Economic & Market Overview
• The US stock market benefitted from a surge in excitement around Artificial Intelligence (AI).
• The US Federal Reserve raised rates by 0.25% in May to take the upper band to 5.25%.
• The Japanese stock market hit its highest level in 33 years in June, with strong demand from overseas investors.
Inflation and interest rate expectations continued to dominate the narrative for developed markets over the quarter. As the subsidence in
inflation extended beyond the fall in energy prices, expectations of further rate hikes were lowered, helping some equity markets to record
gains over the period. However, the picture was mixed. The US stock market benefitted from a surge in excitement around Artificial
Intelligence (AI), with the technology sector rising strongly on the performance of a handful of stocks. However, the shadow of China loomed
over Emerging Markets, as a lack of growth from the Chinese economy following the end of Covid lockdown restrictions tested the patience
of investors. The UK remained an outlier, with core inflation, that excludes food and energy, continuing to rise. As a consequence, UK interest
rate expectations rose, with the Bank of England unexpectedly increasing rates by 0.5%. Sterling strengthened as a result, which eroded the
value of unhedged overseas assets held by UK investors, whilst both the UK gilt and equity markets fell.
The US Federal Reserve continued its tightening of monetary policy, raising rates by a further 0.25% in May to take the upper band to 5.25%.
There was some evidence that the impact of previous rate rises was coming through, as the annual rate of inflation fell to 4.1%, lower than
forecasts, before touching 3.0% at quarter end. However, unemployment increased only modestly, from 3.4% to 3.7%, with much of this
attributed to people re-entering the labour market, as the US economy marched on. Markets rose strongly, aided by the results of a leading
US semiconductor manufacturer, Nvidia, whose revenues grew by 19% over the first quarter of the year. The strong demand was attributed
to their chips being used in AI applications, with AI being the dominate market theme during the quarter.
The Japanese stock market hit its highest level in 33 years in June, with strong demand from overseas investors, as corporate governance
reforms continued to lead to a greater focus on shareholder returns, if only gradually. However, returns for these same investors were
moderated by continued weakness in the yen, as interest rates remain at minus 0.1%, with Japan enjoying a healthy level of inflation rather
than the runaway levels seen in western economies. At the other end of the spectrum, Chinese inflation fell to zero in June, showing the
weakness in its economy, and markets reacted accordingly, falling significantly to more than eradicate the gains of Q1.
As developed market central banks continued to raise rates, bond markets sold off, with government bonds and investment grade corporate
bonds both recording losses. The additional yield on offer from high yield enabled the asset class to make further gains, despite the rising
rate environment.
Performance Review
The cautious portfolios suffered worse returns of -1.9% to -1.1% over the quarter. These portfolios have more bond exposure which sold off
sharply over the quarter as stubborn inflation numbers, particularly in the UK, took many by surprise. The Bank of England implemented
further rate hikes, bringing the total to five in the current cycle, but raised its inflation forecast to 11%, putting further downward pressure
on bond prices, which have an inverse relationship to interest rates. Elsewhere, our Absolute Return holdings had a mixed quarter, so were
not able to offset the losses within the Fixed Interest part of the portfolio.
Meanwhile, the medium risk portfolios delivered modest returns of -0.4% to 0.3%, whilst the higher risk portfolios delivered a positive return
of 0.2% to 0.6% for the period. In these portfolios both bond and equities came under pressure in the second quarter. Investors moved to
price in further interest rate rises, which, in turn, was a headwind for equities, as the market saw an increased risk of recession. However,
there were some bright spots within equities and our US exposure was particularly helpful, with the standout performer being Premier Miton
US Opportunities, which rose 7.6%. As a result, the equity portion of the portfolio was able to offset the losses within the Fixed Interest
exposure and generate a small positive return.
Portfolio Changes
Tactical Asset Allocation
• Reduced Absolute Return, increased Fixed Interest.
Outlook
Interest rates have risen substantially in a somewhat crude attempt to crush inflation via an economic slowdown. The evidence suggests
that the policy is working, as inflationary pressures are coming down over an increasingly broad number of areas, although central banks
would have liked it to have happened more quickly. As monetary policy acts with a lag, the trick for central banks is judging when they have
tightened enough, but not too much to trigger a recession. Evidence of the hoped for slowdown is coming through in housing markets,
company surveys on sales pipelines, and investment and hiring intentions, as well as falling demand for credit. However, so far,
unemployment has barely moved. As a result, market confidence in a soft economic landing, i.e., a slowdown without substantial
unemployment, is growing, at least for now.
Trying to forecast a soft-landing or a recession is fraught with difficulty, so we prefer to invest in those areas where valuations make sense
today. Unlike twelve months ago, the bond market is offering very attractive income yields, as well as much stronger defensive characteristics
should a recession occur. Consequently, we have increased our exposure to government bonds, whilst reducing Absolute Return. Within
equity markets, we have increased our exposure to defensive areas such as consumer staples, and favour areas trading at a discount to their
long-term average, such as Emerging Market equities, whilst having lower exposure to in-vogue sectors trading at expensive valuations,
such as technology.
As a result of our positioning, the portfolios might lag should we have a meaningful bull market. However, we are much more confident on
defending to the downside if we do have a recession. History shows how hard it is for central banks to judge the rate rising part of the cycle
correctly, with a number of occasions when they have over-tightened and tipped economies into recession. Therefore, we believe that this
positioning is not only consistent with our focus on downside protection over being greedy, but sensible on a risk-adjusted basis.