Reflections of the CIO...

Overall, the summer of 2023 was a positive period in world markets, at least until the early part of August, when a period of aggressive profit taking reversed some of the progress of the preceding two months. This progress was most noticeable in equity markets, with gains driven by a resilient US economy in particular, and corporate earnings results more generally. As we look to the final part of the year, the long anticipated impact of rising interest rates has yet to be felt in any meaningful way by most economies and we think this ‘lack of disaster’ has been behind the general grind upwards in riskier assets year to date.

Perhaps the most impressive thing about the equity market’s performance so far has been that it happened despite the negative influence of a very shaky global bond market. August in particular was a poor month for bonds, as market prices adjusted to reflect not only the deteriorating fiscal position of governments, but also the realisation that interest rates would have to stay ‘higher for longer’ in order to win the battle against inflation. Although progress on inflation fighting has generally been good this year, there is a growing awareness that the easy part of the journey is now complete. Further progress in pushing inflation lower will probably require ongoing, sustained pressure from high interest rates for a while yet, a view that bond market investors were reluctant to price in until very recently.

Adding to the sober mood of early August was a sharp increase in worry about the performance of the Chinese economy. Despite multiple initiatives from the Chinese government to alleviate the pressure from a property market bust, the gloomy mood of Chinese consumers and foreign investors was not improving. There was a growing sense that intervention on a much larger scale would be needed to restore confidence and that did not look like it would be forthcoming in the near term. The economic news from the UK and Europe was also underwhelming, with significant uncertainty surrounding the question of how far higher the respective central banks could push interest rates without prompting a nasty recession.

In our opinion, we are now most likely to enter a period where interest rates plateau at high levels, well into next year. The US, European and UK economies are all at roughly the same position on this point but have very different abilities to handle this coming period of tighter financial conditions. This has fed into the relative performance of each geography this year and also expectations for the future. Some of the pessimistic assumptions embedded in UK assets, for example, are beginning to look overdone to us and, whilst we are in no hurry to up exposure just yet, we suspect it may not be too long before we change that view. Elsewhere, China remains an enigma, with investors accepting that they really do not have any particular edge in forecasting the next set of policy actions from the Chinese Communist Party. This makes China something of a wild card for the future, retaining both the ability to surprise to the upside or continue to disappoint, making it harder to calibrate the global growth picture as thoughts turn to 2024.

This coming period of ‘higher for longer’ interest rates will be one during which the risks of recession and market panic play off against the rewards of taming inflation. Sentiment will very likely continue to wax and wane depending upon how short term news flow lends weight to one particular argument or the other. Market time horizons will consequently also remain short term, making the overall trading environment hard to read and prone to sharp reversals. Overall, we think it will be a tricky, if not dangerous period for markets to navigate.

At the same time, we can also see clear long term positive signals emerging. The most prominent of these is the return of long term ‘real’ (or after inflation) interest rates back to pre-financial crisis levels in the USA. In other words, after a very short period of time, the long term cost of US dollars has ‘normalised’ and the fact that this has happened without a spectacular crisis or deep recession is something to celebrate.

However, there is always a ‘but’, and in this case it is the fact that the negative effects of these global interest rate rises are usually felt after a long lag, and that this pain has simply just not arrived yet. The latter part of the year should be a period during which enough evidence can be accumulated to allow us to work out what the real underlying trend actually is. Until that evidence accumulates, we still think it best to remain patient but alert, until the picture becomes clearer.