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Monthly Market Commentary - May 2023

Date: 07 July 2023

5 minute read

Market volatility reduced in April, with stock and bond markets experiencing calmer conditions. For sterling-based investors the MSCI All Country World ex UK Index was marginally negative for the month compared to a positive return on UK equities of 3.6%. Gilts yields rose and longer/index-dated issues fell sharply.

Although returns of late have been modest the return of calm has been a welcome development, following some of the panic that ensued in March as fears surrounding the health of the banking sector ratcheted up It should not come as a surprise that the speed and scale of the increases in benchmark interest rates over the last 15 months have had adverse consequences and banks can be particularly vulnerable due to their business models – they are often exposed to potential liquidity mis-matches due to typically lending money long term that is mostly funded from short-term borrowing.    

Therefore, when rates rise faster in the short term than the long term, profits can be squeezed, and it can become increasingly difficult to attract sufficient deposits. Larger banks are less susceptible to this due to a greater degree of diversification. This dynamic is something we have seen many times before and the main issues now for markets, as far as we are concerned, is how the relevant authorities manage the rehabilitation process for the impacted regional banks and how successful they are in preventing widespread contagion. Central banks have the ability to print money at the requisite level to prevent a total collapse, but as this is at odds with their current inflation-fighting efforts, it remains to be seen how much appetite they have to go down this route.

Our view is that the situation will likely linger at a similar level to present conditions, providing a delicate balancing act. This will have an adverse impact on the broader economy, increasing the probability of a recession with general lending conditions tightening as standards are raised.   

Remain on a firmer footing

Generally speaking, the problems that have arisen are confined to US regional banks and the larger multinational institutions remain on a firmer footing, in part due to legislation introduced in the wake of the 2007-09 financial crisis. Credit Suisse is an obvious exception, but its woes can be traced back to a long series of events highlighting poor business practices, the recent change in interest environment merely exposed these weaknesses.

The current preponderance of US regional banks is too fragmented and not well suited to the evolving financial environment, reminiscent in some ways of the Savings and Loan crisis in the late 1980s and early 1990s. We believe there will likely be considerable consolidation in the coming years. There are currently around 4,000 regional banks and it would not be all together surprising should this figure half within five years through a series of defensive mergers. The biggest issue facing many of these troubled banks is a lack of capital to support their loan books, leaving them exposed to significant changes in the lending landscape. 

Since SVB’s failure the Fed has increased its balance sheet significantly, beginning with US banks borrowing US$300bn central bank reserves in the following week and a further US$150bn from the discount window. This additional liquidity has played a key role in the dampening of volatility, along with the returning confidence in banks.

Since SVB’s failure the Fed has increased its balance sheet significantly, beginning with US banks borrowing US$300bn central bank reserves in the following week and a further US$150bn from the discount window. This additional liquidity has played a key role in the dampening of volatility, along with the returning confidence in banks.

UK shares gained around 2.6% in April, while the pound moved up against the US dollar from 1.23 to 1.24. Government bond yields edged higher last month, with the 10-year gilt yield rising 27 basis points to end April at 3.78%.

UK inflation continues to be stickier than expected, with the March reading of the consumer price index coming in at 10.1% - the seventh consecutive month this metric has printed in double-digit territory. Continental European shares extended their good run, continuing to outperform their UK and US peers, ending April up over 4%.

The latest leading economic indicators from the UK, Eurozone and US all show a striking divergence between the level of activity in the manufacturing and services sector, making it difficult to draw a clear picture for the overall economy. Manufacturing has undergone a sizable slowdown in each region with purchasing managers indices (PMIs) well into contractionary territory whereas the equivalent services data is printing well into expansionary territory. This divergence has been apparent for some time now and still shows little sign of converging.

Price over volume

First quarter earnings have been pretty good on the whole, in particular for large cap US tech stocks. Although profits are down on last year, the decline has been a little less than feared and the majority of firms have manged to beat analyst forecasts.

Looking through the reports one theme that is evidently becoming more common is companies seeking to pass on rising costs by increasing prices, even if it comes at the expense of small volume declines. Several prominent consumer staple/discretionary firms have published results showing growth in overall sales revenue even though volumes have fallen.

Seemingly higher inflation has afforded these firms the opportunity to push on price which, while good for earnings, ultimately will mean additional inflationary pressure going forward. Although developed economies have held up better than feared thus far, there are numerous signs that activity is slowing and dynamics such as these further complicate the outlook for central bankers hoping for a swift return of inflation to target.

 The Fed funds rate currently stands 5.25% after another 25 basis point increase at the start of May but derivatives markets are still pricing in interest rate cuts before the end of 2023, putting the year-end implied rate at 4.3%. This is in contrast to the situation in the UK where markets expect interest rates to be higher at the end of the year, forecasting that Bank of England rate setters will look through a softening economy and maintain their vigilant stance on stubbornly high inflation.


Duncan Gwyther

Chief Investment Officer

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