News & Insight • Market Insights

04 July 2023 | William Buckhurst

Thoughts on 2023 - The Halfway Point

Had one been armed with the knowledge at the start of the year...

... that inflation numbers were not going to come down as quickly as many had anticipated and that, consequently, rates and bond yields would remain elevated, a reasonable assumption would have been that equity markets – and risk assets generally – would suffer further declines.  Yet, as is often the case with markets, the opposite occurred.  Global equities (in sterling terms) finished the first six months of the year up 9% and substantially higher in local currency terms (sterling was surprisingly strong against the US dollar). Although it is worth pointing out that the UK market, hampered by even higher inflation, finished essentially flat, unwinding much of its outperformance last year, and so returns for UK investors have been slightly diminished

Artificial Intelligence

One of the themes that drove markets higher during the first half of 2023 was the sudden mania surrounding Artificial Intelligence (AI).  It seemed to us at times that – regardless of the sector they operated in – all it took was for a CEO to mention the words AI during a quarterly earnings call and they immediately drove their share price a few percentage points higher. In many cases this was real - AI was mentioned no less than 50 times on the Q1 earnings call by Microsoft management and the shares finished the first half pretty close to their all-time highs.  Nvidia, which manufacturers chips that power many AI products, announced a stunning upgrade to earnings.  Their quarterly revenue topped $7.2bn, smashing their $6.5bn target, while they predicted $11bn in revenue for the next quarter, leaving the $7.2bn expectations from analysts in the dust.  The shares finished the first half 30% higher than their late 2021 highs, but now trade on an eye-watering 67x price to forward earnings ratio.  Large technology companies look to have resumed their defensive mantle and for the most part their long-term earnings power is now largely unchanged over the last year and a half even in cases where near-term earnings estimates have come down and they have faced valuation headwinds from higher risk-free rates.

A consequence of this, however, is that 2023 so far has been a story of very narrow leadership as equity market returns have been dominated by the largest companies in the index. So much so that Apple became the first $3tn company commanding a market capitalisation far in excess of the combined value of the UK’s 100 leading shares. Put differently, there has seldom or never been less reward for taking the risk of investing in stocks outside the biggest mega-caps and many active managers underperformed the index during the first half of the year.

Hard or Soft Landings

Back in the real world, the question has been whether the global economy will face a soft or hard landing.  Arguably, this has been the most widely anticipated recession ever that still (technically) has not actually happened.  Germany did enter a technical recession (two consecutive quarters of negative economic growth) earlier in the year, the UK looks to be just avoiding one, while the US is still in expansion mode having seen annualised growth of 2.6% and 2% over the last two quarters.  In fact, this year there have been a surprisingly high number of important economic data releases surprising on the upside.  A recent report showed that demand in the US for long-lasting manufactured goods in the US, instead of contracting by 1.0% on the month as was expected, bounced by 2.7%.  Orders excluding transport (which is known to have large swings) also outperformed, gaining 0.6% on the month.  The ongoing strength of people’s wallets has much to do with it. In the UK, retail sales have grown in four out of the last five months and consumer sentiment surveys remain surprisingly buoyant. This doesn’t suggest that the economy will be dropping into recession at all imminently and employment data remains strong.

The flipside to this is that rate cuts, or even a prolonged pause, are now firmly off the table.  Whereas we entered the year expecting cuts by now, a series of increasingly hawkish comments from Federal Reserve Chairman, Jay Powell, culminated in this in March:

“The latest economic data have come in stronger than expected, which suggests that the ultimate level of interest rates is likely to be higher than previously anticipated. If the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes.”

It remains to be seen, however, as to whether the series of rate hikes imposed so far will have a lag effect on overall economic activity and that the much anticipated hard-landing has not gone away but has just been postponed. The risk remains that, just as central banks were too slow to raise rates while inflation was taking hold, they continue to tighten as economic activity starts to weaken.  We can see very clearly that monetary supply is already contracting. 

The Regional View

A widely anticipated recovery in China – prompted by the sudden abandonment late last year of its zero-Covid policy – has on the whole failed to materialise.  Chinese and Hong Kong equities have once again significantly underperformed broader Asian markets this year. Investors accustomed to lavish Chinese government spending are still awaiting renewed policy support.  The measured tone from April’s Politburo meeting has dimmed hopes of a near-term announcement and recent economic data confirms China's recovery post-Covid lockdowns has been fragile and uneven with imports, industrial production and real estate investment still falling.  As a result, Chinese equities now trade on a significant discount to developed as well as other emerging markets and look cheap for a region still forecast to grow earnings anywhere between 15-20% over the next two years while showing real economic growth.

Japan, in contrast, appears to be in a sweet spot having decisively left the deflationary environment behind but not facing runaway inflation. Accommodative real interest rates are helping catalyse corporate expenditure which has already risen to multi-year highs. In another important shift, Japan’s nominal GDP growth is now rising at a healthy pace after a long period of flatlining.  The lifting of border controls for all arrivals in April and the reclassification of Covid-19 as a category 5 disease comparable with seasonal influenza have helped the process of economic and social normalisation. In particular, the return of inbound tourism – now at around 70% of pre-Covid levels – is providing a boost that is set to continue as visitors from China gradually increase.

As a result, Japanese equities rose each month this year to touch 23-year highs (although, again, the surprising strength in sterling dampened returns for UK investors).   Yet the market is still attractively priced: around half of Japanese stocks still trade below their asset (“book”) value.  Looking at a widely used metric, the price-to-book ratio, the median in Japan is just over 1 (in the US, the equivalent number is 3.9 times) highlighting how much cheaper Japanese companies are compared to their US equivalents. The average company in Japan is high-quality and awash with cash and, as corporate governance standards continue to improve, will return more in dividends as well as excess capital through buybacks.

Following a strong 2022, Indian equities continued their recent run of good form.  The International Monetary Fund (IMF) now expects India to outperform all major emerging and advanced economies this year, predicting 5.9% growth in GDP.  India recently overtook China to become the world’s most populous nation with 1.43bn people, representing an enormous pool of potential workers and consumers that companies — both in India and abroad — can tap into.

It has not all been good news...  

Over in investment trust land the steady ascent of two- and 10-year gilt yields has had a direct impact on the broad UK REIT and infrastructure sector – areas that traditionally acted as useful diversifiers and often sources of inflation-linked revenues. UK interest rates started their steep incline in the tail end of 2021 and ever since then listed funds investing in longer duration or real assets have fallen back steadily, with the overall sector now trading at a sharp discount to stated asset value.  The listed alternative income sector has also not been helped by confusing and – at times – over-zealous regulatory requirements surrounding cost disclosures which have created forced and (in our view) unnecessary selling pressure.

UK gilt yields have now risen to levels higher than the spike that was triggered last Autumn by Kwasi Kwarteng’s disastrous mini-budget.  This is in stark contrast to US and German yields which are still lower or at the same levels they were at the start of the year – as things stand the UK still looks like a real outlier. There is a concern that embedded inflation will prove to be peculiar to the UK and so bond yields and ultimately borrowing costs will have to remain higher for longer.  Meanwhile the yields to maturity on some short and medium dated gilts – for the first time in almost a generation – look quite appealing.  The TINA (There Is No Alternative [to equities]) trade looks to have been subsumed by TARA (There’s A Real Alternative).