Monthly Market Commentary - October 2023

A deal has been done to avert a shutdown of the US Government, but its details are far from inspiring. It only takes us up to mid- November when we can look forward to another stand-off. The mechanics of these negotiations means there is now  the prospect of the Speaker of the House being removed by his own party, so aggravated are they by the fact that the deal to avoid a shutdown  relied  on supposedly secret negotiations with Democrats and promises for more Ukraine funding at a later date. The right wing caucus of the Republican party have been looking for deep spending cuts to be made to the US budget and also the rejection of more funding for Ukraine, so the outcome is far from satisfactory to them.

None of this is a good look for the US. Investors  have  grown  tired  of  the shenanigans in Washington and the US debt ceiling debacle has become a regularly occurring one. There is now, arguably for the
first time, the sense amongst some that the US debt situation is reaching a point where it actually ‘mattersʼ. Whether this is behind the recent move higher in bond yields or not (and it looks as if it is at least in part), there are reasons to think the financial status of the Republic, combined with dysfunctional politics, is having an impact.

The rising cost of debt, the downgrades from rating agencies and the rise in credit default swaps on US debt are all indicators that something important is happening, however slowly that may be. Bond yields really have taken off over the last month – some feel that the market is finally accepting higher rates for longer and a more embedded inflation, others feel it is a reflection of a soft landing and better growth prospects but the supply/demand dynamic in the Treasury market must surely be partly responsible.

Coupled with the geopolitics – the political rise of China and the other BRICS countries, the backdrop could easily be characterised as having an ‘End of Empireʼ feel. Is the mighty US and its reserve currency finally running out of steam? The doubters will point to the US being at the vanguard of the technological revolution, but this might not be enough and has not always been
historically.

Of course, the fate of the US and its political and economic system does not equate to the fortunes of US corporates. However, there are implications and if one is already questioning valuations in the US equity market these sort of slow burning problems further erode conviction. We have an unpredictable US Presidential election next year as well, which, combined with the strong possibility of economic downturn, compounds problems for investors. A sector and thematically focused strategycontinues to look best here.

The global march higher in long-term bond yields is not sparing the European economies. Italian debt is now trading at the highest premium to German debt since March following the Italian Governmentʼs reduction of its growth targets and increase in its budget deficit expectations. Of course, the issues are not restricted to Italy, the German 30 year itself is now at the highest levels since 2014 and there is the feeling that the bond market is finally starting to rebel against the cocktail of economic risks which the economy faces, arguably pricing in the stagflationary forces which have started to emerge. Letʼs not forget that the European sovereigns are not in an enviable position in terms of debt and demographics, so it is natural for investors to be concerned about the region when yields move higher.

Proximity to the war in Ukraine was very unhelpful to European equities in the spring of last year and there are signs that the united front against Russia is starting to weaken materially. Still, the continent finds itself exposed to the higher oil prices which are now establishing themselves in the global economy, this time via the Saudi Arabia and Russia cuts. The weakening economic data both in manufacturing and services do not paint the rosiest picture for the region and we are not especially enthusiastic about the       prospects for European equities as a collective.

Europeʼs rich history means it has hosted many Empires. We are all familiar with the more ‘recentʼ British, Spanish and Portuguese ones but the Holy Roman Empire, founded by Charlemagne and a revival of the ancient Imperial Roman State, dates back to the 9th century.

This is another area where exposure needs to be especially focused at the present time and we are maintaining a focus on larger and income generating names given our expectation of recessionary conditions.

As we enter the first week of October, China celebrates its final ‘golden weekʼ of the year, a set of three seven days plus national holidays introduced in 2000, with a big boost to consumer spending on leisure and tourism anticipated. The May version saw consumer spending down 10% from the 2019 pre-pandemic equivalent and market watchers will be keen to assess the progress of consumer confidence in the coming weeks.

Chinaʼs economic and market performance ultimately remains disappointing year to date. To the end of September, investors in the average fund in the Investment Association (IA) China/Greater China sector have seen a -12.83% return, compared to a small 0.83% gain in the IA Global Emerging Markets sector and 5.47% return of the IA Global Sector. The expected unleashing of pent-up consumer demand as China re- opened after its more protracted Covid-19 containment program failed to materialise and confidence in the economy is low.

