Where to find value in current markets
Joanne Benson, Head of Investments, Copia Capital
After a positive first quarter, investors grappled with a range of macroeconomic factors, resulting in mixed asset returns in Q2.
Broadly speaking, equities continued the upward trend we saw in quarter one.
Sterling investors saw a 5% increase in global equity returns during the quarter, with an overall 8.5% rise by the end of June. The US, the largest component in the MSCI World Index, significantly contributed to global growth with a 10% return in the first half, while Japan added 7% during the period.
In comparison, Europe’s growth faded in Q2, although a robust first quarter meant it finished the half year with 8% growth. The UK was also weaker in the second quarter, with returns down modestly. However, Asia and Emerging Markets were the weakest regions, seeing respective declines of 4% and 2% over the quarter, mainly due to the patchier-than-expected post-lockdown recovery in China.
Bond markets have had a more difficult time, thanks to the Central Banks’ continued efforts to get to grips with inflation numbers. For investors in UK government bonds, interest rate increases have proved a real challenge as this debt tends to be very long-dated and more sensitive to changes in rates. UK Corporate bonds have also suffered, with markets pricing in an interest rate peak of 6% after core inflation and wage growth both came in at over 7% in May. However, investors in UK high-yield bonds, which are less vulnerable to interest rate fluctuations, have had a much more pleasant experience. Investments in US bonds have also performed better, thanks to falling inflation there.
Following strong performance in 2022, commodities had a challenging first half this year, with profit-taking and concern around future growth influencing short-term prices.
The macroeconomic outlook
Looking at the bigger macroeconomic picture, markets are grappling with three things: the growth outlook, inflation and central bank action on interest rates.
In recent months, central banks have been in tightening mode to tackle high inflation. This has been evident through interest rate rises in the US, UK and Europe, and quantitative tightening, which involves removing assets from the central banks’ balance sheets to reduce the money supply. The financial system has also been further squeezed by banks, particularly in the US, which have narrowed their lending standards, increasing the cost of debt for businesses.
Overall, equity markets are nervous that the pace of interest rate hikes and quantitative tightening, alongside tighter lending standards from the banks, will combine to create a headwind to economic growth this year, sparking fears of recession.
Although the latest headline numbers from the US put inflation at 3%, core inflation (excluding energy and food prices), remains at 4.8%, primarily driven by housing and strong wage growth, causing the Fed to suggest there is still ‘work to do’ to bring this down. In the UK, the latest inflation figure for June was lower than expected, but at 8.2%, it significantly exceeds the Bank of England’s 2% target, leading investors to expect another rate rise.
Looking at other economic indicators, jobs market data has proved pretty resilient so far, but consumer sentiment is fairly weak. Additionally, the savings rate in the US has dropped significantly and household debt is rising. Overall, we believe we are entering a difficult period for growth.
The investment outlook
Despite the challenging macroeconomic environment, we’re cautiously optimistic that value is returning to certain sectors of the market. The crucial question is where markets have priced in that risk and where haven’t they?
Fixed income is core to our portfolio right now. We see particular opportunities in short-duration fixed income assets. These assets currently offer a highly competitive yield compared to cash and with low downside risk relative to equities.
Due to the market conditions, we’re more cautious about equities, but we are seeing some opportunities.
We’re positive on China over the long term, particularly in the domestic stocks around the emergence of middle-class consumers with growing disposable income. Economic data following China’s reopening suggests consumer spending is rising on things that were difficult to access during the lockdown, like very high-end luxury goods, but sales are yet to increase in other areas. Domestic travel within the region is also picking up, although international travel hasn’t yet returned.
We’re also increasing exposure to Japan in our client portfolios. One long-term driver of growth is corporate governance reforms that are pushing Japanese corporates to improve their capital efficiency and hoard less cash on their balance sheets. For inclusion in the Tokyo Stock Exchange’s prestigious new Prime 150 Index, businesses must meet specific criteria in terms of corporate behaviour and allocation of capital.
Furthermore, Japan benefits from strong trade links with China, allowing us to participate in China’s reopening story while minimising geopolitical risk. In addition, Japan’s own reopening only occurred towards the end of last year, presenting further opportunities for investors. There are some challenges for Japan, but I think a lot of the risk has already been priced in, so it’s definitely an area of interest.
We’re more cautious about the US. While it has seen strong returns to date this year, they have primarily been driven by a handful of mega cap technology stocks, including Apple, Microsoft and NVIDIA. These businesses have seen significant share price rises, largely fuelled by the excitement around AI. Meta, for instance, is up an astonishing 70% over the last 12 months. The S&P500 returned 11% in the year to the end of June, with the top 10 stocks contributing 43% and the other 490 stocks adding just under 1% over the same period.
In some cases, the higher valuation can be justified, with some US businesses showing higher growth rates than their European counterparts. However, we’re not aggressively chasing the returns seen from top 10 stocks as we believe there’s likely to be more risk than upside at this point, but opportunities still exist within the wider US market.
Overall, the outlook remains uncertain but improving. We’re cautious about the health of markets, but see value in certain select sectors of the market.