Monthly Market Commentary - July 2023

It is probably fair to say that some of the euphoria has evaporated from the sphere of US equities after the AI-fuelled rally over the last few months. There is of course the scope for a renewal of the momentum in that space, but it feels as if markets are now in a more cautious mode. Some of this is attributable to the Federal Reserve looking set to raise rates over the next few months after its ‘hawkish pauseʼ in June. The yield curve – which has been a very impressive predictor of downturns in previous cycles – continues to show inversions across various time periods  and  betting  against  its predictive abilities looks a tad reckless to us.

The resilience is likely to be tested in our view as the recessionary forces that have already pushed down the manufacturing sector start to affect the wider economy.

Earnings disappointments may well be what drives the next correction – estimates remain high and if revenues take a hit and pricing conditions deteriorate, there is scope for meaningful falls. Though there is very little clarity on the matter of liquidity, we still expect some ramifications from the record issuance of treasuries and the rebuilding of the Treasury General Account (TGA) following the debt ceiling resolution. We also expect a deterioration in credit availability as regional banks adapt to difficulties in the commercial real estate sector as the year progresses.

So much complacency has taken hold around the avoidance of recession that stocks appear to be pushing their luck. AI may well play a key role in the advance of stocks over the coming years but whether its advent will be sufficient to prevent a pull back in markets is highly debatable and we reject this notion. In fact, the dominance of the ‘big 7ʼ stocks makes the US market acutely vulnerable. Though technology has led the growth style to outperform of late, it seems likely to us that value will regain the ascendancy but probably the less cyclical and defensive elements of it. Inflation could well surprise on the upside in the second half of the year and those more rate sensitive areas of the market that have rallied of late could come under pressure again. At some point, the US is going to look attractive to us with our having been underweight for so long, but it feels reckless to buy the wider index at this time.

The USʼs geography means it experiences an exceptional amount of extreme weather. Given its locations between two oceans, and dominated by storm fronts and jet streams, the country regularly experiences tornadoes, hurricanes, floods, droughts, and wildfires. The Gulf of Mexico, where hot air is injected underneath cooler, dry air from the mountain ranges, is a particularly unique area from a meteorological point of view.

We continue to do a lot of work on the US, not least in the smaller companies arena, but will bide our time given the ongoing valuation premium.

The European economy is looking decidedly sluggish with the latest purchasing managersʼ index (an overall measure of the level of manufacturing and services activity) falling to almost a six- month low last month. This means it is approaching the level consistent with contraction and is a significant blow to those who had hoped for an economic recovery after two disappointing quarters. Technical factors aside, it looks as if the region may well enter a recession in the coming months. One might think this would lead policy setters to relent in their pursuit of higher rates, but the European Central Bank (ECB) has sounded pretty hawkish in their recent pronouncements and President Lagarde has declared it too early to declare victory over inflation. Rates have risen to 3.5% and the suggestion is that they will go as high as 4% in this cycle. Historically, the ECB has a track record of continuing to tighten even as economic data has deteriorated – with 2008 being a notorious example.

Interestingly, although input prices have fallen for manufacturers, they have continued to rise for services companies. Workersʼ wages are rising at a rate of around 5% per annum with unemployment at a relatively low level of 6.5% in April. Headline inflation numbers were always going to fall off given the energy factor, but the core rate (stripping out energy and food) is still over 5%. In this sense, the story is  not  dissimilar  to  that  in the   UK.

Another  similarity with our domestic economy is the pressure being felt in parts of the European property market, with German residential prices being marked down significantly and commercial real estate showing weakness across the continent.

The European Environmental Agency estimates that nearly 200,000 people in Europe have died from extreme weather conditions since 1980. A remarkable number but, when one considers the issues caused by heat and rising global temperatures, perhaps it is not that surprising.

European companies have actually held up better than most over 2023 but as we reference in relation to the US in this monthʼs MMC, earnings and liquidity are likely to act as headwinds as we move through the summer. It also must be considered that if the US is closer to the end of its tightening cycle than is Europe, this could act as a further relative headwind. If one is looking for other potential negatives regarding sentiment, then the tragic Russia- Ukraine war could be something to consider – the geographical proximity to the conflict might weigh on investorsʼ minds if further escalation takes place.

