Monthly Market Commentary from Quilter Cheviot
By Duncan Gwyther, Chief Investment Officer
Global stock markets posted positive returns in the first quarter of 2023, with the MSCI All Country World Index returning 4.5% for a sterling-based investor. Bond markets are also higher year-to-date, as investors are starting to expect an imminent end to the cycle of increasing interest rate.
Given the recent negative headlines regarding the banking sector it is perhaps surprising to some that equities gained in March. The collapse of Silicon Valley Bank (SVB) and government-brokered takeover of Credit Suisse by UBS caused heightened near-term volatility, but the aversion of a wider fallout has seemingly reassured investors for the time being.
Although rising interest rates played a role in the demise of SVB and Credit Suisse, their downfall was largely due to factors specific to themselves – interest rate risk mismanagement at SVB and a prolonged period of poor performance from Credit Suisse – rather than indicative of systemic weakness. There’s been a feeling that the Federal Reserve (Fed) would continue raising rates until something broke, and SVB’s insolvency, along with troubles at other US regional banks, means this bar has been met.
While the Fed increased rates after SVB went insolvent, expectations for further increases have diminished with derivatives markets once more pricing in cuts before year end. Since the Fed embarked on its interest rate rising cycle just over a year ago they have lifted the funds rate from 0.25% to 5.00%. The full impact of this rapid increase is yet to be fully felt in the broader economy due to the inherent monetary policy lag and although recent economic resilience has been pleasing, weakness may lie ahead.
Bond markets came flying out of the traps in January, but the strong rally fizzled out in February due to persistently strong economic data. Recent turmoil in the banking sector reinvigorated calls for an imminent end to central banks increasing rates and bond prices moved firmly higher while equity markets were hit by bouts of volatility.
The market-implied year end fed funds rate is now around 4%, down from a peak of 5.5% in early March. This has impacted the US Treasury market with the two-year yield down nearly 100 basis points, and the 10-year yield almost 50 basis points lower, from their March highs. It was pleasing to see these well-known diversification dynamics play out after being largely absent for much of last year, demonstrating the benefits of holding bonds alongside equities in a portfolio
Fixed interest markets appear to be signalling a greater risk of recession than six weeks ago, but stocks have remained fairly sanguine to this prospect. The question of whether we are in for a hard or soft landing remains unanswered, but it appears increasingly likely that there will be a landing at least, with a “goldilocks” no landing scenario, whereby inflation returns to target and the economy continues along just fine, looking like a long shot, at best.
US tech indices have benefitted from falling bond yields in 2023, with benchmarks 17% higher compared to broader US indices gaining 7.5% in local currency terms. Despite the prospect of weak earnings this year investors now appear to be looking forward to a recovery in 2024, supported by lower bond yields. We think markets have rather got ahead of themselves as history suggests that weaker growth, even when accompanied by falling interest rates, can prove challenging for risk assets.
It is not surprising that financials have been amongst the worst performing sectors recently given the banking headlines. However, the consensus view is that the banking system is on a far firmer footing than during the 2007-09 crisis and there is plenty of bad news already baked-in to share valuations.
US regional banks are expected to face tighter regulatory scrutiny, which along with recent issues will cause a tightening of credit. Recent reports show large withdrawals from banks with the capital flowing into money market funds. Should this continue, it will tighten financial conditions further and weigh on economic activity as well as weaken banks. Large US lenders and European banks seem relatively better off at present, with far larger capital buffers than 15 years ago.
The recent weakness in financial stocks has weighed on UK benchmarks, with large cap indices edging back into positive territory for the year at the end of March. A falling oil price has also detracted from UK indices. Brent crude, an international oil benchmark, fell to its lowest level in over a year last month, dipping to the low US$70s. The market has since rebounded though, boosted by OPEC+ production cuts, to trade in the mid US$80s at the start of April.
Price pressures in most places decreased during the first quarter, but there have been warning signs that high inflation may prove stickier than hoped – a 10.4% annual increase in the latest UK consumer price index is its sixth consecutive double-digit print. At 6.2%, the core reading is the same as last May’s, suggesting disinflation is yet to begin in earnest. This poses a problem for the Bank of England, who delivered an 11th consecutive interest rate increase last month, taking the base rate to 4.25%. Sterling has benefitted from general US dollar weakness, trading around the 1.24 handle and just below its year-to-date peak.
Inflationary pressures presently appear more in services than goods, driven to a greater extent by higher wages rather than elevated commodity prices, although soaring food costs remain problematic. Europe exemplifies this with a closing of the spread between headline and core inflation, as the latest headline figure fell to a one-year low while the core equivalent hit a new eurozone high of 5.7%. Continental European stock benchmarks have advanced in recent weeks, outpacing US and UK peers year-to-date, up by just shy of 10%.