Overall, Q2 and the 1H of 2023 has been rewarding for portfolios as evident from the table below showing returns by asset class and style:
There was a definite “risk-on” theme and this has played out with a strong performance from growth equities both for Q2 (+10.5%) but also YTD (+27.3%). Much of this has been driven by technology. For reference, YTD, the NASDAQ is up up +35% while the NASDAQ 100 is up +42%. The tone around interest rates has become much more tempered as inflation (headline at least) continues to move down at a good pace. Core inflation remains elevated but is – very slowly – drifting downward. Overlay all this with a consumer that, certainly in Developed Markets (DMs), is holding up and still spending. Furthermore, wage gains are improving and in countries like the US beating headline inflation. We are starting to see other improvements too such as a bottom in the housing market, some moderation in weak manufacturing activity and upward revisions to GDP forecasts – a clear indication that initial estimates were over bearish.
Specific asset classes are worth a mention:
Bonds: Index-Linked (-1.8%) and US Treasuries (-1.4%) were the only declining sectors. The former is explained by the reversal in inflation trends while the latter is explained by the risk-on environment and rotation from bonds into equities. YTD, all sectors remain comfortably up with US High Yield (+5.4%) delivering real, positive returns. UK Government bonds were hit -6% on the quarter to finish down -4% YTD.
Commodities: are seeing a reversal this year following last year’s success story. Two factors are driving this – Russian energy sales at hugely discounted prices and a very slow China economy plagued by weak demand from overseas, a still-weakened property market and a slower than expected recovery on the domestic front. Advances by US Shale producers is also seeing an uptick in production with greater efficiencies.
Equities: In local currency terms, Japan has been the star performer up +22.7% YTD and +14.4% on the Quarter; the S&P 500 is up +16.9% and +8.7% respectively. Europe had an okay quarter (+3.0%) but is still up strongly YTD (+13.8%). The Yen remains weak which boosted equities – this helps companies that derive a substantial portion of their revenues from overseas. That said, those non-Yen investors would have suffered a FX loss on conversion.
What does the road look like from here?
We are in something of a “Goldilocks” scenario:
Headline inflation continues to decline at varying rates across the globe helped by steep declines in energy price inflation and declines in food inflation.
Core inflation is still slowing but slowly.
Rate hikes are in the twilight zone – the bulk of the hikes are done, the full impact has yet to come through and there may be the occasional rate hike here and there. The steep hikes we have seen so far are over – if anything, risk is skewed to a risk of policy error.
Wages are rising and, as headline inflation comes down, we are approaching real wage price inflation.
Although manufacturing activity has been declining into contractionary territory, the rate of decline is bottoming out. Q3 will help identify if this means the inventory build up is clearing out. If so, production should rise and inventory rebuild should start up again. The latter will be a boost to GDP.
We have been witnessing a mild correction in the US$ vs most of the other majors. This should not be associated with a loss in faith in the US itself – just a rebalancing. The chart below compares the US$ Trade Weighted Index (TWI, a measure of the US$ vs a basket of other currencies) and the US$ Equilibrium Exhange Rate TWI. Basically, at any point in time, the US$ is over and under its equilibrium level – right now, it is over. It’s a correction – not a confidence-driven sell off.
Finally, valuations. These have notched up since the last Quarterly report– see chart below:
The US is now above its percentile range. The MSCI World and MSCI AC World are also higher but they have a large allocation to the US (some 60+%). AsiaPacific (ex. Japan), Japan, Dev. Europe and EM have all risen with Japan and Europe still on low valuations.
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