The key developments seen throughout August were:
- Evidence of slowing US economic activity, suggesting the Federal Reserve could cool inflation closer to the 2% target while maintaining positive economic growth.
- Labour markets and company earnings demonstrate ongoing resilience.
- In order to support US Government spending for the remainder of the year, financing requirements would increase from $726bn to $1,000bn in the US.
- Economic data from China continued to disappoint, alongside signs of renewed credit pressure in the property sector.
Below we add additional context.
Bond yields:
Generally, when interest rate expectations increase, this pushes up bond yields as investors demand a higher return if they are purchasing bonds. When this occurs, anyone holding a bond will see a decrease in the value of that asset.
The combination of data from China, Japan and US Treasury led to a rise in bond yields driving negative price returns from global government bonds.
Bonds with longer maturity dates are more sensitive to interest rate changes and expectations. This was most evident in US Government Bonds (Treasury Notes) with 10 years or more to maturity the most impacted as expectations for both the size and number of interest rate cuts has fallen significantly. For example, the 30-year US Treasury yield increased from 4.0% to 4.4% at peak[1].
An additional consideration being the higher yield on Japanese bonds and associated costs of hedging currency may moderate Japanese demand for US Treasury bonds. The larger move in US Treasury bonds, in relative terms, allowed the US Dollar to strengthen relative to the Pound[2].
The rise in sovereign bond yields and changing yield curve shape also influenced returns from bonds issued by companies. Those bonds which have a higher sensitivity (duration) to interest rates were more challenged, typically higher quality investment grade, relative to high yield bonds.
Weaker forward looking economic data from China with expectations of weaker demand looking ahead failed to curtail the rise in oil prices. This is following the reduction in supply from OPEC+ members during the month.
Higher bond yields influence how a business may be valued via the discounting of future profits. The rise in yields fed through to negative returns from global equities.
Emerging markets, influenced by China’s challenges, amongst the worst performers followed by Europe and UK. The US and Japan were better performing regions on a relative basis, the former supported by robust corporate profit expectations, the latter reporting robust economic growth with a weaker Yen supporting export demand.
In the final two weeks of the month bond yields did moderate (30-year US treasury from 4.4% to 4.2%), leading to better returns for bonds and rate sensitive stocks. Driven by tentative signs of cooling US economic data, initial evidence that the material interest rate changes are starting to impact. This may challenge the Federal Reserve’s preference for a longer period of restrictive monetary policy, providing an appetite for a reduction in interest rates sooner than previously thought[3].
Economic Growth:
- Unemployment ticked up to 3.8% with wage growth at 1.1%[4]
- Economic growth in China lagging behind the 5% target due to financial pressures in the property sector[5]
As a closed economy, Chinese officials have significant influence in steering the economic growth pathway via policy, announcing various policy actions to help stimulate.
Here in the UK, economic growth is positive but modest, with Q2 GDP growth +0.2%. Wage growth at 7.8% remains a headwind to the Bank of England’s Monetary Policy Committee attempts to moderate inflation towards the 2.0% target[6].
Inflation to Disinflation:
Headline inflation in the US is running close to one third of peak levels in Summer 2022 (currently 3.2%), supporting some optimism the Federal Reserve may achieve their longer term 2.0% target[7].
In the UK and Europe there is less disinflation momentum leading us to believe on a relative basis, the Bank of England and European Central Bank will be required to retain a restrictive policy stance for longer than the US.
Earnings:
Despite the headwinds, we are seeing an improvement in forward looking corporate earnings expectations. Global earnings growth expectations have moved from negative in the first half of the year to expected growth of +1.3% in Q3 and +9.7% in Q4 of this year[8].
Asset Valuations:
From a yield perspective, opportunities exist in sovereign bonds. However, the excess spread of corporate bonds over government bonds is minimal relative to their 20-year history. This means whilst the income (yield) is attractive, the asset class does not currently present attractive value on a forward-looking spread basis. Therefore, our managers are not increasing exposure, retaining preference for government bonds through an overweight to duration, with both the yield and diversification benefits of the asset class attractive.
Within equities, valuation opportunities are evident in European, UK, Chinese, and Japanese equities.
Market cap weighted US equities look expensive compared to history. Our active managers have been using an equally weighted index to capture the benefits of an improved economic outlook in a valuation aware way.
Opportunities for growth:
- Government bonds – the income yield is attractive and this asset class offers diversification benefits.
- Inflation-linked bonds – offer an attractive real yield, plus the potential to outperform If central banks pivot and reduce interest rates
- US equity equal weight – aiming to capture economic resilience in a valuation conscious way
- Japanese equities – valuation support and tailwind from structural change that may encourage companies to provide a better return to investors through better cash management via dividends and share buybacks
This article is not a personal recommendation or financial advice and the forecasts provided are not a reliable indicator of future performance.
[1] Bloomberg L.P. (31/08/2023)
[2] Bloomberg L.P. (31/08/2023)
[3] Bloomberg L.P. (31/08/2023)
[4] Bloomberg L.P. (31/08/2023)
[5] Bloomberg L.P. (31/08/2023)
[6] Bloomberg L.P. (31/08/2023)
[7] Bloomberg L.P. (31/08/2023)
[8] Bloomberg L.P. (31/08/2023)
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