QCE Quarterly Investment Commentary - Q2 2023

The second quarter was constructive for equity investors building on the progress made in Q1 despite significant headwinds and an overflowing “worry” in-tray.

US equities were the standout winners on the quarter with an 8% return in euro term, whilst European and UK equities generated more meagre +0.6% and -0.7% returns respectively. European Government Bonds produced a more modest return of +0.1% but that compared favourably to the negative returns of -1.8% in the case of US Treasuries and -3.2% in the case of UK Gilts.

The backdrop for bonds in general proved more difficult as global inflation remained stubbornly higher than predicted prompting global central banks to continue their aggressive interest rate tightening campaign. Interest rates are at 16-year highs in the USA (5.25%); 22-year highs in Europe (3.5% ECB deposit rate) and 15-year highs in the UK (5.0%) with central banks threatening there is still yet more rate increases to come.

The 11th hour deal to avoid a US debt default removed yet another hazard from the horizon, but in so doing, exposed yet again the highly polarised and partisan nature of US politics which is now normalised. The political temperature is set to remain elevated in the USA as we go through the second of half of 2023, with sights set on who will be the nominees for the 2024 US Presidential election.

The first armed uprising in Russia in over three decades (however oddly executed) serves as a timely reminder of the ongoing instability in the region and the potential for knock-on effects. Whilst recent events have led to plenty of speculation, not much has changed from the financial markets’ viewpoint that the Ukraine/Russia conflagration is at the epicentre of potential risks for H2 2023 and beyond.

The other main risk to an orderly second half for the capital markets lies in how far central banks will go to eliminate elevated inflation. The Fed, the European Central Bank (ECB) and Bank of England (BOE), are all now expected to raise interest rates further than was predicted at the end of March. Full credit to the Fed choosing to skip raising rates at its June meeting, saying they wanted more time to see how much the tighter monetary conditions were affecting the US economy.

Nevertheless, Fed chair Jay Powell still predicts there are a couple more rate rises in store for the US before the Fed is “done”. It’s unthinkable that Federal Funds could hit 6.0%, but we’ll watch and wait. The ECB and BOE are still very much in “fighting talk” mode. Which is all well and good, but if economies begin to teeter on the brink (European economy experienced a technical recession in Q2 ’23 and the UK narrowly avoided one) authorities may have to move fast to reinvigorate growth.

Despite this uncertain economic backdrop, the global economy continues to hold up better than expected with weakness in manufacturing more than offset by growth in services supported by robust consumer spending buoyed by strong labour markets. However, forward looking leading economic business surveys are flashing warning signs with credit creation and bank lending, particularly in the USA, at its weakest for many years.

But back to the standout equity market of the quarter (the USA) and what to make of it all. There is quite a lot of debate about the “narrowness” or lack of “breadth” of the US equity market, but arguably it has been thus since the inception of the “MFAANG” phenomenon 10-years ago. This acronym (Microsoft, Facebook, Apple, Amazon, Netflix and Google/Alphabet) was coined by investors to describe the high growth potential of these companies. With the AI euphoria (or hubris depending on your view) we need to add another “N” to that acronym with Nvidia now itself another trillion-dollar market cap. Lastly, Tesla is also within striking distance of the US$1.0tn market cap, so we’ll have to come up with a new label.

Generative artificial intelligence (AI) is just what the tech sector needed at the right time to help propel it to a new plane. Before it exploded onto the scene in Q2 of this year, it would have been hard to argue for yet more re-rating of the technology sector at the expense of all the rest of the market. But that would have been wrong. Apple has exceeded US$3tn in market cap and Microsoft is a mere US$0.5bn behind. Apple and Microsoft account for 15% of large-cap US indices and the top 5 tech companies account for in excess of 25% of the index, an all-time record. In my Q1 commentary I did highlight the extraordinary earnings power of these behemoths and their ability to re-engineer themselves with new businesses literally overnight, but their growth means there are an awful lot of public companies being “pushed to the side” in the quest for benchmarked performance.

Whilst we believe in the clear potential of AI, and already have some exposure to likely ‘winners’ in the area, we continue to believe that the key to outperformance from here is to remain very highly diversified by geography, sector and currency and be agnostic as to style (growth vs value)