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Summary
- While stronger sterling (up 5.8% against the dollar for the quarter) limited some of the international gains for our UK investors, the macro backdrop remains friendly. Progress continued on inflation and economic growth remains solid. This provided the platform for another positive quarter for investment markets.
- The biggest macro surprise of the quarter came from China. An aggressive monetary stimulus package met the most under-owned and unloved major equity market there is. This triggered a sharp rally in Chinese assets as well as a much needed boost for European companies with a large China exposure.
- The risk today is that the current uptick we are seeing in the unemployment rate develops into something more serious. If this does happen, central banks have scope to cut rates so (unlike 2022) fixed income should provide a cushion against any equity market falls. We are maintaining our fixed income overweight.
- That said, investment grade corporate credit yields, which peaked at nearly 7% in 2023, are back down closer to 5%. We therefore took some profits in investment grade credit and reinvested the proceeds into gold, which is a continued beneficiary of diversification away from the US dollar
- Given our benign economic outlook, we also added US high yield for some client portfolios and will likely continue with this in early Q4.
- Our alternatives had a good quarter, helped by strong performance by the investment trusts. The investment trust market has three tailwinds today. Wind-ups and take-outs are reducing the supply of trust assets and more friendly cost disclosure regulation should help with demand. Finally, falling interest rates are a boost for the cashflows these investments generate. Trusts were a drag on our performance in 2023 but we think they will continue their rebound in 2024.
- Finally, recent sterling strength means we are now back above where the currency traded for most of 2019. This is still below its pre-Brexit levels of closer to 1.50 (vs 1.33 at quarter end) but sterling looks to have normalised again after a period of exceptional weakness in 2022.
Q3 Overview: Equities
This was another solid quarter for investment markets. You can see from our usual returns table above that equities and bonds were both up for the quarter. And our alternative investments out-performed them both, helped by the addition of gold to our portfolios as well as a welcome recovery in the investment trust market. The only headwind came for our sterling clients. Sterling gained 5.8% against the dollar in the quarter and 1.8% against the Euro pushing down the sterling value of our unhedged international investments.
The main reason for this is that the macro backdrop continues to be pretty favourable for investors. Inflation looks to be back under control and areas where we see continued strength in inflation – like housing, car insurance and even wages – are naturally backwards looking. Take wages for example. Many wage deals are reset annually and are linked to the annual rate of inflation at that point in time. 12 months ago annual inflation stood at 6.7% in the UK. Today it is 2.2%. UK wage deals should continue to track this fall with a lag. And falling inflation is normally pretty constructive for equity returns (see Chart 1). This has certainly been the story for the last 18 months.
The good news is that growth has managed to hold up even as inflation falls. The UK was the fastest growing G7 economy in the first half of 2024 (see Chart 2). Labour have achieved their objective 4 months into power!
(So no need for any nasties in the budget please!) The risk today is that the small increases in unemployment we have seen recently translate into something bigger. But, for now, there is reason for optimism that the uptick we have seen so far is more about normalising from extremely tight labour market conditions than the start of anything more serious. Indeed, it is often equity markets that are fastest to sniff out any changes in the economic climate. They were strong (and right to be optimistic when most pundits were bearish) early in 2023. Their continued strength today tells you that there is at least one leading indicator that is not sniffing out an imminent recession.
If this all feels a bit normal and boring then I would say (i) you are right and (ii) that is probably a good thing. It is Covid, the global shutdown it caused and the burst in inflation we saw after that very much look to be the outliers. 2022 in particular proved to be a very nasty year for investors as bonds and equities both fell at the same time. It is worth pointing out how unusual this is. Lombard Odier calculate it has happened 3 times in the US in the last 100 or so years (see Chart 3). Bonds lost money in the first half of the year as growth proved stronger than many expected but equities made gains for the same reason. After a couple of growth scares in Q3, bonds started to make money again this quarter responding to lower growth risks. With inflation back under control, it looks like the traditional approach to investing (equities plus bonds as a natural hedge) is working again.
