Bonds and equities rally in a volatile quarter

As the first quarter of 2023 draws to a close, the outlook for the global economy is better than we forecasted at the end of 2022. Economic activity in both the US and Europe has been relatively resilient, primarily due to lower energy prices and the Chinese economy reopening sooner than anticipated. However, more recent developments in the global banking sector have complicated the picture – and introduced more uncertainty over the direction of monetary policy. The Federal Reserve and other central banks have to chart a difficult course between continued inflationary pressures on the one hand and potential threats to financial stability on the other.

The first quarter was marked by elevated volatility and distinctive challenges for investors, both of which we expect to continue as we move through the rest of the year. As Warren Buffet noted, in these market environments: “the most important quality for an investor is temperament”. We continue to actively assess the economic and market environment to understand the risks and opportunities that may arise.

Economics

At a headline level, inflation continued to decline during the quarter as energy and food prices fell. The pace of change has, however, been slower than investors were expecting, as inflationary forces have proved more persistent. Robust labour markets and continued consumer spending both have driven a continued rise in prices for many services. Certain economies including the UK have also had to contend with continued rises in food prices, resulting in a surprise increase in headline inflation in March.

The global economic growth outlook improved over the first quarter.

The sudden relaxation of China’s Covid restrictions and re-opening of the world’s second-largest economy should support both domestic Chinese growth and the global economy. China’s household savings grew by $2.6 trillion in 2022. As normal patterns of behaviour and consumption return, this should fuel higher levels of spending. Historically, an improving Chinese economy has been positive for manufacturing activity in Europe and the US. Increased travel could also benefit Japan: in 2019, nearly 10 million visitors from China spent $12.5 billion while on holiday there.

In Europe, a relatively warm winter has meant that the threat of an energy crisis has been avoided for now and the near-term economic outlook has improved.

Given the improved growth outlook and expectation of lower inflation, consumer sentiment in Europe, the UK and the US has started to improve, albeit from a low base. This is an important consideration in service-led economies.

Consumer sentiment is picking up

While the outlook has improved, the banking crisis shows that risks remain.

We believe that systemic risks to the banking system are relatively low and that the difficulties at Silicon Valley Bank and Credit Suisse were a result of a loss of confidence in institutions with idiosyncratic risks. Even so, recent stresses in the sector could increase the probability of an economic slowdown and recession, especially in the US.

US regional banks provide 50% of corporate loans and 80% of commercial real estate loans. Tighter regulation could lead to a slowdown in credit growth, which has historically weighed on economic activity. This, in turn, could prove to be disinflationary, particularly if it translates into labour market weakness.

As we move into the second quarter, uncertainty remains over the direction of monetary policy as the Federal Reserve and other central banks assess the outlook for inflation and risks to financial stability. Markets have been quick to assume that banking sector stress will push the Federal Reserve to cut interest rates. In our view, recent events could see interest rates peak sooner and perhaps at a lower level than previously anticipated. However, we believe that the Federal Reserve and other central banks will be very reluctant to cut interest rates until they consider that inflation is clearly under control.

Market review

Overall, the first quarter was positive for risk assets, with investor sentiment supported by the better economic outlook, falling inflation and the expectation of a peak in interest rates. Global equities ended the period up 5.3%. However, the headline number masks significant volatility and a shift in market leadership as a result of changes in interest rate expectations.

Bond yields fell in January as investors anticipated a peak in interest rates and in March when they started to anticipate interest rate cuts. In both periods, growth equities outperformed. However, bond yields rose over concerns about a continued hawkish policy in February. Value sectors briefly regained their leadership.

In this environment, we do not feel that it is appropriate to take large bets within our equity allocation on either style or region. We remain focused on identifying high-quality companies with strong balance sheets.

As was the case for much of 2022, the performance of equities and fixed income assets remained closely correlated. Overall, both government bond and credit markets delivered positive returns over the period, with gilts rising 2.3% and UK corporate bonds advancing by 2.4%. European markets saw similar moves, with European government bonds rising 2% the Swiss government bond index advancing 4.6% in local currency terms.

We increased our exposure to government bonds during the quarter. Valuations look more attractive following the re-pricing we saw last year, and we believe the defensive characteristics of government bonds should re-assert themselves as inflationary pressures continue to fall, offering a hedge against the potential for a more meaningful growth slowdown.

Within alternatives, broad commodities declined over the quarter, with the Bloomberg Commodity index falling 8.4% as oil and gas prices continued to adjust to lower-than-expected demand. We remain happy to hold commodities both in the near term as a hedge against further energy market disruptions and longer term to benefit from increased demand for metals to support the energy transition, in an environment where supply is constrained. Within the commodity complex, gold demonstrated its more defensive characteristics, performing strongly in March as investors sought out safe havens amidst banking sector stress. We are maintaining our gold exposure as part of our blend of defensive assets.