Q3 2023 Market Review & Outlook

There were echoes of 2022, as global stocks and bonds simultaneously struggled in the third quarter. Markets reacted negatively to the prospect of an extended period of ‘higher-for-longer’ interest rates and, with borrowing costs and oil prices rising sharply, there were few safe hiding places for investors. Oil, cash, and the US dollar were rare exceptions.

Headline inflation continued to moderate in Q3 2023, but progress has been slower than hoped despite central banks aggressively raising rates over the past 18 months. After a resilient first half to the year, the OECD now expects that the cumulative effects of tighter monetary policy, rising energy prices, and slow growth in China, will result in “sub-par” global economic growth in 2023 and 2024. The OECD also projects that headline inflation in the G20 will be 6% this year and 4.8% next year, which is materially higher than the 2% target set by central banks.

This quarter, our material underweight to public equities has been a drag on performance, however this has been more than offset by our exposure to commodities and the strength of our private equity holdings. Below, we review what has happened in markets since the summer and share out thoughts about how we are positioned going into the final quarter of the year.

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FIXED INCOME

Fiscal concerns and the prospect of a prolonged period of elevated interest rates sent government bonds lower during the third quarter as yields rose sharply. The main catalyst for the spike in yields has been renewed hawkishness from central banks, with the Federal Reserve projecting that borrowing costs will remain around current levels well into next year. Yields have also reacted to the worsening fiscal outlook in the US; rising oil prices; and the Bank of Japan’s increased willingness to loosen their yield curve control policy.

The US Treasury market failed to serve as a safe-haven, with the benchmark 10-year US Treasury yield currently sitting at a 16-year high of 4.80%. Treasuries are on track to post an unprecedented third straight annual loss unless yields fall during the final quarter of the year. Investors are now anticipating that the Fed’s policy rate will remain around 4.8% by the end of 2024, while the ECB’s deposit rate is expected to be around 3.5%.

In the US, the Fed’s hawkish rhetoric comes at a time of fiscal concerns due to soaring government deficits and a credit downgrade by Fitch. The Fed is also continuing with its policy of ‘quantitative tightening,’ which is adding to downward pressure on longer-dated government bonds.

In Europe, Italian yields rose sharply in September after the Italian government increased its budget deficit targets and downgraded growth estimates. German 10-year Bund yields are close to 3%, the highest level in nearly 12 years. Meanwhile, Greece has regained its investment grade status, and the 10-year Greek yield is currently lower than the UK-equivalent. In Japan, yields have nearly doubled, although on a relative basis remain low at 0.75%.

In credit markets, high yield bonds, which are less sensitive to changes in interest rates, performed comparatively better in Q3. In the US high yield market, yields have remained comparatively range-bound in recent months, between 8.3% and 9.0%. As Treasury yields have risen, yield spreads have compressed, which reflects the strength of the underlying US economy.

In this uncertain economic environment, we think the ability to dynamically allocate between asset classes is crucial for the credit funds that we allocate to. It can potentially enable skilled fund managers to capture attractive yields across markets while strategically adjusting risk exposure. In short, it can potentially help credit investors stay ahead of the curve.

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EQUITIES

After a positive first half of the year, the third quarter proved more challenging for equity markets. Developed market equities fell by -3.4% and are now up +11.6% year-to-date.

The S&P 500 peaked in late July, and since then has fallen by around 7%. Despite earnings estimates holding steady, valuations have declined at a headline level from 21x earnings to 19.5x. US tech stocks have not been immune from rising rates, however those stocks that are perceived to be the winners from developments in AI continue to outperform this year. Nvidia and Meta are up around 190% and 150% respectively. There are several economic headwinds for stocks to contend with in the US, including the ongoing autoworker strike, the risk of a government shutdown, and the imminent resumption of student-loan payments. These factors, combined with the rising oil price, and tightening financial conditions, would suggest that valuations still do not reflect the level of risk.

Small and mid-size US stocks are struggling under the strain of higher interest rates. A protracted period of higher rates will expose the vulnerabilities of smaller companies with weaker balance sheets. The Russell 2000 small-cap index has fallen 11% since its peak in July, which is materially behind the S&P 500. Small- cap stocks are more vulnerable due to their weaker balance sheets, higher debt levels and a larger of share of earnings used to pay interest on debt. Smaller companies also have a higher portion of debt which is floating rate, exposing them in a rising rate environment. In contrast, the leading technology stocks, which dominate US large-cap indices, are significant beneficiaries of rising rates due to the large amount of cash that they hold on their balance sheets. Despite these headwinds, smaller cap stocks, which trade on depressed valuations, could rebound sharply if the economic picture improves and a hard landing is avoided. We are currently assessing boutique funds who have a track record of generating alpha in this less efficient market.

Equities in Europe have proven relatively resilient despite the pessimistic economic outlook. This may be a consequence of valuations starting the quarter at more depressed levels in Europe when compared to both the US and Japan. The UK FTSE-All Share was up 1.9% in Q3, which can be attributed to its higher exposure to energy stocks that outperformed as oil and gas prices rose steeply.

Notable exception to the equity market declines were Japan and India. The Bank of Japan, in contrast to other developed market central banks, has maintained easy monetary policy and yen-weakness remains a supportive tailwind for Japanese exporters. Japan benefits from its perceived safe-haven status, which is appealing during times of economic uncertainty. Japanese equities were the best performing major equity market for the quarter, up 2.5% in local currency terms and have delivered returns of 26% in local currency terms this year. Meanwhile, India was a rare bright spot within emerging markets. Indian stocks have outperformed this year, with the Indian economy performing well.

