhere has seen the Dollar bounce off its lows.

The level of rates is better than expected, albeit weak, and growth so far has seen the Euro and Pound bounce sharply from their October lows. However, should the challenges present in the Eurozone and UK economy lead to a harder landing, this may see the ‘greenback’ garner further support.

Fixed Income

While government bonds started performing in the wake of the US regional banking crisis, the economic resilience and elevated, but declining inflation so far has seen yields move back towards their highs for the year.

Given the UK inflation shock in the second quarter, gilts are now yielding in excess of their US peers and offer value. However, we would continue to stress caution on the long duration nature of index linked gilts.

With central banks still reducing their balance sheets and given the uncertainty surrounding the inflation outlook we still believe a neutral stance is appropriate.

As central banks have normalised policy, we have seen both government bond yields move higher. With the BoE, ECB and the Fed unwinding their balance sheets, this is taking liquidity out of the market.

While the yields on offer are elevated relative to history, investors have moved to take advantage and have been heavily favouring corporate debt. As such, the additional compensation for corporate bonds in light of moderating economic momentum has become less attractive. As such, we would advocate a highly selective approach.

As financial conditions tighten further, this typically results in an increased level of defaults. While companies have extended maturities, resulting in less acute pressures, sentiment may weigh on this market. The overall yield looks attractive, but we would stress selectivity amidst moderate compensation for this asset class.

Emerging Market Debt

With developed market central banks still set to tighten policy somewhat further, this historically has weighed on emerging markets. Though, many emerging market central banks have already raised rates substantially, which is likely to result in a much smaller impact than previous hiking cycles.

However, certain countries are facing debt sustainability issues. Therefore, we retain our neutral stance across this diverse asset class.

Equities

While cyclical exposure had buoyed the FTSE 100 Index last year, financials and commodity exposure alongside the strength in Sterling, has seen the index lag peers this year.

The market continues to trade at valuations that look cheap compared to markets elsewhere in the world, which may offer investors the opportunity to pick-up companies at discounted prices. As such, we have seen a pickup in takeover activity.

However, the UK domestic economy faces headwinds from inflation and interest rate rises, weighing on more domestic focused stocks such as those in the FTSE 250. Considering the mix of factors, we recommend a selective approach in this market.

After a torrid time last year given the outbreak of war on its borders, the combination of a less acute energy crisis and the re-opening of China has improved the outlook for Europe with luxury stocks benefitting from this.

However, the issues surrounding longer term energy security remain and political challenges may weigh on future growth potential. Furthermore, the ECB’s aggressive hiking cycle may exacerbate the issues between nations of the Eurozone. As such, we retain our neutral view.

The ongoing volatility surrounding growth, inflation and its impact on the long-term discount rate has continued to cause gyrations between cyclical and less-cyclical companies. Bank stocks remain weak, while technology stocks have led the market on the back of AI optimism.

Furthermore, the outlook in the face of rising interest costs and slowing demand may be more challenging for earnings going forward. Hence, we expect volatility to continue.

Nonetheless, the US market remains a source of attractive companies with good long-term prospects.

While The Bank of Japan’s new Governor has delivered a moderate tweak to policy, the shift that many investors had been expecting has not yet materialised. The confused messaging has pushed the Yen to its weakest level this year.

However, given the export nature of the Japanese economy, this has supported the Nikkei Index at least in local currency terms. Given moderate valuations and increased international investor interest, Japan could have room to perform if global growth remains resilient.

China’s rebound from its re-opening has been underwhelming, resulting in recent policy loosening. While consumption has bounced, weak external demand has weighed on its industrial prowess. The equity markets have given up most of their earlier gains, providing scope for a re-rating should increasing stimulative policies bear fruit.

However, the risks of political business interference in China remains high, but this is cushioned by the cheap valuations relative to other markets. A growing China tends to provide support for the wider region. The lack of sanctions on Russia confirm that energy headwinds are less of an issue for some countries in the region. As such, we think the potential for long-term growth is higher here than elsewhere.

While some emerging markets are being impacted by softening goods demand from the West, their policy mix has seen inflation rates remain more moderate, offering them more scope to stimulate domestic demand.

Commodity prices have seen some upward momentum over the summer months, supported by supply cuts. However, tightening financial conditions in the West may reduce investment in foreign economies and could weigh on sentiment.

Despite this, long- term growth prospects for many emerging markets remain high. Hence, we continue to stress a highly selective approach in this diverse universe, emphasise its volatile nature and maintain our neutral stance.

Alternative Investments

Hedge Funds/Targeted Absolute Return

Given pronounced movements across interest rate expectations, this will undoubtedly weigh on financing costs which may temper some merger and acquisition (M&A) activity. Conversely, the elevated levels of interest rate volatility may present opportunities elsewhere.

On the regulatory side, geopolitical fronts mean that regulatory intervention has become more commonplace. This has tempered our enthusiasm for event-driven strategies.

More broadly, when allocating to this space, we look for funds that could diversify returns away from the directionality of conventional bonds and equity markets, and favour these strategies.

Nevertheless, we continue to stress the importance of finding the right vehicle and investment manager, which requires extensive due diligence on the strategy and fund.

Property

Rising borrowing costs continue to weigh on property markets globally. Tightening liquidity conditions are likely to further dampen enthusiasm for long term assets with limited liquidity.

This could see lockups in open-ended property funds become more commonplace. Therefore, we continue to stress that any exposure to property should be selective and closed-ended over open-ended vehicles.

Although property has historically been a good hedge against inflation, the sharp rise in borrowing costs may alter that characteristic, at least in the short to medium term.