Overall, the balance of risk and potential reward means we are maintaining European allocations this month.

One of the major events last month was Yevgeny Prigozhinʼs mercenary military group seemingly beginning an uprising in Russia before events suddenly de-escalated. There is still lots of speculation about what actually happened, whether it was an abandoned revolution, a test of loyalty for senior government officials or even a ruse to relocate troops to Belarus for a future offensive. While it was clearly a significant event from a political perspective, markets seemed to largely ignore this.

From one perspective, it is difficult to understand what happened in the first place, let alone decipher the economic implications, so it is right that market participants were not taking major bets or repositioning on these events. It can also be argued that little has changed meaningfully for markets; the war in Ukraine and its fallout are still likely to drag on for years from here and the potential endgames are ultimately unchanged. Ukraine may eventually lose support of its Western allies (perhaps a change in US government next year will be less sympathetic) or Russia may see its government change and end the war. Of course, the latter may also mean a more aggressive Russia – regime change is no guarantee that the war will end any quicker.

Both scenarios are unlikely to see things return to normal – Russia will remain a Pariah state and continue to be under sanctions for a long time. There will be no instant return of cheap(er) energy or agricultural goods. Russia will remain frozen out of markets (a reason in itself why markets have not moved much). While there are black swan events, particularly around nuclear incidents, this has not meaningfully changed. China and India continue to put pressure on Russia not to use these, as does the threat of NATO escalation.

Honister Pass in the Lake District holds the UK record for most rain in twenty-four hours, with 34.1 centimetres/13.4 inches of rain falling there in December 2015. The world record is over five times that amount in 1966, when Tropical Storm Denise hit La Reunion Island in the Indian Ocean. Between 7 and 8 January, 182 centimetres/71.8 inches of rain fell – which was the height of Elvis Presley!

Coincidentally, the last time Japanʼs Nikkei 225 Index was at levels near today was when the Soviet Union was collapsing, with the flagship Tokyo Index at record levels. Japan has disappointed investors previously and been known as ‘the land of false dawns‘ rather than the rising sun, even with the Abenomics economic reform programmes of the last decade proving to be an ineffective solution to a well-known problem. However, things are now beginning to change, with the Tokyo Stock Exchange having brought in reforms  that   seem  to   have  refocused corporate Japan on shareholder value.

Along with new categories within the stock market and kicking out stocks that are effectively controlled by banks and insurers, the most significant reform in recent guidance has been a focus on the price-to- book ratio. This is a measure of the value of total share capital held by a company against its total assets. For many Japanese companies, this ratio is below 1, meaning in theory if you sold all assets of the company, it would be worth more than the share price. The new regulations mean companies must make a statement on their price-to-book ratio if it is below 1 and detail what plans they have for improvement. This has led to many Japanese companies buying back shares or returning large amounts of capital to shareholders in the form of special dividends. It also looks as if international interest in Japan is starting to grow again as hope gathers that this time it really is different.

Markets continue to see the Russia and Ukraine conflict as relatively contained and risks well considered. Japan continues to be positive and is an area we remain positive on despite reaching record highs. Elsewhere, we have been reducing our India exposure, seeing this market as relative expensive now, presenting us a good opportunity to take profits.

UK water companies dominated discussions in the infrastructure and utilities space over June. The sector came under stress following news that the UKʼs largest water company, Thames Water, entered emergency talks with the water regulator (Ofwat) as well as ministers and government departments, amid concerns it needs a multibillion cash injection to keep operating. The Government is preparing an administration that would give it control of the heavily indebted utility, which serves 15 million customers, by putting it into temporary national ownership. The story has been dominating headlines and is clearly of public interest but within portfolios there is relatively little exposure to UK water companies and, as such, this is not something you need to worry about – at least from an investment perspective!

