In relation to economic growth, optimism around the resilience of economic data faded towards the end of March with the Fed expecting the unemployment rate to reach 4.5% by the end of 2023 as interest rates slow the economy. Regarding inflation, prices have continued to cool across economies throughout the quarter which has been supported by falling energy prices. However, concerns remain among central banks and investors that inflation is now in stickier areas that will likely be more stubborn to bring down. This is particularly the case for the UK where a recent uptick in the inflation rate also surprised markets.
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Market Commentary – March 2023 & Q1 2023
After a strong start to the year across major asset classes followed by a tougher February, the end of the opening quarter has been more of a mixed picture as markets grapple with conflicting economic data, the prospect of global recessions and a banking sector crisis.
Data from Refinitiv, 1 April 2023.
A question remaining of great importance to investors is whether central banks can tame inflation without causing systemic issues and instability within financial markets. Following the rapid withdrawal of liquidity from rate rises and a cessation of quantitative easing (QE), we had already started to see some cracks appear in financial stability in 2022, including the LDI pension crisis in the UK. During Q1 2023 we have seen three US banks fail and in Europe we have seen Credit Suisse collapse, the latter leading to an eventual takeover from UBS. While financial conditions have undoubtedly played a part in these events, it is important to note that each of these banks had some degree of idiosyncratic issues ranging from poor risk management in the case of Silicon Valley Bank (SVB) to an outright loss of confidence in scandal-ridden Credit Suisse. One of Warren Buffett's most famous quotes pertinent to the current situation: “Only when the tide goes out do you learn who has been swimming naked.” The tide is now receding and vulnerable companies who have had their shelf lives artificially extended by free money have become the casualties so far.
With a great deal of hyperbole in financial news, it is also important to make a distinction between the current situation and 2008. Factors causing the failures are less so about credit. SVB’s demise was about liquidity and unhedged interest rate risk rather than bad loans. Compared to 2008 economies are also generally in a much stronger position. From January – August 2008 the unemployment rate in the US averaged 5.4%. The unemployment rate in February 2023 recorded at 3.6% and more vacancies than unemployed persons. In addition, mortgage debt service payments and household debt are much lower than in 2008. With that said, with the degree of financial tightening we are currently seeing we are also wary of how quickly this picture could change and we are watching the data closely.
Notwithstanding stronger foundations in certain areas, the Federal Reserve (the Fed) launched a number of initiatives to ensure financial stability and ensure banks can meet the needs of all depositors. Data released by the Fed revealed that banks borrowed a record amount through the discount window (a liquidity backstop for banks) in the week following the crisis with the Fed’s balance sheet having expanded by $297bn by March 15th. Banks' use of the Fed's safety net exceeded the level reached during the 2008 and 2020 crises and equated to undoing around 50% of total balance sheet reduction from quantitative tightening in just 10 days. A silver lining argument here is that pressure on banks could contribute to a tightening of financial conditions that the Fed was unable to achieve with just rate hikes resulting in the Fed achieving their goal on inflation with a lower terminal rate. Following the turmoil, the Fed raised the target federal funds rate by a modest 25bps on 22nd March although reiterated inflation as a priority.
Market reactions to this included sharp falls in bond yields with the market initially pricing in interest rate cuts as soon as June 2023. Longer duration assets within both fixed income and equities rallied strongly following the response. Within fixed income, longer dated index-linked gilts were the best performer over March with a 9% return. Growth stocks within technology and consumer discretionary that have been particularly under pressure from rising rates, were the main winners and the Nasdaq booked a 16.8% quarterly gain - the best quarter for the index since 2020. Performance here has been more about valuation multiple expansion than earnings and we are cautious that this is a short-term relief rally of early cycle sectors outperforming in a late cycle environment. It is worth noting that the concentration of mega-cap tech within global equity and US indices has done almost all of the heavy lifting with performance over the quarter. The top 10 contributors to MSCI All Country World Index all sit in technology and have contributed 3.4% to the 4.5% return of the index over Q1 with 65% of the index constituents detracting over the month.
In a similar vein to the LDI pension crisis in the UK, we do not see the recent bank issues as having a major impact on central banks’ stance on inflation and believe we are likely to see further issues where central banks provide temporary and ‘problem specific’ support where required, on the route to further tightening. We have not yet seen signs of contagion from the banking sector problems and there is clearly still work to be done on bringing inflation down with UK CPI still printing in double digits and US inflation and employment both remaining strong. While there is some evidence economic conditions have started to deteriorate, we expect the Fed to err on the side of caution and continue to be aggressive on inflation at the likely expense of a recession. With this in mind, we currently have a preference for quality assets and are closely watching for other unintended consequences and potential opportunities. We believe a well-diversified and balanced approach is sensible as macro factors continue to drive sentiment and a wide dispersion of possible outcomes remains, however we do expect company specifics to return as a key driver of performance as the picture becomes clearer on the economy and inflation.
UK equities detracted 2.8% in March as banks and insurers saw knock-on-effects from SVB and Credit Suisse, however this simply took the financial sector performance on a round trip back to zero for the month following a strong start to the year. Materials also were a notable detractor in the UK, with Glencore, Anglo American and Rio Tinto among the worst performers as commodity markets broadly fell (excluding precious metals). Industrials outperformed as did the consumer discretionary sector.
