August marked the first monthly decline for global stock markets since February, although a recovery into month end and depreciation in the GBP/USD rate meant the majority of losses were recouped. The weakness emanated from renewed concerns for the health of the Chinese property market, soft economic data from China and rising sovereign bond yields. In sterling terms, the MSCI All Country World Index returned -1.3% against gilts down -0.6%.
Rising bond yields were the main driver for equity weakness in the first half of August, while the recovery into month end was underpinned by an easing in yields after reaching multi-year highs. The correlation between government bond yields and stock markets remains strong as sentiment among investors in both asset classes is being driven largely by near-term expectations of central bank policies and long-term forecasts of inflation.
The US labour market has attracted a greater degree of attention of late and employment data released in early September raised hopes that there has been some cooling in this regard. A bad-news-is-good-news perspective has taken hold, whereby signs of a softening in employment gauges in the world’s largest economy increased hopes that disinflation will continue without the Federal Reserve (Fed) raising interest rates further. This dynamic was seen clearly after the announcement of a sharp drop in the US job openings number – a labour market gauge prominently cited by the Fed – leading to the strongest rally in US equity markets in two months.
A growing consensus
There is a growing consensus that the Fed and European Central Bank (ECB) are done lifting rates for this cycle. The picture for the Bank of England (BoE) is a bit different in that the market sees one or two more 25 basis point increases and that the base rate in 12 months’ time will be around current levels (5.25%) – compared to 50 basis points to 100 basis points lower for the Fed (currently 5.25%-5.50%) and ECB (currently at 3.75%).
US equities declined 1.6% in local currency terms in August, but the 1.3% drop in the GBP/USD rate to 1.27 cushioned the loss for UK investors. UK equities fell around 2.5% in August a similar size drop to that seen in global equities without the cushioning of the currency moves. The MSCI Europe ex UK declined 2.4% in local currency terms, with banks in particular underperforming after the Italian government announced a tax on “excess” profits brought about by higher interest rate levels. With the euro declining by a comparable amount as the pound against the US dollar there was minimal currency impact.
In the equity space there have been notable revisions on future earnings since second quarter results, with upgrades in the US and Japan while the UK and Emerging Markets have been downgraded. More resilient consumer spending and a rising oil price has led to upgrades for consumer discretionary and energy. Overall, valuations remain near their long-term average. The so-called “magnificent seven” (Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA and Tesla) are still seen as key drivers of US market performance, with the degree of concentration of returns at a benchmark level at a multi-year high. In other words, index returns are currently heavily dependent on the performance of these seven stocks.
Oil back at US$90
Further cuts in output and a more resilient demand backdrop than was previously expected has driven the price of oil higher in recent months, with international benchmark Brent crude moving back to the US$90 a barrel mark. The market was trading in the low US$70s in June but after three consecutive monthly gains price has pushed up to its highest level since September 2022.
Saudi Arabia, the de facto leader of OPEC+ has played a significant role in the rally, consistently surprising the market with the length of its supply cuts. Two extensions of the one million barrels per day (1m b/d) production cuts in the last couple of weeks, first to the end of September and subsequently until year end, has caused the latest push higher. Russia supported the move by also extending its 300k b/d voluntary cut to the end of the year.
Rising oil prices and the possibility of more supply disruption this winter in natural gas - the Russia/Ukraine war shows little sign of ceasing - pose a threat which could contribute to another round of energy-related inflationary pressures after recent encouragement in this regard. The UK posted a sharp drop in the July consumer price index reading to 6.8% annually, down from 7.9% in the prior month.
Thus far, economies have held up better than feared to the aggressive tightening of monetary policy and UK growth surprised to the upside in the second quarter, as GDP increased 0.2% quarter-on-quarter, better than consensus forecasts for a print of 0.0%. Similarly supportive data in the US has raised hope that central banks will manage to pull off a “soft” landing, although the potential for further energy shocks remain a risk, suggesting it is still too early to declare victory on high inflation.
In summary, even if GDP growth is surprising to the upside in the near term it is still slowing compared to previous years. Inflation is moderating and core inflation, in particular, could prove more sticky if labour markets remain tight. On the monetary policy front, growing expectations for a “soft” landing mean that even though central banks are unlikely to raise rates much further, reductions in the coming months seem unlikely.
We continue to favour a pragmatic approach to portfolio construction, regularly adjusting exposures to regions and sectors. Following our latest asset allocation meeting we have decided to reduce our cash position modestly, increasing our exposure to US equities and fixed income. We have been underweight US equities and the move will further unwind this, while we believe that increased fixed income investment is attractive given our assessment of where we are in the interest rate cycle.