For consumers, this has meant less spending and for businesses, focus has turned internally on cost-savings rather than expansion. Previously, the Chinese Government has provided massive stimulus to support the economy, usually focused on infrastructure spending or the housing market. However, this time they have been more reluctant to follow the same playbook, with these measures only being short-term fixes which cause future issues such as high debt levels in the housing sector, which the economy currently faces. There have been recent reforms focusing on the consumer and we would expect any eventual stimulus to follow this route.

Which empires had the best names? To English readers, the Song Dynasty of China may sound like a musical place, the Sultanate of Rûm a place for a drink and the Kushan Empire as a comfy place to sit.

Within the rest of the world in brief, Japan continues to perform well, benefiting from increasing traction of corporate reforms and investor interest. We still think India looks expensive compared to other markets,  including other  Asian markets. While we have seen tensions between India and Canada, we do not see these as significant in a longer- term context.  We also continue to like Latin American equities, which have been benefiting from re-shoring to the USA, with Mexico amongst the chief beneficiaries.

We do not have direct exposure to Chinese equities, partially on concerns around the economy, as well as the negative impact of potential government interference in the market. This lack of exposure has been positive year to date. We remain cautious on Chinese equities and would need to see a catalyst and improved governance before we consider re-allocating directly. We are however, positive on Japanese equities, and emerging markets (outside of China and India) including selective direct Latin American exposure.

A sell-off in longer maturity bonds, which we discussed in last month’s edition, continued through September as markets continue to digest the higher-for-longer interest rate narrative. Following a trough at the end of August, the 10-year US Treasury bond yield has moved 0.8% higher to 4.88% (at the time of writing) while the 30-year yield now sits at 4.99%, a post-global financial crisis high for both. There are several factors at play here but broadly markets are pricing an environment where low unemployment, combined with a resilient economy, is feeding an uncertain inflation dynamic and therefore an increased possibility of higher- for-longer interest rates.

While consumer price inflation (CPI) in major western economies has fallen as several base effects, such as higher energy prices, drop- out of readings, achieving and maintaining traditional inflation targets of circa 2% appears challenging. The recent spike upwards in the oil price an example of where pitfalls may lie. Perhaps more concerning was an unexpected rise in job openings during August. That all said, US core inflation (which excluded more volatile food and energy pricing) is seeing some moderation and this month did surprise on the downside.

So, while the US Federal Reserve held interest rates at their September rate-setting meeting, odds of a 0.25% November rise, which previously was discounted almost entirely, now stand at circa 30%. Beyond this, the timeline for interest rates cuts to begin has been pushed further into 2024. Clearly this is all forecast, and the lagged effect of the to-date interest rate rises remains to be seen. However, a further rise strays deeper into the dangerous territory of monetary policy having been tightened too far without taking sufficient pause to judge the impact. Regardless, it is apparent the implications of higher borrowing costs are suggesting a tougher environment than seen for many years and since the middle of September equity markets have fallen accordingly.

Interestingly, we are also now seeing a return of term premium – essentially the excess compensation investors require for holding bonds with longer to maturity. Until this month, term premium on 10-year US Treasuries had been below zero for over two years and prior to briefly breaching zero in 2021 had been negative since 2017. This had been deliberate suppression by the US Federal Reserve (Fed) to hold down long- term borrowing costs through quantitative easing (buying bonds). Now the Fed are reducing their balance sheet (selling or letting bonds mature) and government financing needs are elevated, so there is greater uncertainty surrounding the future path of bond yields. This is leading to investors requiring a premium to buy longer maturity issuance. Indeed, we would suggest that it is now issuance levels that are causing the greatest concern.

Closer to home, UK gilts are behaving in a similar manner – the 10-year gilt registering a 4.58% yield with the 30-year at 5.05%. We would note moves here have been less pronounced than in the US Treasury yield curve, likely based on an expectation the UK economy will prove less resilient than the US. Overall, a tough period for bonds and it will be interesting to see how long economies can continue to function under such elevated borrowing costs.

Our fixed income allocations comprise healthy exposures to a mix of high- quality US Treasury bonds, where we are actively managing interest rate sensitivity, investment grade (the strongest) corporate bond issuers and to take advantage of attractive real yields, exposure to emerging market debt. While there will undoubtedly be short-term data driven fluctuations in the growth and inflation outlook the value of bonds, from both an income and capital return perspective, has not been this appealing for some time.

