Multi-Asset team Q2 market insight

The Marlborough Multi-Asset Team present their latest quarterly markets review, in which Nathan Sweeney says that investors spooked by a tide of bad economic news could miss the opportunities that come with steadily falling inflation and interest rates.

2023 is likely to remain a challenging year for investors but not due to market performance, I’m referring to the potential for investors to miss out on investment opportunities due to the symphony of bad news ringing from the rafters.

The first quarter of 2023 did not disappoint on this front. Investors remain on the edge of their seats as inflation concerns persist, a recession is all but guaranteed, and now the banking system is on the verge of collapse. Deciphering between the media noise and the actual data that markets react to can be challenging.

So, what lies ahead for the rest of 2023? In our Q1 review and outlook, we will delve into some of the key topics on investors’ minds. We will assess each separately and answer some of your clients’ questions.

Inflation:

We have seen some mixed readings on price rises. Do you still expect them to slow down in 2023?

Yes, we expect inflation to continue to fall throughout 2023. February’s inflation numbers in the UK came in higher than the market expected (surprised to the upside), and no doubt, investors will be concerned that inflation figures have moved back up.

In my presentations this year, I have regularly talked about the media noise, which, given the news, will be on full volume about the ravages of inflation. Ultimately, the market believes inflation will trend down, despite the inevitable hiccups along the way.

Here are some examples of why we here at Marlborough, the central bankers, and markets expect inflation to trend down: firstly, supply chains are beginning to normalise after a long period of disruption post-Covid, as companies have hired the required staff to remove backlogs, enabling them to resume normal service.

A variety of different commodities, ranging from oil to cotton, have been falling in price since they reached a peak last year - this is one of the reasons why inflation has begun to fall already. Higher interest rates have led to slower demand for housing, which results in less need for goods to furnish houses, which will help to bring down prices as retailers compete for business by reducing their prices. And lastly, stock or inventory levels at retailers are high due to lower demand, which means we are likely to see increased discounts on goods on sale, which will help bring about lower inflation.

Banking Collapse:

Have we not learned our lessons from the financial crisis of 2008? Are we on the verge of another systemic banking collapse?

No, we are not. It’s human nature to look at historical periods to try and make sense of what’s happening today. Therefore, it’s only natural for investors to immediately think of the 2008 financial crisis when they hear news of banks going under.

However, bank failures are not uncommon. In fact, there have been more than 560 bank failures since 2001 in the US alone. Nevertheless, the collapse of Silicon Valley Bank (SVB) stands out, as it’s the biggest bank to fail since 2008.

Firstly, it’s important to highlight that this was no ordinary bank; unlike most banks, the Silicon Valley Bank predominantly took deposits from tech start-up companies in the US. Traditionally, banks make money from lending to their customers. SVB customers did not need loans, as they were getting a wall of money from venture capital investors. The bank decided to try and make some money by buying low-risk government bonds. Unfortunately, bonds decrease in value as interest rates rise.

As the start-up companies were no longer getting floods of cash through the door, they had to start withdrawing their money on deposit to fund day-to-day business operations. The bank then had to sell the bonds at a loss to raise cash to service these customers. Rumours began circulating around Silicon Valley, and clients started to withdraw their money quickly… the rest is history. It’s common practice for banks to take out insurance against potential losses on their bond holdings. SVB had no such insurance. And that’s where they went wrong.

The reality is, it’s a totally different story from banks in the UK and Europe, because they are extremely well capitalised in the aftermath of the 2008 financial crisis. This has led to a big change in behaviour, and these banks now have very high levels of cash in reserve.

In 2010, French bank Société Générale held cash equal to only 5% of its deposit liabilities. But in December 2022, it was 40%. BNP Paribas has gone from 6% to 32%. Deutsche Bank from 3% to 29%. We, like central bankers in the UK and Europe, do not see any systemic issues within the banking sector. The reality is, the banking sector is in a much stronger position today compared to in the past.

Interest rate rises:

Borrowing costs continue to rise. Is there any end in sight to interest rate rises?

Overall, both the banking turbulence and the recent central bank (Federal Reserve or Fed as it is called) meeting in the US (the same applies to the UK and Europe) have sparked a shift in market expectations of interest rate hikes.

Markets currently forecast no further rate hikes, and they expect the Fed to start cutting rates as early as their July meeting. In fact,  there are three rate cuts priced in for 2023, which would bring interest rates down to around 4.25%, well below the 5.1% indicated by the Fed in their March meeting.

In our view, the Fed is certainly close to the end of its tightening cycle, perhaps with one more rate hike up its sleeve. However, we don’t see scope for rate cuts just yet, particularly as inflation remains high and the labour market is tight. The Fed will most likely cut rates or signal rate cuts when it sees inflation move meaningfully towards its 2% target, or when it sees the economy and labour market sharply weakening.