Against a backdrop of negative news flow, it may be surprising to note that the MSCI World Infrastructure Index delivered a positive return of 0.62% (in £ terms) over June. While this is lower than the return from global equities, as measured by the MSCI All Companies World Index (3.15%), which continues to be propelled by a narrow range of outperforming stocks, it is certainly a more attractive figure than those reading UK headlines may have envisioned. The reality is that UK-listed infrastructure is a very small part of a wide investible universe. Issues impacting the UK infrastructure sector may feel acute to us ‘Britsʼ but to global infrastructure investors, the UKʼs water concerns are but a drop in the ocean, if you can excuse the pun.

One of the well-known UK-listed infrastructure investment trusts does have exposure to Thames Tideway Tunnel and although this is a separate entity, Thames Water has a licence to collect Tidewayʼs revenues from its customers (which are then passed to Tideway). That said, statutory and regulatory protections would come into force should Thames Water buckle under its debt pile, so exposure here is minimal. The rhetoric we have heard from specialists around peers of Thames Water has also been surprisingly optimistic; the consensus is that each business must be taken on its own merits. There are listed water businesses in better shape in terms of finance, even if some may have work to do in terms of performance.

We continue to believe that a small allocation to global-listed infrastructure remains appropriate. There are few certainties in life but (aside from death and taxes) you could make a good case that the need for more infrastructure in every form – roads, rail lines, healthcare facilities and electricity – is one of them.

Last autumn, unseasonably heavy rain pelted North Americaʼs southern belt resulting in flooding that, somewhat ironically, caused water access issues. Several water treatment plants were damaged, leaving residents across Georgia and Mississippi relying on bottled or boiled water until the issues were resolved. The event highlighted the vulnerability of water systems across developed nations in the face of shifting weather patterns.

We could simply replicate much of what was said in last monthʼs fixed income section and it would be entirely relevant to June; stubborn inflation readings, particularly core inflation (which strips out food and energy prices), are forcing financial markets to reassess their outlook for global interest rate policy. Essentially, we witnessed another month in which bond yields moved upwards, pricing either a higher terminal interest rate for certain economies or reshaping the timeline for interest rate cuts in others. As we know, higher interest rates make the fixed coupon of a bond less appealing, so bond prices fall, pushing up their available yield in response. Taking a widely followed bond index such as the  Bloomberg  Global Aggregate  as a  useful  proxy  for performance year–to–date (to 30 June 2023 in GBP), this seems an excellent time to revisit performance, as we move into the second half of the year, bonds have fallen by 4%. This comes even after posting a positive 2% for the month of January.

Does this mean fixed income has lost its shine? Or is this just a temporary setback as markets seek to frame greater conviction in interest rate policy? There is perhaps less conviction than seen through the fourth quarter of 2022 and moving into 2023, when investors poured into fixed income as yields of 5-6% became widely available from even the highest quality (most likely to pay their coupons and maturity proceeds) bond issues. However, we would fall on the side of the latter and have previously noted rate volatility as likely to impact short-term performance.

From a flow of capital perspective, we are not seeing considerable weakness – most investors seem to be holding their nerve, recognising the rate volatility, and looking at longer-term return potential. A yield-to- maturity (when a bond is held until its maturity date) of mid-single digits in a high-quality fixed income instrument is an appealing prospect and does still provide a premium over cash. There may be deviations in price until it matures but the outcome is known and visible (providing the bond does not default).

Similarly, for those who invest collectively into actively-managed bond funds or bond index trackers, as we do presently, while we cannot rely on a yield-to-maturity (as we are not holding individual bonds to maturity), we can seek to position the duration, or interest rate sensitivity, of our bond exposures. Duration positioning can help in protecting against higher rate movements due to predictability of outcomes. As we noted above, if interest rates move higher, the price of a bond moves lower due to its fixed coupon. Broadly, for every 1% move in interest rates, a bondʼs price moves 1% in the opposite direction for each year of duration. For example, taking a bond with six years of duration, a 1% upwards move in interest rates causes a 6% decline in the bondʼs price. Conversely, a 1% decrease in interest rates sees a 6% increase. Therefore, if we reduce duration at a portfolio level, we can mitigate the detrimental impact of higher interest rates – this is something we have been actively doing.

