Quarter three (Q3) 2023 saw a marked disparity in economic momentum. Japan and the US generally performed above expectations whilst Continental Europe and China clearly decelerated and in the case of the former many numbers were actually negative. The UK performed in between the extremes, with construction and manufacturing data generally weak, but the consumer hanging in. The consensus for overall growth is once again being revised up from depressed levels.
One of our macro predictions for 2023 was borne during Q3 2023 as China and Brazil started the Emerging Market interest rate reduction cycle despite the Federal Reserve (Fed), European Central Bank (ECB) and Bank of England all enacting further rises. We anticipated this as Emerging Markets had moved to restrictive policy earlier than their Western counterparts and therefore they were at a more advanced stage in the inflation cycle. One part that has not played out thus far is our expectation for the Bank of Japan to end its policy of artificially suppressing bond yields via a mechanism called Yield Curve Control. The Japanese have tweaked the policy by allowing bond yields to move 1% away from target as opposed to the prior limit of 0.5%. However, with both economic activity and inflation running above expectations we can see no rationale for the policy to remain in place. The Japanese yen has been very weak this year and would benefit from such a policy change.
As expected, there are increasing signs that inflation has peaked in the West; with the exception of the high July 2023 UK wages number and recent rise in oil prices. The table below illustrates this. In fact, China is just exiting deflation, whilst the US enjoyed a faster fall in inflation than the UK and Europe because their gas market reacts to spot prices, as opposed to prices set by regulators, with a lag. Ironically, in the short-term, that is likely to lead to a faster rise in inflation due to the recovery in energy prices of late.
Financial markets generally made little progress during Q3 with the exceptions of oil and the US dollar, which both made strong advances. Oil was the leader with returns exceeding 25%. This, in itself, was an unusual occurrence as oil usually does well when the US currency is weakening, not strengthening. The reason it was able to do well in Q3 was due to extended production cuts from Saudi Arabia and falling US inventories.
In local currency terms, UK equities held up better than most others, delivering small absolute returns, but the weakness of sterling enabled many international markets, excluding China, to also deliver small gains for sterling investors over the quarter.
In bond markets there was a tug of war between central bankers implying interest rates would stay higher for longer and data releases showing building evidence of a peak in inflation. So, somewhat surprisingly, short to medium-term corporate and government bonds in the UK actually delivered low single-digit positive returns whilst longer-dated bonds (15 years plus) sold off.
Chinese shares continued to struggle as investors honed in on sluggish data continuing from Q2 2023 and property companies returned to the headlines due to ongoing debt problems, which first surfaced during 2022. What was mostly ignored was the ramping up of measures by the Chinese authorities to stabilise the property market in particular, but also to reaccelerate growth in the overall economy. These steps include easing of restrictions on buying second homes in major cities, reducing down payments (to levels still much higher than in the UK), cutting interest rates, and more generally announcing 31 specific measures aimed at boosting the private sector.
Despite European economic numbers significantly underperforming the US, in local currency terms, European stocks marginally outperformed the US, albeit the euro weakened against a generally strong dollar.
Positioning and Outlook
Looking ahead, we expect the US economy to slow materially from its recent strong showing, while we expect at least a mild reacceleration in China, as well as a rebuilding of confidence there as prior easing measures begin to have a positive impact. The charts below show that a significant part of US economic outperformance of late has been due to their government being more willing to take on debt and run higher budget deficits than Europe and the UK. The size of current US deficits is very rarely seen outside of recessions and goes counter to traditional economic thinking.
Therefore, it is very unlikely the deficits are sustainable. This represents one driver of excess growth that will dissipate. It is also likely that it will dissipate just as the consumer comes under incremental pressure from the end of the temporary suspension of student debt, and some indebted companies suffer incrementally from the tightening in bank lending standards.
In the Macro section, we mentioned the weakness of the yen. Historically, this has been a boon for Japanese equities and the recent experience has been no exception. Japanese equities could, therefore, be vulnerable short-term if the yen reverses some of its recent decline as and when Yield Curve Control ends.
We are very close to the end of the global tightening cycle and a good way through the manufacturing recession. As discussed above, the consumer has not felt the full impact of interest rate rises, and this will surely work through the system in coming quarters. However, markets are supposed to be discounting the future, and as soon as they work out rate rises are over, they will start to look forward to a recovery, even if short-term economic data has not improved at that point.
We are, therefore, continuing with our position of being overweight short-term bonds as well as equities in the UK and China.
Given we are confident that inflation has peaked, and that interest rate rises are either over or very nearly over, we think that bonds can at least deliver total returns in line with the yield they pay. The chart above shows that of late when bonds have lost money, so too have equities (as the correlation between the two assets is high). The reverse is also true. Therefore, as bonds look set to deliver positive returns over the next 12 months, our conclusion is that equities will too. As mentioned above, this is despite near-term economic softness and consequent financial market volatility.
Appendix: Thomas Lloyd Energy Impact (TLEI) Update
We wanted to provide you with an update on Thomas Lloyd. It is our only investment trust holding within Wayfarer portfolios and it is involved in running and, to a lesser extent, constructing clean energy plants in Asia. Demand for energy in Asia is still growing and the need for cleaner sources of energy is increasing even faster and therefore TLEI has an attractive long-term opportunity set ahead of it. However, like most of its peers, it was affected by both rising interest rates (which depress value of future cash flows) and significant cost inflation on materials, in particular solar panels. This led the fund manager to inform the Board that one of their Indian construction projects may no longer viable. Although this development was only supposed to account for 4% of net asset value, the Board questioned the non-recourse nature of the non-completion penalty as described in the prospectus. The Board then questioned the timing and fullness of the disclosures the investment manager (a division of Thomas Lloyd) provided to both them and the auditor. Whilst Thomas Lloyd issued rebuttals amidst a public fall out, the net result is that the shares have been suspended since the 24 April 2023 and the Board have, as of the last week of September 2023, replaced Thomas Lloyd (who is a 15% shareholder in TLEI) as investment manager with Octopus Energy Generation as interim manager until April 2024. The interim nature of the appointment is because the Board is conducting a strategic review on how best to relaunch the company. Octopus are very experienced in the sector from construction through to investment and will manage the portfolio of operational assets that TLEI have. As inflation has now subsided, the construction project may now be viable so a decision will be taken on that soon.
We should also highlight that most of TLEI’s peers have had to reduce net asset value estimates over 2023 due to higher rates, so this will undoubtedly happen when TLEI finally produces 2022 year-end and interim results to June 2023. Furthermore, when the shares reopen it is likely investors will impose a discount on net asset value because of all the controversy. We found the public nature of the spat unseemly and it is unlikely to have done shareholders any favours.
However, as the assets prove themselves operationally and as interest rates peak we would expect values to come back and growth opportunities to present themselves once again.
We will update our clients on developments in future commentaries.
Ian Brady, Chief Investment Officer
For more industry terms and definitions, visit our glossary here.
All Index data figures are sourced by Morningstar and correct as at 30 September 2023, unless otherwise stated.
The value of investments or any income arising from them may fluctuate and are not guaranteed. Past performance is not necessarily a guide to future performance.