Q4 2023 Investment Update

After performing strongly in the first half of 2023, most equity markets posted declines in their own (local) currencies in the third quarter. It was only due to sterling weakness that these translated into modest gains for UK investors. However, the UK stands out as the best performing developed equity market in Q3 with the FTSE All Share returning 1.9% vs. 0.88% for the FT All World index. The same can be said for Government bonds with all major Government bond markets declining when measured in their local currency. Corporate bonds though actually posted positive returns. Commodities also generated positive returns although this was entirely due to the strong oil price driven by supply cuts rather than strong demand. Oil was up c. 30% in Q3 (more on this later).

The main driver for this reversal is a case of “good news is bad news”, in that markets react negatively to better than expected economic news. Despite the significant rise in interest rates this year the major economic blocks are now likely to avoid a recession in 2023 (although the outlook for 2024 is less rosy). However, whilst inflation is clearly declining, it is not falling fast or far enough for Central Banks liking. Market participants are coming around to the view that interest rates will stay “higher for longer” even if we are at or near the end of the rate increase cycle. Frankly we are surprised that the “market” is surprised by this revelation. Central Banks have been signalling this development for quite a while. The net effect is that yields on longer dated bonds (over 15 years to maturity) have risen significantly (yields move inversely to price), notably in the US. We also suspect that this may also be driven by the prospect of more sellers (the US is running a large budget deficit) and less buyers (especially the Chinese).

In this environment assets that are less susceptible to rising bond yields have done well. Areas where we have positioned our portfolios such as shorter dated (less than 5 years to maturity) investment grade corporate bonds have delivered positive returns. Value equities and higher dividend yielding equities have also outperformed the broad equity indices in Q3.

As we get closer to year-end investors start to go through the routine of gazing into their crystal balls.

We feel that there are lots of small but increasingly confirmative signals that economies are slowing down and the effect of rising interest rates is impacting the economy. The rise in the oil price is also a potential headwind, acting as a “tax” on economic activity and adding to inflationary pressures. Rising bond yields also increase the cost of borrowing for consumers and companies. Therefore, we expect corporate profitability to face further challenges going into 2024. We often mention valuations and one of our core principles is that what you pay for an investment is a significant factor in determining the medium term returns from that investment. Rising bond yields make equity valuations less attractive (investors often use the yield on the US 10 year Treasury as a key input into valuing equities). So, a combination of building headwinds to profit growth and valuations affirms our continued underweight stance in equities.