The first six months of 2023 had many surprises for investors. It was a humbling period for those in the forecasting business!
Economic growth was stronger than expected in the U.S., but much weaker than expected in China. The major central banks had to hike interest rates higher than was expected at the start of the year because of stubborn core inflation, reflecting continuingly tight labour markets and -in the U.S.- government stimulus programs.
The much-predicted recessions in the U.S and UK never materialised, because consumer demand remained strong (thanks to pay growth). Instead, we saw a recession in Germany, which was a surprise. Its export manufacturing sector was expected to be a major beneficiary of China emerging from Covid lockdown late last year and from falls in global energy prices.
But China post-lockdown rebound was relatively weak and has been one of the big macro-economic surprises of the year so far. Indeed, while other major economies tighten monetary policy to bring down inflation, China’s central bank began cutting borrowing rates in the spring in order to stimulate lending. Not only to help prop up the ailing property sector, but also to stimulate demand and avoid deflation. Quite remarkably, China’s annual consumer price inflation was flat in June.
Disappointing import demand from China resulted in weaker than expected eurozone growth, as well as weakness in industrial metals.
A relatively minor bank crisis in the U.S. in March managed to trigger the downfall of illustrious Credit Suisse, a continent away. In the U.S., the political response was to demand a re-instatement of some of the post-financial crisis regulations that were eased under the Trump administration (thanks to lobbying by the banks).
In Switzerland, a little soul-searching was done by the media and politicians about the conduct of Credit Suisse in recent decades. But the biggest surprise was not so much the failure of the bank, but the decision by the Swiss regulators to preserve some equity value while wiping out the ‘contingent capital’ investors.
Most investors in so-called CoCos believe that their investment ranks above ordinary equity in any winding up of assets. A question mark now hangs over this hybrid form of capital that many European banks issued in large quantities after the financial crisis, in order to boost their core capital ratios.
Tech and Japanese stocks were the surprise winners
On capital markets, short dated fixed income provided more excitement than investors perhaps want to see from a supposedly safe asst class. The sensitivity of two-year bonds to frequently changing interest rate expectations led to substantial volatility, as did the concerns over the debt ceiling. Over a three-week period in March, as the bank crisis infolded, the two-year yield fell from 5.1% to 3.8%, to end at 4.9% in late June. The Bloomberg U.S. Treasuries index rose 1.2% over the first half.
The Bloomberg UK gilts index fell 4.5%, as yields rose in response to very stubborn core UK inflation – that continues to rise, even as U.S. and eurozone core inflation falls.
It is increasingly clear that the UK economy is inadequate to supply the goods and services demanded by consumers and businesses. Inflation and/or more imports and a larger current account deficit, are the result of any growth in demand. Both effects will require higher interest rates to counter, the prospect of which helped support sterling over the six months.
A period of rising interest rates should be bad for stocks, particularly growth companies. This is because higher funding costs makes jam-tomorrow investments harder to justify. But high inflation would give an advantage to those value stocks that can pass on price rises.
Instead, global stock market returns were strong, and…led by tech! The NASDAQ rose an astonishing 39%, led by the largest names. The argument for this is that Big Tech is cash rich, and so relatively insulated from higher borrowing costs. In addition, many of the companies are effectively advertisers and more sensitive to domestic retail demand in the economy than they are to interest rates.
A strong theme within tech from May was enthusiasm over artificial intelligence. This was triggered by very strong earnings results from semiconductor manufacturer Nvidia, whose generative artificial intelligence chip is thought to be two years ahead of its nearest competitor. Nvidia’s market cap rapidly passed the $1 trillion level, as its price/earnings ratio passed 100. It has joined the Big Tech club.
The broader S&P 500 rose 16%. The value-heavy eurozone and Japanese markets also performed well, the Euro Stoxx 50 index up 16%, and the Japanese TOPIX up 23%. Japan’s re-emergence this year as a stock market of interest to global investors was another surprise, given the persistent fear that the Bank of Japan may abandon its loose monetary policy and cause a rally in the yen.
Given that value-heavy stock markets elsewhere performed well, the poor performance of the UK’s FTSE 100 was disappointing. The index was broadly unchanged over the period. Weakness in global energy and metals prices hurt some of the largest listed companies, while domestic-focused companies were affected by deteriorating expectations of the country’s growth prospects.
The MSCI Emerging Markets index rose 5%, dragged down by negative returns on Chinese stocks and nervousness over the effect of higher U.S. interest rates on companies and countries that have borrowed heavily in dollars over the last decade.
The second half of the year has begun with a flurry of U.S. economic data confirming that economic activity, and inflation, are slowing. This has triggered a renewed rally in global risk assets, on hope that a new economic cycle will kick in as the Fed first ends its rate hikes, and then starts to cut rates.
Given the persistent disappointment on this score during the first halve, and Fed chair Jay Powell’s known reluctance to avoid the mistake of 1980 (when the Fed cut rates too soon), it may be too soon to be placing bets on the next economic cycle.
Interest rates may stabilise in the U.S., but they will continue to increase in the UK and eurozone, and everywhere may remain higher, for longer than expected, given the stubbornness of core inflation. A diversified approach to investing, through multi-asset funds, remains the best approach to investing given the current uncertainties.
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