“Once, I had an empire in a golden age…”, the first line of Taylor Swiftʼs ‘Castles Crumblingʼ has been stuck in my head since I considered writing about infrastructure framed by this monthʼs theme. I could see parallels between Taylorʼs metaphorical disintegrating castles and burning bridges, and the need for global infrastructure maintenance. This topic has been a staple in the British media recently, from sewage and pollutants pouring into rivers and coastal waters, to schools and hospitals literally crumbling down. Regular weather events too, appear to constantly surprise authorities across the globe with rail lines buckling and road surfaces melting amid heatwaves, not to mention extreme flooding during periods of heavy rainfall.

The Roman Empire controlled territories on three continents – Europe, Asia, and Africa. All these distant locations were connected with ancient roads and a surprising fact is that over a fifth of them were paved in stone. Even today in Britain, many of the old Roman roads are still in use – Ermine Street (London to York), Watling Street (Dover to Wroxeter), and Fosse Way (Exeter to Lincoln).

The issue is not unique to the UK, Europeʼs aging infrastructure made international headlines in August 2018 when a motorway bridge collapsed in Genoa, Italy, killing 43 people. The tragedy shone a light on the poor maintenance of aging infrastructure across Europe, an issue that has long concerned operators in the abnormal transport industry. Heavy goods vehicles are already barred from a number of German bridges, including the Leverkusen Bridge over the Rhine north of Cologne, one of the busiest motorway bridges in Germany and which has been closed to large vehicles since 2012 after cracks were discovered.

This problem has been brewing for decades. Civil engineering experts have long warned that the concrete so beloved of the 1960s and 1970s construction boom had a limited lifespan. Across the board, infrastructure has suffered from years of low investment, weak maintenance and general neglect. This entails a period of forced investment, not just to meet net zero ambitions, but to continue living and travelling in the comfortable way we have become accustomed. The G20ʼs Global Infrastructure Outlook initiative estimates that current investment will leave the world with a $15 trillion infrastructure funding gap by 2040. Governments cannot afford to make all of these investments, so projects are increasingly turning to private markets for capital, providing opportunities for investors.

Over the past few years, the asset class has been somewhat written off as a ‘bond proxyʼ and an alternative source of income which is less attractive now that bond yields have risen. We believe this is a very short-term view and underestimates the long-term potential and defensive characteristics of investing in essential long-life assets with high barriers to entry and inflation protection.

We maintain an allocation towards global infrastructure within portfolios seeking to benefit from the increasingly urgent need to upgrade, maintain and in some cases, build infrastructure around the world.

Oil prices surged more than 25% over the third quarter of the year, breaching the $90 level by the end of September, as the Saudi- Russian alliance proves to be a formidable challenge for oil markets. Saudi Arabia has confirmed it will continue with a voluntary cut of one million barrels per day (bpd) until the end of 2023, while Russia has said it would keep a 300,000 bpd voluntary export curb until the end of December. The International Energy Agency and the Organisation of the Petroleum Exporting Countries (OPEC) recently published updated forecasts showing that global oil markets now face a supply shortfall of more than three million barrels a day next quarter, which is potentially the biggest deficit in more than a decade.

Last year, the global oil market changed in profound and historic ways following Russiaʼs full-scale invasion of Ukraine. Oil no longer flows according to market logic or economic sense; instead, a large ‘shadowʼ market of oil shunned by the West from Russia, Iran and Venezuela has emerged. This splintering, which continues to unfold with the EUʼs ban on Russian refined products earlier this year, has had a significant impact on trade flows, market transparency and pricing and could usher in a new era of structurally higher oil prices.

Higher energy prices are of course headache fuel for central banks in their bid to curtail inflation. A sustained rise in the oil price threatens to impede a campaign by major developed market central banks to bring prices under control just as they appeared to be bearing fruit. Higher petrol prices were primarily responsible for a 3.7% year-on-year uptick in US consumer prices in August, versus a 3.2% rise in July, according to data released by the US Bureau of Labor Statistics.

John D. Rockefellerʼs trillion-dollar oil empire set the stage for the development of the modern petroleum industry, but did you know he came from somewhat humble beginnings? Rockefellerʼs early education consisted of attending local schools and working various jobs to support his family. At the age of 16, he found work as a bookkeeper, where he honed his skills in finance.

Within core portfolios we have exposure to companies that produce and distribute oil and gas worldwide. We have recently increased this position as, despite higher moves in energy prices, we remain positive.