Beat the heat before the storm

31 July 2023 – Sultry heat and then ominous calm: the usual portents of a ferocious storm. In financial markets too, 2023 continues to heat up. Against most expectations, equity markets have risen significantly across most of the developed world: US and European equity markets are up more than 20%, while Japan and the technology-heavy Nasdaq are up 28% and 44% respectively.

The most sensible explanation for this is AI exuberance, combined with subsiding fears of climbing interest rates. Both factors explain the leadership of US technology stocks, many of which have climbed 50% this year, with Meta (Facebook) up an astonishing 165%!

July continued to roast, with all asset classes posting positive returns for the month. Leading this ‘blanket’ rally were commodities, which returned >10% due to higher raw material demand from China in conjunction with lower supply, as Russia blockaded Ukrainian grain exports via the Black Sea.

In equity markets all major indices were boosted during the month, with China leading the rally after further stimulus to boost consumer demand was announced. All US equity sectors were higher in July with commodity (energy) and interest-rate sensitive (financial) names leading the way. In Australia the return drivers were similar, although the traditionally sensitive sectors of health care and consumer staples lost ground with negative returns over the month, driven by a sell-off in supermarket stocks.
Bond yields spiked early in the month due to stronger US employment data; however that move was largely retraced as the month progressed, leaving yields modestly higher by the end of July and close to the upper end of their one-year range.

Within currencies the USD was slightly weaker during the month, leading to rallies in most other major currencies. While major currency moves were relatively small, it was interesting to note that the Japanese yen (JPY) and Australian dollar (AUD) reversed their YTD momentum. While the Bank of Japan continues to keep the official interest rate below 0%, they did announce a relaxation of their bond buying program, now permitting yields to rise to 1%. Investors saw these higher yields as a step towards policy normalisation and the yen rallied. The AUD rally was driven by the expectation of increased future iron ore demand from Chinese policy stimulus.

Beware the boiling

With hindsight the explanation of investment returns is a simple task. But we are continuing to focus on the forward outlook, managing our investment exposures on a multi-quarter and multi-year basis. We believe there is a heightened probability that the rest of the world will join Europe in a recession in the second half of the year and we are positioned accordingly. As we said last month, we think that the current behavioural environment as that of the ‘boiling frog’: investors’ FOMO has them chasing historical returns while ignoring the growing fundamental evidence of slowing economic activity.

As various measures of economic activity gather negative momentum the market is choosing to focus in on the lofty expectations of artificial intelligence and the belief that central banks will be cutting interest rates within the next 6-12 months. We are convinced these beliefs are in the realm of wishful thinking and that due to the usual time lags consumers are only just coming to terms with the impact of Q1’s interest rate hikes.
A potentially positive development in Q2 was the ‘pausing’ of interest rate hikes both here in Australia and the US. While this pause may signal the end of hiking pain, the 0.5% of additional interest rate increases that came in the second quarter of this year are still only just flowing through to mortgage rates. In Australia, as more property owners switch from cheap fixed rate mortgages of around 2% to the current variable rate of 6%, consumption will fall, followed by asset prices.

The combination of the current market heat and brewing economic storm clouds leave us with the view that capital preservation remains the right course of action for our members today.

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