With growth and inflation in the West remaining well behaved, the big macro surprise for the quarter (and maybe the year?) came out of China. For most international investors, China is the most unloved and under-owned market there is. Poor demographics (arising from the longstanding one child policy) and the property boom and bust are slowing the real economy. Deglobalisation and the chance of a new Trump presidency have helped push down Chinese equity markets even further. Even after the recent 20% plus rally, the MSCI China Index is still 46% behind the MSCI World over the last 3 years. Wherever you looked, be it market returns or economic growth numbers, there wasn’t much to like in China. Unsurprising, global equity allocations to China sit at all-time lows (see Chart 4).
So, when the Chinese authorities announced a comprehensive monetary support package (including lower mortgage borrowing rates) with the promise of more to come there was plenty of scope for markets and sentiment to move sharply. Note, part of the focus is indeed on getting equity markets going again. The Communist Party’s common prosperity programme in particular was not seen to be particularly equity friendly so this has been a welcome change of tone. The package included a RMB300bn (£34bn) lending facility to help Chinese companies buyback their own shares.
To put this in context imagine if the UK’s Labour government announced a £30bn programme to help share buybacks this October!
Chinese equity markets rose over 20% in the days following the policy announcement. We added China to our high equity content portfolios and were able to catch some of this. If we see a pullback we will look to do the same for our medium risk portfolios. Although this feels like a trade today rather than a longer term strategic investment, there is still enough upside here in the short term to make it look attractive.
Fixed Income Overview
Now the inflation genie looks to be back in the bottle, central banks can once again move back to responding to growth scares. In practice, this also means central banks want to get back to what they think is a neutral (not too tight, not too loose) rate of interest. This currently looks to be around 3%-3.5% in the US and UK (see Chart 5 for the UK) and probably around 2% in the Eurozone. Given our benign inflation view, I’d expect them to get there. If anything, I think the risks to our view are that we start to see an economic slowdown from here rather than any re-acceleration. If this is the case we might well end up with lower terminal rates than markets expect today.
That said, at the start of 2023, I wrote that earning 7% or so on short-dated investment grade corporate credit was a very attractive low risk opportunity. Our core UK short dated corporate credit fund is now up 12.3% since the start of 2023 (equivalent to a 6.8% annualised return and close to the 7% we penciled in). It has very much done its job. However, those same forward looking yields are 5% today. We are therefore taking some profits and are on the lookout for some higher potential returns. We added gold in the quarter to our bespoke client portfolios. This asset is a continued beneficiary of deglobalisation and a reluctance many countries now have to be too exposed to US dollars. Also, given our short term economic outlook remains pretty benign we added US high yield to some of our portfolios in Q3 and we would expect to continue to add, where appropriate, in early Q4.
Alternatives
Our alternative investments were generally among our best performers for the quarter. We were helped here by our new gold positions continuing their march higher, but I would also add that our investment trust positions have continued their recovery from their April lows.
There are three factors at play here. First, falling interest rates have helped the fundamental story for property and other cashflow producing assets (like renewable energy). Second, valuations in the trust market had disconnected meaningfully from where assets were trading in private markets. This meant we have seen a number of wind ups and take-outs (including the music right company Hipgnosis and the LXi real estate investment trust). I often tell people why bother to look at the physical property market when you can buy a diversified pool of assets at a 25% or so discount in the real estate investment trust market and not have to worry about stamp duty, agent fees or selling it quickly if you change your mind. It seems this logic has finally caught on with some private buyers. As the number of listed trusts reduces, so the prices for the ones that remain should naturally drift closer to their true Net Asset Values.
Finally, the government remains focused on boosting investment in UK equity markets. Investment trusts used to be subject to some pretty penal cost disclosure legislation. In order to help re-start this part of the UK market it looks likely some of these will be removed. If you combine improving fundamentals (via lower debt costs) with reduced supply (as trusts are slowly wound up or bought out) you should continue to see some decent returns. We hope the strength we saw in this market will continue into Q4.
Chris Brown
Chief Investment Officer
The value of investments may fall as well as rise and you may not get back all capital invested. Past Performance is not a guide to future performance and should not be relied upon. Nothing in this market commentary should be read as or constitutes investment advice.
