Monthly Market Commentary - June 2023

So, the debt ceiling was navigated successfully, and the issue of the enormous US debt pile has been kicked down the road. We never really feared there would be a failure to reach an agreement, but it is a reminder that the finances of the worldʼs largest economy are less than exemplary. However, what many are concerned about is what happens next. A large number of US government bonds will now be offered to the market to meet financing needs and the mechanics of the financial system mean this could cause a drain of liquidity from risk assets. It is certainly something to watch over the next quarter or two but for now markets are enjoying a modest bounce in response to the averting of what would have been a catastrophe.

As the markets have looked around for a growth story, with the cycle looking tired and investors anxious about the possibility of recession, they have received a gift in the form of the excitement around AI (convenient, eh?). This has the potential to transform our working and financial worlds but the hyperbole around it does seem a little excessive. Much of this will be a realised gain many years into the future but this has not stopped something of a fever developing around the subject. Of course, some businesses are already benefiting from it and this has helped large technology companies to become the star performers of late. Businesses that will benefit very directly, such as Nvidia, have seen their valuations skyrocket and the trend has exacerbated the ‘narrownessʼ of the US marketʼs gains. The market overall is up around 10% for the year but if you ‘equal weightʼ the S&P index (so remove the disproportionate effect of the very large companiesʼ share price movements), it is roughly unchanged.

Always at the forefront of technological change, perhaps the US is inspired by its love of science fiction. There have certainly been many famous TV series, with Star Trek probably the most successful, maintaining its popularity since its first airing in 1966.

We are not getting over-excited about recent developments. Some exposure to these exciting growth areas is clearly warranted but the wider market looks expensive to us, and the economic outlook remains challenged. If it were not for the strange resilience of the employment market, then it would be a slam dunk for a recessionary outcome but it appears this is being further delayed. With the prospect of rates staying higher for longer and continued stresses in the banking system (not least from commercial real estate), it might not quite be the time to bet the house on US equities, AI fuelled or otherwise.

Those advocating for European equities have enthused in recent quarters about the exposure to the Chinese recovery story. The recent data suggests that China is actually emerging post-Covid-19 rather more slowly than many had hoped, which has taken away some of the enthusiasm for large exporters who benefit from selling into the country. Europe itself is not experiencing an easy time of it either and although many are hopeful that widespread recession can be avoided, German manufacturing data points towards a much more challenged outlook and even suggests Europeʼs largest economy is already in a recession. Inflation is proving sticky across the eurozone, as it is in the UK and elsewhere with the European Central Bank (ECB) looking set on imposing further rate rises, raising liquidity concerns for European stocks.

So much has been written about the influence of the large tech companies on the US index and its fortunes but European luxury goods businesses have been having a considerable effect on European indices, soaring to eye-watering valuations. They have, however, come under some pressure over the last few weeks, not least because of the aforementioned difficulties in China, which constitutes such an important market for them.

One famous European science fiction book is Solaris – a 1961 novel by Stanislaw Lem. It centres around a group of scientists trying to understand extra-terrestrial intelligence – a task not dissimilar to trying to understand the activities of central bankers in the modern era!

Things can change dramatically in financial markets and a timely reminder of this has been Greeceʼs move from being a problem child ten years ago to being an economy producing nearly 6% GDP growth, with debt to GDP falling 40 percentage points since the eurozone crisis (itʼs still at 170% by the way!). Unemployment is down to around 10%, which is a considerable improvement, and the political landscape is much more amenable to building a secure economy. Donʼt misunderstand us – we are not ready to start investing directly in Greek risk assets but it is useful to reflect on how opportunities can occur in the most unlikely of areas.

We are maintaining positions – with small allocations to European funds and further exposure through thematic funds.

After the relaxation of zero-Covid policies at the end of the year, it was expected that China would experience a rapid rebound with foreign investorsʼ sentiment turning positive. It was expected that the ending of the restrictions would see the Chinese domestic consumers start spending again, drawing down on their ‘Covid piggybanksʼ. Despite this enthusiasm, Chinaʼs recovery has been more fragile and equity markets (having rallied on hopes) have been brought back to November levels by the reality.

