Major Asset Class Returns for 3rd Quarter 2023, local currency terms.
Investment Review 3rd Quarter 2023
Global financial markets adhered to the traditional summer playbook, and then some. Prices of risk assets drifted lower amid lighter volumes, before accelerating to the downside in September, traditionally the weakest month for equities in the calendar year.
Asset class returns for the quarter in the table above evoke memories of 2022; most global equity markets and G7 government bonds were marked down, presenting positional challenges for investors with few places to seek shelter. All equity sectors were offside except for energy and communication services. Oil rallied almost 30% on both supply and demand factors, whilst the dollar is proving to be the cleanest shirt in a dirty pile of laundry.
The chief protagonist remains US Federal Reserve Chairman Jerome Powell, who, alongside colleagues at the Federal Open Market Committee, opted to leave interest rates at the September meeting unchanged at the 5.25 - 5.50% level. Crucially, the accompanying statement also opened the door to one further interest rate hike this year along with fewer expected rate cuts in 2024.
Three clear takeaways for investors; 1) inflation remains uncomfortably high relative to the Fed’s ‘neutral’ target of 2%, 2) the economy is stronger than policymakers had anticipated, and 3) interest rates are on course to remain higher-for-longer. Judging by the market’s reaction, investors hoping for ‘peak rate’ rhetoric and a path to lower rates received the proverbial bucket of cold water.
We would caution that the Federal Reserve does not boast a stellar track record regarding interest rate projections. As recently as September 2021, just over a year after having unleashed monetary stimulus programmes typically reserved for wartime emergencies, the Fed was forecasting 2022 and 2023 US interest rates of 0.3% and 1.0% respectively on the premise that inflation was expected to remain ‘transitory’.
That does not mean that the Fed’s projected path cannot happen, merely that like the rest of us, Powell and his colleagues do not possess the ability to look around corners.
A key observation from the quarter is that the so-called ‘Magnificent 7’ (Alphabet, Amazon, Apple, Nvidia, Meta, Microsoft, Tesla), stocks that have driven the bulk of this year’s headline index gains, were finally pulled down with the market.
The defensive characteristics that have made these names ‘all-weather’ exposure, namely high visibility business streams, profitability in a low growth world, (selectively) high cash levels, and AI beneficiaries, have been superseded by valuation concerns in a world in which the discount rate is going parabolic and pressuring future cash flows.
US yields are rapidly repricing a higher-for-longer interest rate scenario, leading to a material sell-off in prices (prices move inversely to yields) across the government bond spectrum. By the end of September, the benchmark 10-year US Treasury yield rose to 4.5%, a seventeen year high, whilst the average nationwide 30-year US fixed-rate mortgage touched 7.31%1, the highest level since the year 2000. Little surprise that the housing market is beginning to freeze.
Elsewhere, on the Central Bank front, the Bank of England, and our own Monetary Policy Committee also decided to keep interest rates on hold in its September meeting at 5.25% in a tight, 5-4 split vote. The majority, including the BoE’s governor Andrew Bailey, felt it was appropriate to leave rates unchanged for the first time since November 2021 and take a more data dependent approach going forward.
The decision provides some modest relief for hard pressed mortgage holders and indebted companies. Two key reasons for the decision to hold were that recent UK economic data had proved noticeably weaker and there was a surprise drop in August inflation. The latter was at +6.7% YoY, still uncomfortably above the Bank of England’s target of +2%, but lower than forecasts of +7% YoY, owing to food inflation slowing down.
Meanwhile in Europe, German business sentiment registered the fifth consecutive month of decline, pointing to probable future economic strife in the months ahead. The country’s steadfast decision to power down on nuclear (the last three plants were closed in April this year) looks increasingly likely to be short-sighted, whilst its auto industry, for decades the engine room of European growth, is facing an existential crisis from competition.
China Woes Continue
Emerging market equities modestly outperformed developed markets over the quarter, although the contrast in single country market performance was meaningful.
China’s equity market continues to struggle, with the much-hyped post pandemic economic reopening proving to be a damp squib, whilst the country’s beleaguered property sector moved back into the spotlight. Evergrande, a company with more than US$300 billion in liabilities, defaulted, whilst Country Garden, China’s largest developer, warned that it is facing the gravest challenges in its history, whilst acknowledging it had missed interest payments on two if its bonds. The property market is key in China, as it accounts for fully one quarter of economic activity.
Separately, the government also took the drastic step of deciding against reporting the youth unemployment figure of those aged between 16 and 24 years old (estimates are north of 30%), citing the need to improve the quality of data it collects. This has done little to bolster investor confidence, particularly among overseas investors, who have chosen to access the ‘China story’ through alternative channels including Japanese automakers and European luxury goods companies.
Moving to the commodity complex, precious metals finally caught a cold given the rise in real yields witnessed over the summer. Gold is often retained as a hedge against the profligacy of governments and/or the demise of fiat currency, and whilst this argument can be maintained in the current environment, its zero-yielding characteristic renders it ‘high opportunity cost’ given prevailing money market and bond yields.
Energy was standout sector, rising in a quarter where all other sectors were underwater. The market is waking up to the fact that China is slowing, not collapsing, and Saudi Arabia is backing rhetoric with action in restricting supply. We also witnessed a modest uptick in the US Strategic Petroleum Reserve (SPR) which remains at half capacity (approximately 350 million barrels of oil) following the enormous draw down initiated by the Biden Administration ahead of an election year.