Contrary to consensus, the latest quarterly GDP data showed that the economy did not contract in Q4 2022. The Bank of England (BoE) now expects the country to fall into a recession later in 2023. The recession is expected be shallower than previously expected. Much of this is down to energy prices cooling. The BoE has continued to raise interest rates as inflation remains the main concern. Inflation data broke a 3-month stretch of declines with surprise rise to 10.4% in February, in part due to the resilience of the domestic economy.
European shares delivered strong gains in Q1 despite turbulence in the banking sector and a more muted March. The largest contributors were the technology, consumer discretionary and communication services sectors. Energy was the only sector in negative territory for the quarter with a 0.3% decline.
The European Central Bank (ECB) raised interest rates by 50bps in both February and March. Inflation for the Eurozone cooled to a one-year low in March. Consumer prices rose by 6.9%, down from 8.5% in February. However, core inflation (excluding food and energy costs) rose to 5.7% from 5.6%.
US equities rose 1.4% over March, ending Q1 2023 up 4.8%. The Nasdaq had its best quarter since 2020 and delivered a 16.8% quarterly gain. The failure of three US banks led to volatility with the KBW Regional Banking Index falling -20.7% in March. The US indices were carried by mega-cap technology over the quarter with the majority of other sectors flat or down and technology contributing 4.7% to the S&P 500. As expected, the Fed hiked its fed funds rate an expected 25 basis points (bps) in March.
Japanese stocks rose strongly in Q1 with the Topix up 3.4% in sterling or 7.2% in yen terms. Japanese financial stocks were severely hit by concerns in the banking sector. However, the market rebounded toward the end of the month. Yen weakness supported cyclical stocks.
At the beginning of the year investors remained focused on the Bank of Japan (BoJ), following the surprise adjustment to the yield curve control policy which was announced in mid-December. Contrary to speculation across many market participants, BoJ governor Haruhiko Kuroda left policy unchanged at the January policy meeting. Speculation has shifted to the policy stance of new governor, Kazuo Ueda, who is scheduled to replace Kuroda in April.
Asia ex Japan and Emerging Markets
Asia ex Japan equities recorded a positive performance in the first quarter, with leading contributors including Taiwan, Singapore and South Korea offsetting weaker performances by India, and Hong Kong. China’s sudden abandonment of its zero covid policy at the end of last year has led to a strong rebound in its economy since the beginning of the year, while inflation has so far remained low, allowing the People’s Bank of China (PBOC) to maintain an easy monetary policy. Credit growth beat expectations in January and February and contributed to better economic momentum.
Global emerging markets also posted positive returns over the quarter. The best-performing market was the Czech Republic. Mexico outperformed against a backdrop of improving economic data. Peru, Indonesia and Chile also outperformed. South Africa, Poland and Thailand lagged the index. South Africa continues to suffer from an electricity crisis. The country was also under pressure in February by the Financial Action Task Force given failures in its processes to combat money laundering and terrorist financing. Brazil was down in sterling and dollar terms against a backdrop of softening economic data and anti-government riots in January.
The UK 10-year yield fell from 3.71% to 3.49% and two-year decreased from 4.07% to 3.44%. Treasury yields fell during March, but the Treasury curve remains inverted. The yield on the 10-year U.S. Treasury ended the month at 3.46% versus 3.92% in February. The 2-year Treasury yield fell 79 bps to 4.03%. The 2-10 spread (the difference between the 10-year Treasury yield and 2-year Treasury yield) remains inverted at -56 bps. Both investment-grade corporate and high-yield spreads widened during month.
Property and Alternatives
March was also a difficult month for Real Estate Investment Trusts (REITs) and wider real asset trusts. REITs ended the quarter giving back all gains from the recovery seen earlier in the year, detracting 8.1% in March, ending the full quarter at -1.4%. Recent meetings we have had with property fund managers and sector analysts have indicated that certain sectors within UK commercial property, including retail warehouses and Grade A offices, are doing well from a rental perspective and perhaps better than market expected. A key risk for the sector is that many of the REITs are geared and will need to refinance their debt over the course of the next few years. This may well result in an increase in the interest rate they pay, with negative consequences for dividend cover.
Renewable energy infrastructure trusts were brighter spots within the direct infrastructure sector over the quarter and produced some lower single digit returns. We continue to believe that trusts in this space offers investors exposure to core UK infrastructure assets that are essential for the energy transition and for energy security. Both are likely to be central investment themes, globally, for many years to come.
Commodities recorded a negative performance in the first quarter. Energy was the worst-performing component of the index, while precious metals and industrial metals achieved strong performance following heightened market uncertainty and the impact of central bank actions on real yields. Within energy, prices for natural gas, gas oil and heating oil were all sharply lower. Within industrial metals, the price of nickel was sharply lower in the first quarter, while the decline in the price of lead was more muted. Copper and aluminium prices both advanced in the quarter.
Past performance is not a reliable indicator of future performance.