In particular, the property and manufacturing sectors have been weak. Research from Gavekal suggests that property sales have fallen to just 63% of their 2019 levels in April. Manufacturing data has also been weaker than expected despite exports increasing, suggesting it cannot be dismissed as a consequence of a global slowdown. Youth unemployment has also risen, reaching a record 20.4%, although the figure for older workers has been flatter, partially suggesting graduates may have been focused on the wrong areas.

Godzilla, the Japanese nuclear-empowered dinosaur-like monster, is perhaps the most iconic creature in science fiction but his appearance could have been very different. Creator Tomoyuki Tanaka had come up with the premise of a monster created by nuclear testing for the original film in the mid-1950s but not the type of creature. The special effects designer Eiji Tsuburaya had suggested a giant octopus instead, an idea for a film he had written a script for.

Elsewhere in Asia, Japanese equity markets have been hitting highs, seemingly despite a lack of appetite from overseas investors. As we explored last month, the Bank of Japanʼs continuation to ease monetary policy has been supportive, with inflation becoming embedded also a positive for markets as investors move out of cash. Overseas investorsʼ interest will most likely depend on the state of the US and global economy and animal spirits generally (Japan should do well if investors become positive on global equities) but for now, the corporate governance and other domestic factors have been supportive.

It may well be that China does recover from here and this is just a hiccup rather than China having peaked, but sentiment has turned, and it is difficult to get overly enthusiastic on China at present. We remain constructive on the outlook for Japanese equities and are typically at least neutral in our positioning to the region.

As we wrote last month, technology (or more accurately, certain stocks within the technology sector) appears to be enjoying a return to its halcyon days. So far, 2023 has been the year of the technology titans, with seven large US companies (Apple, Microsoft, Alphabet, Amazon, Tesla, Netflix and Nvidia) driving the US market. As Richard noted, the collective returns from this ‘magnificent sevenʼ of stocks account for the entire 10% return of the US index (the S&P 500) to end May, while the other 493 companies combined are delivering a slightly negative return. This certainly validates our choice to eschew a larger holding in broad US equities in favour of focusing on our preferred themes, one of which is of course digitisation and AI adoption, leading us to invest in technology companies.

Nvidia stole the spotlight over the month. While the company is not quite a household name yet, Nvidia makes computer chips that were once mainly used to run graphics- heavy video games and are now in high demand as the tech world races to create new versions of AI like ChatGPT (as demonstrated in Simonʼs UK section). Shares in Nvidia rose 24% in one day after its $11bn sales forecast for the three months ending in July came in more than 50% ahead of Wall Streetʼs previous estimates.

The question is, where do these stocks go from here? These stocks are now extremely expensive and as investors we must ask, are their lofty valuations justified? The argument from proponents of the sector is that current earnings pale in comparison to expected future earnings growth.

Companies like Microsoft, Google parent Alphabet, Amazon and Nvidia are enjoying very strong business trends and are viewed as the clear winners of the generative AI revolution. Just about every AI tool you can think of relies on clouds like Amazon Web Services, Microsoft Azure, or Google Cloud, or some combination of the three. This means that even AI startups with ambitions of competing with the big tech titans are still contributing to these major companiesʼ respective bottom lines. Barring a major and unforeseen shake up in the industry, it appears that the rapid adoption of AI will only make ‘big techʼ more dominant and entrenched in several industries. Attempting to compete against one of the big seven now can be compared to David facing up to Goliath – but only if David is a grain of sand and Goliath is the ocean!

There might be no World Wide Web as we know it today without Arthur C. Clarkeʼs 1960s-era short story, “Dial F for Frankenstein”. The sci-fi story is about a global, interconnected telecommunications system that gains sentience, and it served as one of Tim Berners-Leeʼs inspirations when he created the Web while working at CERN in the 1980s. Fortunately for us, the Web has not gained consciousness and taken over the world as in Clarkeʼs story … at least, not yet.

As you may know, across portfolios we have exposure to technology equities via specialist fund managers. While we are not keen to fill our boots with these stocks at their current valuations, we continue to hold these positions given that solutions and services provided by technology companies are now seen as indispensable to the majority of industries as well as in our daily lives.

