Reflections of the CIO… April 2023

April was another month of puzzling market performance. Another large bank failure combined with an unexpected spike in oil prices would usually combine to raise volatility (or risk aversion) across asset classes, but for this month at least, that did not happen. In fact, the opposite occurred, with volatility falling across stock, bond and foreign exchange markets in a co-ordinated manner. Whilst the bond markets still look unsettled, stock markets look positively relaxed given the build up of adverse top down headlines. The view from 100,000 feet up remains one of calm, whilst at ground level major swings and shifts are taking place. In this tricky environment we continue to feel that portfolio risk-taking should err on the side of caution, until the direction of key trends in growth, inflation and interest rates become easier to predict.

The month began with a 6% spike in the oil price, driven by surprise production cuts from OPEC. The moves were seen as part of ongoing changes in the geopolitical landscape – a ‘Saudi first’ approach – which adds to the complexity of the multiple geopolitical risks investors are currently trying to price. And yet, the market reaction to this price spike and its implications for inflation, was one of indifference. On the same day as the OPEC announcement investors were much more interested in soft manufacturing data, judging that the downward pressure on oil prices from slowing demand would more than offset the upward pressure from production cuts. Whilst there is sound logic to this view, investors also simultaneously struggled with the fact that the ongoing earnings season was providing little evidence of a slowdown in corporate profits, whatever the economic data was implying. The day of reckoning, when a recession arrives and brings a profits crunch with it, might indeed be coming, but it isn’t here yet and in the interim stock markets prefer to remain optimistic, in stark contrast to their bond market cousins who increasingly price in a pessimistic view.

Below the surface there are some signs that all is not as well as it seems, particularly in equity markets. Take the S&P 500 for example, where a huge 86% of year to date returns have been driven by just 10 stocks. These stocks once again are technology related and are being propelled upwards by excitement around the potential of narrative artificial intelligence (or AI which produces creative content, such as ChatGPT). Narrow leadership of equity markets is not a sign of stability, nor health in our opinion and if we look outside this particular small group, the rest of the US market is having a much more pedestrian time. We have been in a very similar situation before in late 2021, when US and global markets where propelled ever higher by a smaller and smaller group of stocks, before economic reality brought everything back down to earth during an ugly 2022. We don’t think history will repeat itself to the same extent, but it does have a habit of rhyming, hence our ongoing patience in waiting for clearer trends to arrive before making any aggressive changes to portfolios.

Our attempt to square the circle between rolling headline crises and calm, but schizophrenic markets is that we remain in an interim period where the impact of a years plus worth of interest rate rises is yet to be fully felt in the real economy and in the inflation readings. Central Banks may have done enough to cure inflation without killing growth, or they may not. Policymakers and investors don’t really know enough yet to choose one answer with conviction, hence the ongoing focus on very short term economic data, which is pored over for guidance on underlying trends. Markets wax and wane depending on the outcome of the latest key reading, but conviction in any one outcome is still lacking. The net result is an ongoing holding pattern, with markets awaiting permission to land. We don’t think that in the end the landing will be ‘hard’, but we aren’t convinced enough about that view to aggressively implement it in your portfolios. Instead, we are positioned for a volatile summer as we expect to pass through a number of potentially disruptive events (e.g. arguments over the US debt ceiling), which are unlikely to prompt moves to the upside. Simultaneously, we are lining up ideas in more distressed assets (e.g. smaller company equities, real estate) which we think can make a meaningful difference to long term returns. We aren’t quite at the end of the transition from the old investment world of low rates and low inflation to the new world of higher rates and higher inflation, but we are well advanced, and the end is in sight. A little more patience now will hopefully serve us very well in the future.