Further, there is also a cushioning effect available. Take a bond with a 6% yield (typical of many high-quality bonds we could currently buy) and six years of duration (again, typical of the same high-quality bonds), a 1% increase in rates reduces the outcome is known and visible (providing the bond does not default).

Similarly, for those who invest collectively into actively-managed bond funds or bond index trackers, as we do presently, while we cannot rely on a yield-to-maturity (as we are not holding individual bonds to maturity), we can seek to position the duration, or interest rate sensitivity, of our bond exposures. Duration positioning can help in protecting against higher rate movements due to predictability of outcomes. As we noted above, if interest rates move higher, the price of a bond moves lower due to its fixed coupon. Broadly, for every 1% move in interest rates, a bondʼs price moves 1% in the opposite direction for each year of duration. For example, taking a bond with six years of duration, a 1% upwards move in interest rates causes a 6% decline in the bondʼs price. Conversely, a 1% decrease in interest rates sees a 6% increase. Therefore, if we reduce duration at a portfolio level, we can mitigate the detrimental impact of higher interest rates – this is something we have been actively doing.

Further, there is also a cushioning effect available. Take a bond with a 6% yield (typical of many high-quality bonds we could currently buy) and six years of duration (again, typical of the same high-quality bonds), a 1% increase in rates reduces the price by 6% but this is compensated by our 6% yield – we only forego one year of yield and the value of our bond is not lessened. So, higher yields provide a stronger buffer and with yields on sterling high-quality bonds almost 1% higher than at the start of the year, we are currently in a good position. It should be noted that duration is no unknown factor either, it is a calculation related to all future cash flows (coupon and maturity proceeds) of a bond and the time taken to receive them.

While this section has strayed from the typical monthly update we normally include, it hopefully demonstrates the scale of opportunity available in fixed income and the levels of visibility surrounding outcomes. Put simply, and all things equal, there is a great deal of transparency in the way a bond will behave, allowing us to position accordingly. Higher yields are providing cushion against higher rates and with yields notably more attractive over the past year, the outlook for bonds over the medium term remains appealing. When interest rate cuts come, and they must as debt loads become harder to bear for many economies, returns should prove even better.

This may appear to be a fixed income double header and to be completely transparent, it is. However, we will link this piece, in a not entirely tenuous manner, to currency. To set the scene, we know performance of various currencies can be driven by certain pre-determined factors. That may be through the carry trade, where investors seek to profit from the interest rate differentials between two countries,  or perhaps through the traditional safe-haven dynamics of the Swiss franc or the US dollar into which investors retreat during risk-off periods.

The Swiss Federal Institute for Forest, Snow and Landscape Research WSL has been collecting information on damage caused by extreme weather for the past 50 years. There are 27,000 severe weather events on record with estimated damage costs of around 15 billion Swiss francs.

Regarding the US dollar, both these factors (among others) have driven performance of the greenback in recent years – the US Federal Reserve started raising interest rates ahead of many other major central banks, increasing the attractiveness of the currency, while volatility, particularly post Russiaʼs invasion of Ukraine, pushed the dollar higher against most global currencies. Then of course there are more idiosyncratic factors; the value of sterling, relative to the US dollar, being detrimentally impacted by Brexit.

So, while the US dollar has prospered, this has come at the expense of many other assets. None more so than emerging market debt. Most emerging market economies finance a portion of their spending needs by issuing bonds in US dollars. After all, it is the most widely traded global currency and therefore makes the bonds more appealing to a wider set of investors. Unfortunately, a more expensive US dollar, relative to the home currency a bond is issued from, becomes problematic. Simply put, it costs more, in terms of your domestic currency, to buy the dollars needed to service bond coupons and maturity proceeds. This has all come through a period when bonds yields, and therefore the cost of borrowing, have been moving rapidly higher. While there is more to the underperformance of emerging market assets, relative to those in the US, this is broadly the crux and resulted in a horrendous period for the emerging market debt asset class through 2022.