While the narrowing stock market breadth described above (where a market is led by a handful of stocks) is generally considered an ominous sign, our long-term focus and diversified approach across portfolios leads us to partake in some of the upside from this rally while delivering some downside protection should the bubble burst.

A tough month for fixed income, with most bond markets negative, as investors (once more) reappraised the outlook for interest rates. Where previously, a slowing of inflationary pressures globally reinforced the belief we had reached peak inflation, some surprisingly strong core inflation readings (core inflation data excludes the more unpredictable food and energy components of consumer price inflation) sent bond yields higher, and conversely bond prices lower. In the UK, the picture was even starker, a lower-than-anticipated fall in Aprilʼs UK consumer price inflation (CPI) and more importantly, a notable increase in core inflation, to its highest level since March 1992, resulted in investors swiftly revisiting their terminal UK interest rate forecasts.

With UK consumer prices increasing 8.7% year on year and core inflation increasing at 6.8%, inflation clearly remains a challenge, leading to concern over the ability of the Bank of England (BoE) to control it. Persistently strong wage growth in the UK is driving core inflation; data from the Office for National Statistics (ONS) shows average private sector earnings growth (excluding bonuses) had grown 7% in the three months to March compared to a year earlier, while public sector earnings grew at a 20-year high of 5.6%. This highlights the extent to which the economy is undergoing a labour shortage. Further, it also suggests that perhaps nothing short of recession can cool the jobs market and tame rampant inflation. After all, the impact of substantial energy price rises has now fallen out of the year-on-year numbers.

In response, financial markets swiftly priced in further interest rate rises from the BOE – expecting UK interest rates to now peak at 5.5%. The BOE had been expected to pause the rate hiking that has taken place since December 2021 at this monthʼs meeting to assess the lagged impact on the economy but financial markets now price a circa 80% chance of a 0.25% rise, with some possibility of 0.50%.

While events elsewhere generate similar concern (an equally strong US jobs market is bringing the same question around peak interest rates), inflation and its impact on interest rates appears more problematic for the UK. In the US, markets still price a circa 70% chance of a pause in the US rate hiking cycle at Juneʼs meeting of the Federal Reserveʼs policy setting committee (though that does indicate less certainty than a month ago when pricing suggested a greater than 90% certainty). Similarly, with inflation seemingly coming under control across Europe, and Germany in a technical recession following two consecutive quarters of contraction in the countryʼs economy, the European Central Bank is anticipated to raise rates a further 0.50% from the current 3.25% before coming to a halt – this 0.50% increase has been well telegraphed and markets have not deviated.

With gilt yields, and thus borrowing costs, now at levels seen around the time of Liz Truss and Kwasi Kwartengʼs mini Budget, there is more work for the BOE to do, particularly in reassuring investors (and the stretched consumer) they can control inflation. The alternative being a persistent cycle of higher prices and wage demands. The BOE still believes inflation will “fall quickly” over the year and “meet their 2% target by late 2024”. At present, financial markets seem less convinced.

When a company or person defaults on debt payments, repossession agencies are often used by the creditor to recover goods. This doesnʼt sound like great material for a thrilling sci-fi adventure but the 1984 film Repo Man proves otherwise. The film centres around a Los Angeles punk rocker who gets caught up in the pursuit of a mysterious Chevrolet Malibu that might be connected to extra-terrestrials.

Our fixed income allocations comprise healthy exposures to a mix of high- quality US Treasury bonds and investment grade (the strongest) corporate bond issuers. We are 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, events this month show that remaining prudent in the levels of interest rate risk taken has been a sensible course of action. Conversely, the 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.

We have discussed copper previously in these pages as a useful indicator of global economic conditions. A retreat in the copper price since the end of March suggests flagging demand and signifies a slowing economy. This time, much of this downwards move can be attributed to a faltering Chinese recovery – the robustness of the countryʼs post-Covid re-opening in doubt after disappointing April data showed a slowdown in the manufacturing sector. As the worldʼs largest copper consumer, it is estimated that China accounts for over half of global demand, any slowing of industrial activity clearly will have a negative impact. Beyond economic conditions, and consequently the strength of copper-intensive sectors such as construction and autos, there are several other factors at play when considering the price of copper.