Chinese stocks continue to struggle, despite a number of new government stimulus measures announced in recent months. Sentiment is poor due to weak consumer confidence, ongoing troubles in the real estate market, and concerning levels of public sector debt. Slowing economic growth in China has proven to be a headwind for global trade, particularly in markets such as Germany that are heavily reliant on Chinese exports. Chinese weakness has also adversely impacted European luxury good stocks who derive a significant portion of their sales from wealthy Chinese buyers.

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COMMODITIES

Oil prices have jumped nearly 30% this quarter, which risks stoking inflation and pushing up bonds yields further. Oil remains 30% below the level it reached after the Russian invasion of Ukraine, however the increase during the last quarter is the eighth biggest since 2000. During September, Saudi Arabia and Russia announced that they will extend oil output cuts through to the end of 2023 which was the main catalyst behind the recent surge in oil and gas prices. The impact of higher oil prices could have significant consequences both on consumer confidence and on the outlook for inflation. Clearly, recent events in Israel have the potential to push oil prices higher and we discuss the resultant geopolitical and financial market risks later in this note.

Normally in an environment where inflation remains well above central bank targets, and economic uncertainty is high, you would expect gold to perform well. Despite this, gold has now slipped into negative territory for the year. This has been driven by rising real yields, which are problematic for gold as it pays no income and incurs costs to store. At times of low or negative real yields, the lack of income from gold is less of a problem, however the opportunity cost in a positive real yield environment makes gold less attractive to investors. That being said, gold prices are seeing some support from Chinese demand that has been driven by Chinese investor concern about the outlook for their home economy. We would also expect recent events in the Middle East to support the gold price.

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CURRENCIES

The US dollar has rallied 3% this quarter as investors turn to the US dollar as a safe haven. The dollar now sits at a six-month high after ten straight weeks of increases. In contrast, the Japanese yen is now close to dropping below the level of Y150/$, at which stage it is highly likely that the Bank of Japan will need to intervene. The last time this level was breached was when the Japanese stock market was the world’s most valuable.

Weakening economic growth in Europe has resulted in the euro falling by close to 6% since mid-July, while the pound continues to lag due to concerns about prospects for the British economy. Sterling was particularly weak during September as the UK had the biggest drop in peak rate expectations in comparison to the US and Europe. This followed the Bank of England’s decision to keep rates on hold after 14 consecutive rises.

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ISRAEL HAMAS CONFLICT

Events over the weekend in Israel and the Gaza Strip must be seen, first, through the lens of humanity. What happened has resulted in the death of innocent civilians and will most likely evolve into another significant human tragedy in the Middle East.

Through the lens of markets, the fear is that an escalation of the conflict could result in a repeat of the Yom Kippur War of 1973 that caused an Arab oil embargo and a sharp spike in the price of oil. Our view is that, at this stage, a comparable move in oil markets is unlikely, particularly as the world is now far less reliant on oil from the Middle East due to US energy independence. That being said, if Iran is drawn into the conflict, then we would expect major oil supply disruption and sustained inflationary pressures. Unsurprisingly, oil prices did react when markets reopened, however the 4% rise in Brent Crude should be viewed in the context of oil price weakness over the past week. At the same time, safe haven assets such as gold, bonds and the dollar have rallied.

While it is too early to speculate about the potential geopolitical ramifications of this tragedy, the biggest risk is that the conflict spreads beyond the Gaza Strip. The actions of Hamas were more extreme than anything witnessed before, so we expect a swift and significant reaction from Israel. Our fear is that Hamas are deliberately looking to provoke Israel into an overreaction. This could pull Lebanon and ultimately Iran into a war, which would have global implications. As well as exacerbating the terrible human cost, this would jeopardise the work that the US have done in brokering an alliance between Israel and Saudi Arabia.

The significance of these events extends beyond the Middle East. Relations between the US and China, which were already strained, have come under renewed pressure after the Senate Majority Leader Chuck Schumer criticised Beijing’s ‘unsympathetic’ response to Hamas’ incursion into Israel. We are concerned that, as the West’s attention is drawn to Israel, China, and indeed Russia, will exploit the situation to further their interests in Taiwan and Ukraine, respectively.

Much like Russia’s invasion of Ukraine, we see this conflict as accelerating trends which are already in place. War tends to be inflationary; war in the Middle East even more so. For some time, we have held the view that inflation and interest rates will remain ‘higher-for-longer,’ and what we have seen over the weekend has only heightened our conviction.

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CONCLUSION

The simultaneous decline in both bonds and stocks in Q3 bore a striking resemblance to 2022, however the economic picture is vastly different. The growth outlook has started to moderate and inflationary pressures, at a headline level, are easing. As such, investors are anticipating that peak interest rates are close. We are mindful that rates could still surprise to the upside, with leading investors warning that sticky inflation could push the US 10-year yield above 5%. Regardless, we retain our view that yields will certainly remain elevated for longer than most market participants expect.

Looking forward, risk to portfolios abound. Russia’s ongoing war in Ukraine, conflict in the Middle East, an escalation in tensions between China and Taiwan, political turbulence in the US, rising oil prices, sticky inflation, tighter financial conditions, higher yields, and a slowdown in China, are all live risks. Given this, and with developed market equities continuing to look fully valued, we retain an underweight exposure to US equities and risk assets more broadly.

The recent rise in yields has made fixed income look more attractive as a source of yield and protection, however, we continue to favour shorter duration bonds and private credit. We retain exposure to alternatives, which should provide a valuable source of diversification if the positive correlation between stocks and bonds persists. In terms of heightened uncertainty, portfolio diversification and careful analysis of events are essential to navigate this environment successfully.