However, now we are in a different environment. Emerging market economies have raised interest rates significantly, in many cases to levels much greater than that available in the US, to protect their currencies. With US interest rates appearing close to their peak, the US dollar loses one of its enticing factors – investors are seeking higher interest rate opportunities elsewhere. Indeed, since its recent peak during the fourth quarter of 2022, the US dollar has lost around 10% of its value when measured against a broad basket of currencies. Not to say, another bout of risk cannot push the dollar higher, more that a structurally higher dollar appears less likely.

So, while many bond sectors have delivered negative returns over the past quarter as interest rates move higher, emerging market bonds are one of the few that managed to eke out a marginally positive return. With yields of over 8% available at an index level for US dollar denominated emerging market bonds, we have made the decision to invest back into the asset class for suitable investors (recognising the more volatile nature of some of the underlying issuing economies) after a period in which we had no exposure. While it is extremely difficult to call directionality of currencies, it is an element we must consider that can also present both opportunities and risks at an asset class level.

Our fixed income allocations comprise healthy exposures to a mix of high- quality US Treasury bonds, investment grade (the strongest) corporate bond issuers and for appropriate investors a new exposure to emerging market debt. We remain conscious of interest rate sensitivity when taking bond positions and while it was widely expected that rate volatility would dampen as inflation began to peak, recent events show that remaining prudent in the levels of interest rate risk taken has been a sensible course of action. Conversely, yields on offer appear even more attractive and the value of bonds as part of portfolio construction has not been this appealing for some time.

Technology, or more precisely artificial intelligence, has dominated investor attention over the past few months. There has been a furore around the theme driven by technological advances as well as the tailwind of long-term demographic shifts that threaten productivity. By contrast, the overall healthcare sector has struggled to gain ground year to date, which may seem curious as the sector looks to benefit from several long-term drivers of growth with a similar mix of non-discretionary demand and exposure to scientific and technological advancement.

Technology may have eclipsed healthcare in terms of coverage and performance this year, but we maintain a strong interest in this space. Investing in healthcare and technology is not an either/or proposition for us, we believe they can be complementary themes within a portfolio. Furthermore, there are particularly interesting investment opportunities to be found within a fusion of both areas, that is, healthcare technology. The ‘HealthTechʼ sector, as it is called in the industry, includes companies that are involved in any technology-enabled healthcare product and service that can be delivered or consumed outside of a hospital or physician’s office (with one notable exception being hospital and practice management software) and has markedly out-performed the broad healthcare sector over 2023. Examples in the space include Cera, which is the UKʼs largest healthcare-at-home provider involved in laying early groundwork for a modern healthcare system utilising digital solutions.

Something of a sleeping giant, health tech investments actually broke records last year (which as we know was hardly a Shangri-la for equities), reaching values of $23 billion overall. Unlike technology companies, which are somewhat concentrated in the US, gems in the health tech space can be found around the world, for instance, the UK actually leads Europeʼs health tech eco- system and seven of the UKʼs unicorn companies operate within the sector.

During the Covid-19 pandemic, healthcare providers had to adapt quickly to social distancing measures, this necessitated the rapid adoption of digital solutions. Although there may have been some resistance at first, most patients have welcomed these changes over the long term. For example, post- pandemic, digital healthcare platforms have aimed to increase access to primary care with only 10% of patient care requests indicating a preference for face-to-face GP consultations in 2022.

Have you noticed your hay fever getting consistently worse each summer? This could be down to climate change and higher temperatures, which are linked to an increase in allergens in the air we breathe. Fortunately though, we can easily obtain allergy medication with the help of digital solutions!

We continue to invest in healthcare companies within portfolios, favouring an actively-managed exposure to a broad range of sub-sectors. Beyond health tech there is a long tail of interesting healthcare companies, such as biotechnology, medical devices, and medical equipment suppliers, all of which are riding long-term trends such as ageing, more healthcare spending and big data.