Markets:

Despite the cacophony of overly pessimistic media reporting on market events, we remain optimistic about the outlook for both equities and bonds for the remainder of the year. Inflation is now slowing, and we expect it to continue to moderate for the rest of the year.

As central banks take their eyes off inflation, they will then focus on financial stability. The recent events in the banking sector increase the probability that central banks will reduce interest rates quicker than expected. So we’re expecting rates to begin their downward move towards the end of this year. This will be welcomed by markets, as falling interest rates reduce business costs and increase profits.

Equities:

Equity markets began the year with more of a risk-on tone, as traditionally cyclical areas like financials, materials, small-cap stocks, and even more speculative parts of the market outperformed. Over the past month, stock market leadership has shifted to reflect more conservative positioning, with defensive sectors like healthcare and consumer staples outperforming, alongside parts of growth and technology.

Growth sectors have been viewed recently as somewhat resilient in the midst of the banking turmoil, especially in companies with strong financial positions and healthy free cash flow. These sectors have also done well when rates move lower, which has been the case in recent weeks.

Bonds:

The bond market has also seen dramatic moves over the past month, by some measures even more so than the stock market. In one month, the 2-year US Treasury yield has gone from a high of 5.1% to around 3.8%, and earlier in March it had its largest three-day drop since 1987. The declines in yields come as investors seek traditional safe-haven assets like government bonds, and as the market expectation for Fed rate cuts this year has increased substantially, putting downward pressure on yields.

Portfolio Activity:

We were defensively positioned throughout much of 2022, with a preference for low-risk, income orientated funds, which invest in dependable companies that are good at managing their balance
sheets. These companies tend to perform well in a downturn, as their profits are less dependent on the economic cycle.

As we entered this year, we became more constructive on the outlook for 2023. Simply put, this was because the news was becoming less alarming compared to last year. Falling inflation and a change in tone from central bankers provided a more favourable backdrop; as such, we have been reducing our short-duration bias and increasing our exposure to growth, like technology  companies, which sold off last year.

On balance, we remain neutrally positioned, and prefer funds that focus on quality businesses with strong balance sheets that can weather the natural bumps on the road to recovery.

As an example, in Europe, we added the BlackRock European Dynamic fund, which we like for the following reasons:

Strong track record:

The BlackRock European Dynamic Fund has a healthy history of outperforming its benchmark index over the long term.

Experienced management team:

The fund is managed by Giles Rothbarth, who has over 20 years of investment experience, and a team of similarly seasoned investment professionals. This team has a deep understanding of European markets and companies, and uses a rigorous, bottom-up investment process to identify high quality, undervalued stocks.

Diversified portfolio:

The BlackRock European Dynamic Fund is a diversified portfolio of European equities, with exposure to a wide range of sectors and countries. This helps to spread risk and reduce the impact of any individual company or sector-specific events. The fund also has the flexibility to invest in small, mid-, and large-cap companies, which can provide additional diversification benefits.

We see opportunities forming in both the equity and bond spaces in the months ahead, beyond the more recent defensive posturing, as markets start to look past the economic downturn, and towards recovery.

It is important to remember that markets are forward-looking; they may not wait until the central banks have started to cut interest rates, or for the economic data to officially bottom, before stocks and bonds start to price in a recovery.

We expect 2023 to be a year in which many asset classes bounce back from their 2022 lows. However, the opportunities will vary across different regions and asset classes. As a result, investors will benefit from holding multi-asset portfolios that can capture these opportunities, while also providing diversified exposure to help buffer the impact of market shocks.

As the focus shifts from inflation and interest rate rises to a slowdown and interest rate cuts, it is important not to allow a challenging economic backdrop and the cacophony of noise that accompanies it to cloud your judgement. We believe the investment opportunities thrown up by the events of 2022 do not happen often and are not to be missed.

Nathan Sweeney - April 2023

Risk Warnings

Capital is at risk. The value and income from investments can go down as well as up and are not guaranteed. An investor may get back significantly less than they invest. Past performance is not a reliable indicator of current or future performance and should not be the sole factor considered when selecting funds. Our funds invest for the long-term and may not be appropriate for investors who plan to take money out within five years. The funds may have exposure to bonds, the prices of which will be impacted by factors including; changes in interest rates, inflation expectations and perceived credit quality. When interest rates rise, bond values generally fall. This risk is generally greater for longer term bonds and for bonds with higher credit quality. The funds invests in other currencies. Changes in exchange rates will therefore affect the value of your investment. The funds may invest a large part of its assets in other funds for which investment decisions are made independently of the fund. If these investment managers perform poorly, the value of your investment is likely to be adversely affected. Investment in other funds may also lead to duplication of fees and commissions. In certain market conditions some assets may be less predictable than usual. This may make it harder to sell at a desired price and/or In a timely manner. All or part of the fees and expenses may be charged to the capital of the funds rather than being deducted from income. Future capital growth may be constrained as a result of this.

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