Reflections of the CIO… May 2023

May was an uncomfortable month for markets, particularly bond markets, as mercurial inflation trends combined with the prospect of a US government debt default to unsettle sentiment and shift prices lower. The damage was confined mainly to bond and commodity markets, with headline equity indices performing better, albeit it was an exceptionally narrow subset of stocks which were behind those gains.

In the end the US debt worries faded away as an outbreak of common sense took hold in the US body politic, allowing a deal to be reached before government money ran out. Although always an unlikely event, given the scale of the chaos that would have been unleashed if the US was unable to pay its debts, markets were always going to be a little jittery as the political drama played out during the month of May.

In the real economy, debt markets had more mundane reasons for being as unsettled as they were, centred around the fact that the latest inflation readings in the US and UK were not so good. This was true in the USA and even more so in the UK, where our underlying inflation readings actually ticked up in the latest report. These readings raised the prospect that interest rates will peak higher than originally thought, and stick there for longer, a point central banks had been trying to communicate for months, but which markets had refused to fully take on board. As the data confirmed the central bank stance, bond prices fell, with the UK gilt market having a particularly rough month, posting losses of around -5%.

The drag to the real economy from interest rates staying higher for longer is also being reflected in the wider commodity markets, with weak oil and metals prices a salient feature of the last two months. The Chinese economy is losing momentum after a strong period of bounce back post lockdown, and this adds to the growing body of evidence that the second half of 2023 is likely to be characterised by a period of sluggish economic growth and rising worries of recession.

Stock markets don’t seem particularly bothered about this prospect, it must be said, especially if one takes headline index levels as the main indicator. Looking closer however, it is becoming clearer and clearer that a powerful rally in a handful of technology stocks deemed to have leadership in the AI (artificial intelligence) arena, are about the only share prices rising with conviction. This narrowness of stock market leadership is now as wide as it has ever been, and that is rarely a healthy dynamic in our opinion. Indeed, the current set up has eerie echoes to late 2021 when a similar pattern occurred before rising interest rates popped the bubble, leading to a torrid performance period in 2022. History won’t end up repeating itself, but it could rhyme, and this is one of the key reasons why, for the moment, our overall portfolio stance remains one of caution.

We must also say that we are seeing opportunities too and are increasingly tempted to tactically add to them over the summer months. The UK government bond market for example has had a horrible last twelve months as it adjusts to the new inflationary world, and we increasingly view this weakness as an opportunity. Although UK interest rates should go higher over the next few months, the lagged effects of these rises are beginning to bite, and ultimately an economic slowdown will force the Bank of England to cut interest rates again, making a decent investment case for locking in the existing higher rates before they disappear.

Similarly, some more risky assets in the alternatives arena – listed private equity funds and some real estate assets, are trading at distressed valuations – the first ingredient needed in building a long-term case for investment. We aren’t quite at the point yet to invest heavily in these areas, but we are certainly close to taking opening positions, whilst being careful to not tip overall portfolio risk profiles too far away from their more cautious stances.

Overall, the market environment is still one characterised by macro uncertainty, which in turn is allowing short term news flow and economic data to dictate price movements. This is a tricky period to navigate through and not one which we feel we have to act aggressively in, albeit we can and do act when we see an opportunity. We would expect this mood to persist for several months more before underlying inflation, economic and interest rate trends can be identified with a bit more conviction. Until then, we will continue to be patient but alert and will keep you updated on any changes to our thinking through the usual channels.