Third quarter review: markets decline after a strong first half of the year

July kicked off the third quarter of 2023 on a strong note, driven by expectations of a "soft landing" for the US economy and excitement about the long-term prospects for AI. A combination of factors, however, including continued interest rate rises, rising government bond yields, weaker economic data, and enduring inflation, negatively impacted markets. Over the quarter, global equities fell by over 3.3%ⁱ and bonds returned -2%ⁱⁱ. The all-round poor quarterly performance was further solidified as September proved to be the worst month of 2023 for markets. 

A few key narratives dominated in Q3, with inflation being the most persistent. Although inflation has cooled slightly as spending shifted back to services post-pandemic, core inflation (excluding food and energy) remains persistent. While headline inflation initially dropped as energy and food costs subsided, we saw fresh oil price surges towards the end of the quarter. This was due to the effects of Saudi Arabian and Russian OPEC+ production cuts, which lowered oil inventories and supported prices. Consequently, Brent crude prices rose almost 30% to a high of $95.31/bbl, marking their biggest quarterly rise since Q1 of the previous year when Russia's invasion of Ukraine began. This performance follows a streak of four consecutive quarters of declines. We continue to believe in the importance of commodities in portfolios. Supply and demand dynamics could support prices over the medium term, and given that inflation remains a concern, they provide additional diversification benefits at a time when bond markets may remain under pressure.

Signs of slowing growth…

Alongside the mixed inflation news, another theme of the quarter were the growing indications that global economic data is softening. The latest US data generally points to an economy that is still expanding but at a slower pace. Employment data continues to weaken a little, but the economy is still adding jobs. House prices have started to rise again and activity in the services sector remains strong. However, figures from Europe, the UK, and China paint a different picture. Purchasing Managers data across Europe over the quarter indicated stagnation in the region as activity has also been hampered by high energy costs. Data in China has also been weaker, and we have cut our expectations for Chinese growth this year to 4.8%, almost two percentage points lower than at the start of the year. The sluggish growth in significant parts of the world economy puts more pressure on the US consumer as the engine of global growth.

 …but rates to remain high 

The fact that core inflation remains well above target means investors increasingly expect central banks to keep interest rates elevated for an extended period before any rate cuts. As Huw Pill of the Bank of England observed in a visual analogy, “less Matterhorn more Table Mountain”. This, combined with other factors, resulted in a substantial bond selloff in Q3, sending yields soaring to multi-year highs worldwide. By the end of the quarter, the 10-year Treasury yield had increased by more than 0.70% to 4.57%, with yields on September 28 peaking at an intraday level of 4.686% – their highest level since 2007. Similarly, 30-year Treasury yields saw their largest quarterly increase since 2009, rising by more than 0.80% to 4.70%. The trend continued in other markets too, with UK Gilts and German bund yields also rising over the quarter. The moves also mark the seventh consecutive year that Bloomberg’s global bond aggregate was down for the month of September.

Overweight bonds

The disappointing performance of bonds made the third quarter even more challenging for multi-asset investors. For most of the year, bond and equity markets have been moving in opposite directions. However, in an unwelcome reminder of 2022, this relationship came under pressure as both asset classes fell together. Nevertheless, we are comfortable with our modest overweight position in government bonds. Bonds now offer attractive levels of income and should start to offer greater diversification benefits if the global economy slows more meaningfully. While we remain shorter duration than any conventional benchmark, we have continued to gradually add to duration as we move closer to the end of the rate cycle. We also have exposure to higher quality credit as well as emerging market debt, where growth prospects are brighter. 

Adding to equity, but remain underweight

This backdrop also meant that equities had a particularly challenging quarter, with energy stocks being the main exception, up +15.6% over the quarter. We remain underweight in equity in the near term, although we continue to look for opportunities to increase exposure, especially as certain regions are becoming attractive. Japan, in particular, is offering better fundamentals, and the less restrictive monetary policy in the region could provide an opportunity for the market to outperform. US inflation continues to fall while its economy remains relatively resilient. We are therefore in the process of taking advantage of the recent de-rating in equity markets to slightly increase our exposure across risk mandates. Importantly, we remain underweight in equity compared to our long-term strategic allocation. This reflects our view that economic growth is slowing and that it is too soon to declare victory against "sticky" core inflation.  It is also a reflection of our concerns that rising long term bond yields eventually have a tendency to disrupt equity markets if the rise is disorderly.

ⁱ MSCI ACWI in USD terms. The index was up 0.7% in GDP due to a weak sterling and dollar strength over the quarter.

ⁱⁱ Bloomberg global aggregate sterling hedged.