Investment Update: November 2023

INVESTMENT UPDATE NOVEMBER

Overview

Markets continued to struggle through October, as the conflict in the Middle East escalated, government borrowing levels rose to multi-year highs and some of the shine wore off the ‘Magnificent 7’ stocks* in the US.

The war in the Middle East initially had investors concerned that the conflict in the region would escalate and move further afield from Israel and Gaza. This in turn prompted fears about the direction of energy prices, with the World Bank stating that it could lead to a large increase in the price of oil. However, as the month drew on, these fears seemed to dissipate and the oil price declined by around $10 over the month.

Government bonds, usually a haven during times of uncertainty, fell during the month, as investors focussed on the implications of interest rates staying ‘higher for longer’ and bond yields rose as a consequence (prices move inversely to yields). The US 10 year bond yield briefly touched 5% - a level not seen for 16 years. Whilst much of the speculation in bonds revolved around the direction of inflation, there are also question marks over the sustainability of government borrowing levels at these current higher levels. The prospect of higher for longer rates, coupled with some mixed news on forward earnings guidance conspired to drag down the share prices of the Magnificent 7 US stocks, which had previously combined to prop up the wider US market, due to their disproportionally large impact on the index. However, at the end of the month, softer economic data and the holding of interest rates by both the US Federal Reserve, ECB and Bank of England, provided a welcome lift for both bond and equity markets post month end.

*Apple, Amazon, Tesla, Nvidia, Microsoft, Meta, Google

US  

Despite a set of generally good Q3 company earnings reports, the US market struggled during the month. This was particularly evident in the aforementioned Magnificent 7, whose lofty valuations during a period of higher interest rates, means that forward guidance during earnings announcements are closely scrutinised by the market. This was most notably evident with Google, which disappointed on the cloud computing front and offered a less rosy picture on its progress in AI than the market liked, which led to its share price falling over 9% in a day. Even Microsoft, which reported good results on AI return on investment, struggled to satisfy the market and its performance was muted on the upside, when earlier in the year its share price would likely have rallied on such news.

Markets were not assisted earlier in the month by the Federal Reserve stating that they may need to hold interest rates higher for longer. In addition to continued earnings announcements, attention in November will no doubt be focussed on the renewed negotiations on the US Government’s debt ceiling which was effectively deferred earlier in the year. Failure to reach an agreement could lead to government shutdowns, but usually some pragmatism prevails.

Europe  

October saw policy rates on hold by the ECB after 10 consecutive rate rises, Christine Lagarde indicated that the drag from monetary policy on growth would “continue to unfold throughout the end of 2023 and the first quarter of 2024”. Data continues to confirm the bleaker outlook for the Euro zone with Services and Manufacturing Purchasing Managers Index (PMI) indicators continuing to fall from last month at 47.8 and 43 respectively in October (a reading below 50 represents contraction). Meanwhile, consumer confidence has also hit its lowest level in nearly 7 months. Consumer Price Index (CPI) numbers came in at an unexpectedly low 2.9% and producer prices have fallen into negative territory. This relatively weaker economic and inflation outlook could perhaps lead the ECB to be the first central bank to reduce rates.

UK

In the UK, market falls in October would have been worse if it had not been for the significant allocation to the energy sector.  Higher interest rates appear to be having an impact on economic activity as shown by a sizeable drop in consumer confidence in October, and a 0.9% month on month fall in retail sales in September. Retail sales in the UK have been somewhat distorted by extreme weather during August and September, but will have reduced aggregate economic activity over the third quarter to be fairly flat. The September Consumer Price Index (CPI) print was flat at an annual rate of 6.7%, which surprised some commentators, with the rise in petrol prices offsetting falls in food and other items. Looking ahead, the October CPI print should fall significantly due to a 25% increase in gas and electricity prices last year falling out of the 12-month calculation. These base effects should be powerful enough to take CPI below 5% even taking in to account recent increases in oil prices. Unsurprisingly, the Bank of England took its lead from the US and Europe, keeping rates steady at 5.25%.

Japan

Performance of Japanese equities has been volatile over the last month with market reactions to stimulus packages being positive in the first few days of November. At the Bank of Japan's October meeting the hard cap of 1% on 10-year bond yields was changed to a "reference point", meaning that the Bank of Japan (BOJ) may allow yields to drift slightly above 1% in the near future. There are mixed thoughts about the end of Yield Curve Control* (YCC), some people think it doesn't matter, others do.  Japan collectively holds over $2 Trillion in foreign bonds and with yields at home rising people fear that there will be a period of reshoring the money, having significant impact on the global bond markets, but a positive impact domestically. 

One of the reasons that investors have been attracted to the Japanese market of late is the introduction of corporate governance reforms. Recent announcements of further corporate reform policies from the Tokyo Stock Exchange will see a monthly list of companies that have not taken action on the reform requests published in a "name and shame" tactic. This is intended to enhance the appeal of investing in Japanese companies by both international and domestic investors alike.

*Yield curve control (YCC) – for a number of years the Bank of Japan have been limiting the maximum yield available on their 10-year bonds by buying bonds in the market, thus limiting the return available.

Asia and Emerging Markets

The improvement seen in September was short lived, and markets were negative in October, with China dragging down sentiment. There was positive economic data around industrial production and retail sales, but this was against a backdrop of continued weakness in the real estate sector and further restrictions of AI chip exports to China. PMI figures were released, coming in at 49.5, indicating a contraction. A record $6.1 billion flowed out of Chinese mainland stocks in October. There is an ongoing divergence in EM central bank interest rates, where some emerging market central banks continued their rate cuts, but others, particularly in Asia, have continued to hike. Removing Russia and Turkey from the figures, who hiked 500bps and 200bps respectively, in October we had 50bps of hikes and 150bps of cuts in emerging markets.

Outlook

As investors continue to pour over every economic data release in search of clues to the future path of central bank policy actions, volatility is likely to continue to remain heightened in global bond markets. Furthermore, the movement of interest rates and prices, in response to new information, may not be uniform across the entire maturity (time to redemption) spectrum as term premium re-emerges in bond markets. However, with government bond valuations now reflecting some reasonable compensation for the elevated levels of uncertainty, the additional spread (level of interest received versus government bonds) on offer from corporate bonds means that investors are being paid a decent all-in yield to cushion against any further short-term weakness. These, more historically normal, investment valuations mean that bonds are now able to better fulfil their traditional income generating role within a portfolio, as well as offer valuable diversification properties as recent high correlations between asset classes continue to decline. Likewise, any downward movement in bond yields is likely to be perceived as positive by equity markets as these are used as a component of share price valuation.

Rockhold Asset Management, with contribution from Alpha Beta Partners and Marlborough, November 2023

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