TEAM continues to advocate for an allocation to energy commodities as an uncorrelated revenue stream and diversifier.
TEAM Positioning & 4th Quarter Outlook
From our previous quarterly:
‘Currently, our expectation is for equities to deliver a strong second half on balance, although we acknowledge that the extent of the first half move in prices, and seasonality, may lead to ‘summer doldrums’.’ At the end of the third quarter, the S&P large cap index and the Nasdaq currently find themselves approximately -5.5% and -7% below their peak July 2023 levels.
We enter the fourth quarter in correction mode with prevailing investor sentiment fragile as G7 government bond yields continue to back up sharply. It is important to remind ourselves that corrective periods do not happen in a vacuum. Regardless of the catalyst (that can typically only be identified ex-post i.e., after the event), they are often accompanied by worrying news headlines and increasingly pessimistic forecasts on the outlook for markets.
Shown below is a table of almost 100 years of returns for the US S&P 500 large cap index (TR column indicating the total return of the index including dividends received), with the maximum intra-year drawdown (DD column indicating drawdown, or the largest peak-to-trough index price decline recorded during the year):
First observation: drawdowns happen every single year. Second observation: the median, or average, drawdown in any single calendar year is -13%. The approximate -6% correction that we are witnessing currently is well within the realms of long-term expectations. Third observation: historically, in a typical year for markets (one not beset by a genuine black swan event), strong positive returns are achievable even with negative double-digit corrections.
Looking ahead to the election year 2024, we are reminded of the power an incumbent president running for re-election has in terms of market returns, +13% on average for the S&P in election years since 19491. This compares to an average loss of -2% when there is no sitting president running and an open field.
As the saying goes, investing is simple but its never easy. Periods of acute market dislocation and stress can feel uncomfortable on the senses, increasing the desire to check one’s portfolio valuation, and elicit a gnawing temptation ‘do something’ to alleviate any short-term pain. Oftentimes, knee-jerk decisions that are made in this scenario materially impede long-term investment outcomes.
Our truly global approach to portfolio construction and flexibility to tactically allocate has buffered our core multi asset range through this difficult summer period, and we find an array of attractive investment opportunities across the four pillars of our menu currently.
Equities: modest overweight
We have a healthy split between US and non-US equity securities. In the US, selective large cap and technology shares continue to offer the defensive characteristics exhibited by consumer staples and healthcare sectors in previous cycles.
In a world where the cost of financing is rising disproportionately for smaller companies, bigger is better. Large cash balances are now earning meaningful interest income, which is finding its way to bottom line profits. Separately, whilst we claim no edge in picking the eventual winners in the AI space, it is hard to argue against big tech companies winning via organic or inorganic (acquisition) means. We have practically zero exposure to small cap and micro-cap companies.
Regarding Japan, we noted in prior commentary that ‘we anticipate adding to this position in due course’. This is likely to be sooner rather than later. The corporate governance revolution is real, and, whilst we do not expect the line to be a straight one from A to B, investors can look forward to the prospect of enhanced returns driven by rising dividends, share buybacks and improved return on equity as companies look to improve balance sheet efficiency.
India remains one of the world’s most exciting domestic demand driven investment stories. The property sector is in its third year of an upturn, whilst there is accumulating evidence of a new capex cycle. Again, the strength of the rally YTD into the summer months has been followed by a correction, presenting the opportunity to bolster exposure.
The UK exposure is international rather than domestic focussed given the economy’s malaise. Energy, commodities, and financials stocks offer style diversification in addition to an attractive, and sustainable yield. Third quarter returns for the UK market are a useful working example.
Fixed interest: modest underweight
We are sharpening the pencils in the fixed interest space, particularly with regards to GILTS for sterling investors. Our preference at this juncture is for emerging market sovereign bonds based on peak policy rates, attractive real yields, and valuations, and investment grade corporate bonds.
Corporate bond yields in aggregate are at their highest levels since the 2008/9 Global Financial Crisis, offering decent compensation even in a period of elevated inflation. The higher yields also enable investors to be more disciplined over credit selection and still pick up attractive returns.
Our energy commodities allocation served us well during what was a decent third quarter for commodities in general. Oil prices have rallied hard as speculative money has been forced to close out aggressive betting against prices going higher, fuelling the rise. We expect the US$100 on WTI crude to offer significant resistance in the short-term.
Gold and gold miners were mainstays of TEAM’s real asset sleeve in 2022 and remain essential portfolio insurance. The positive long-term case for gold remains that the Fed, and by extension G7 central banks, will not be able to effectively normalise monetary policy. Headwinds this quarter have included dollar strength, making the yellow metal more costly to own for ex-dollar investors, and the fact that short-term real rates have turned positive.
We are cognizant that many forward-looking indicators including inverted yield curves, an acute tightening in bank lending standards to small-and-medium sized businesses, weak manufacturing activity, the level of corporate bankruptcies, and the general ‘cost of money’ are all flashing warning signs.
This is reflected in both the allocation of equity risk across geographies and styles, and the retention of selective fixed income, alternative assets, and cash to deliver appropriate portfolio ballast.
TEAM’s flexible investment framework, underpinned by a diverse asset allocation universe and the ability to tactically allocate with conviction, will remain critical as risks - and opportunities - present themselves in the months ahead.
Chief Investment Officer