On one side there is supply – here we can consider the cost of mining and the stability of those regions in which copper can be mined. Regarding the former, a move away from open cast mining, as these deposits become exhausted, to more cost-intensive underground mines requires a higher price to be paid and potentially impacts the grading or amount of copper within each mined ton. As for stability, the three largest copper producers are Chile, Peru and China. Taking the first two, which account for almost 30% of production collectively, Peruʼs supply has been knocked by anti-government unrest while supply in Chile has been stagnant in recent years. Both factors would suggest an increase in price over the longer term.

From a demand perspective, the green transition is heavily reliant on copper and increasing demand here, such as the push towards electric vehicles (which are estimated to use four times the level of copper than a traditional internal combustion engine is expected to lead to scarcity. Similarly, renewable energy and the ubiquitous use of copper in wind and solar power (due to its conductivity and efficiency places further demand on what is seemingly proving a more expensive metal to mine. That all said, there are substitutes and copper does remain 100% recyclable without losing any of its inherent usefulness, so not as clearcut as simply assuming a supply dearth will lead to higher prices but certainly a metal where net-zero demand looks set to only increase. All considered, copper appears set as the ‘metal of the futureʼ.

In Edward E. Smithʼs The Skylark of Space series, copper is used as spaceship fuel, being catalysed by ‘element X’ directly into energy. Copper is indeed used in rocket engines, but for its high thermal conductivity, not as a power source.

The copper theme is one that runs through several of our positions, including global emerging markets, where there are exposures to specific miners, or on the usage side through manufacturing names. While it is often unwise to take distinct positions in a specific commodity (due to idiosyncratic volatility), having diversified exposures to beneficiaries of the green transition, such as this unique metal, should prove fruitful.

Over the past 18 months, energy security has moved to an urgent priority for global governments. Shifting supply and demand patterns across the energy sector have led to volatility in markets as well as real-life implications for consumers and businesses struggling to meet costs. Leaders across the globe must now walk a fine line between securing energy for immediate needs while not neglecting the threat of climate change and ensuring energy supply well into the future. It is clear that more resources must be directed towards clean energy in order to support energy independence as well as even coming close to meeting global targets. For instance, in order to halve global emissions by 2030, industries would have to adopt low- emission solutions that steadily reduce global emissions by 7.6% each year – a technology that does not yet exist.

Giant solar power stations floating in space that beam down enormous amounts of energy to Earth – this is clearly a concept born from the imagination of a science fiction writer, right? While the idea has inspired a number of stories, it was originally developed by Russian scientist, Konstantin Tsiolkovsky, in the 1920s. A century later, scientists are making huge strides in turning the concept into reality. The European Space Agency is now looking to fund such projects, predicting that the first industrial resource we will get from space is ‘beamed powerʼ.

This conundrum is perhaps exemplified by the current debate over Labour leader Keir Starmerʼs promise to block new North Sea oil and gas exploration. There are clearly strong environmental reasons to back this proposal but it is not unrealistic to point out its flaws, namely our need for traditional forms of energy at present to bridge the gaps in the UKʼs clean energy infrastructure. Much improvement and investment is still required if we are to rely solely on renewable energy. There is also the matter of the UKʼs current account deficit, which will only increase if we are forced to import oil and gas rather than rely on domestic production.

This is characteristic of something I have written about before, the disorderly energy transition. Using history as a guide, we know that transitions from one form of energy to another do not happen with alacrity. Instead, an energy transition is a complex, multi- decade process with the push and pull between the traditional form of energy and the new form fraying social tensions. Evidence suggests we are just at the start of this disorderly transition. Next to the actions of legislators, the organisation of the transition will be influenced by asset owners, investors, and companiesʼ own emission reduction plans. We continue to encourage companies to take meaningful steps towards reducing their carbon emissions and increasing energy efficiency. With one eye on the medium term, our core portfolios have some traditional energy exposure as well as investment in companies that are facilitating the energy transition.

In the long term, clean energy will deliver true energy independence, energy not based on a finite resource, which will allow the UK to be the master of its own destiny, no longer beholden to the major oil producers. We continue to invest meaningfully in this area.