Market update – August 2023

Better news on inflation

Markets have rallied further over the summer as inflation continues to fall. This has raised hopes of a “soft landing”, with inflation cooling and the economy avoiding a significant economic contraction. However, markets may now be too optimistic. Core inflation remains well above target and central banks will be wary of allowing it to start rising again. So even if interest rates do not rise much further, they are likely to remain at today’s high levels for a sustained period of time. There are already signs that this is taking a toll on economic activity. Recent survey data from the UK, US and Eurozone suggests that manufacturing is in or close to a contraction, with services sectors also slowing. An additional concern is the potential for another rise in food prices, following Russia’s decision to halt Ukrainian grain exports and India’s restriction on rice exports.

UK by-elections suggest a change of power remains likely

Over the remainder of 2023, markets are likely to increasingly focus on upcoming elections in the UK and US. In three recent by-elections, the UK’s Conservative party avoided a worst-case outcome, but the results did little to change expectations that the party will lose power at the next vote. As things stand, this is expected to be held next autumn, but the government could delay until January 2025 or opt for an earlier date in 2024. Either way, the experience of Liz Truss’ short-lived administration may mean the UK’s two main parties avoid significant shifts in economic policy. The US election, on the other hand, could be more consequential for global markets. Russia’s invasion of Ukraine means that the geopolitical backdrop has changed considerably since the last US election. It is possible that the prospect of a second term for Donald Trump adds to international tensions.

How will China support its economy?

Chinese GDP is estimated to have expanded by an underwhelming 0.8% in the second quarter, following a stronger start to the year. It appears that the cyclical boost from the reopening of China’s economy is fading more quickly than expected. Meanwhile, longer-term structural challenges, centered on the property market, continue to weigh on demand and confidence. The government has promised steps to support domestic demand but has not yet made any specific commitments about the size or timing of any significant stimulus measures. As the rest of the world grapples with excessive inflation, China may in fact be moving towards deflation. This could prompt consumers and businesses to delay spending and investment, making it even harder to restart economic growth.

Portfolio positioning

Given our view that the US economy will slow later this year, we retain an underweight exposure to equities. However, we are monitoring for opportunities to add. We have been increasing our allocation to bonds over the past twelve months. Our gilt exposure, which we increased earlier in the year, has benefited from the latest UK inflation data. High levels of inflation in the UK have made meeting inflation plus return targets more challenging in the shorter term. Despite this, we remain confident in the ability to meet inflation-plus targets over the longer term.