Mid-Year Market Update and Outlook 2023

July 2023

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Investors have seen a tumultuous start to 2023. As we reach the mid-point of the year, we’ve taken a step back to reflect on the dynamic market landscape seen so far and its implications for investors for the remainder of the year.

‹ Inflation remains a challenge for central banks around the world, leading to a continued hawkish stance.

‹ The outlook for interest rates is not clear, but we are likely closer to the peak and market expectation is for easing in the middle of 2024.

‹ The much-heralded US recession has not materialised yet, but persistent inflation and associated restrictive monetary policy means that a recession of some sort cannot be fully discounted.

‹ The economic outlook for the UK remains weak compared to other similar economies, with continued inflationary pressures likely to keep interest rates higher for longer.

QWhat’s the story with inflation?

Inflation has kept central banks on their toes, but aggressive rate hikes seem to have had some effect towards dampening growth in the Consumer Price Index, or CPI (which measures how much the cost of the things we typically buy changes). One of the key determinants on how the inflation story will play out is the labour market. The following charts show how overall inflation has declined, but looking at core inflation — which excludes volatile food and energy prices — high levels still persist.

Signs that headline CPI has peaked

Source: Bloomberg, TwentyFour Asset Management, May 2023

Core CPI is more persistent

Source: Bloomberg, TwentyFour

The US boasts a robust labour market, but cracks are beginning to emerge as unemployment rates experienced a slight uptick in May. Meanwhile in the Eurozone, energy and food costs have fallen since the beginning of the year, but rapid wage growth is threatening to rekindle the inflationary flames before the recent European Central Bank (ECB) interest rate hikes have had sufficient time to put them out.

The United Kingdom faces additional challenges as labour shortages compound the effects of increasing wages. Central banks now anticipate a prolonged battle, pushing the timeline for achieving target inflation levels to late 2024 and beyond.

Source: Bloomberg, TwentyFour Asset Management, May 2023

QHave interest rates peaked?

The outlook for interest rates, the primary tool used by central banks for combatting inflation, varies across regions.

In the US, there is uncertainty over whether there are more rate hikes to come, and how long the Federal Reserve will keep them at their peak. The Fed has been expressing a more cautious tone, often referred to as ‘hawkish’, indicating a potential inclination to take more aggressive measures to control inflation. But the market is effectively calling their bluff, by pricing in limited further hikes and rate cuts to below 4% by the end of 2024.

In the Eurozone, the ECB raised rates by 0.25% in May and it’s expected that there will be two further hikes to a potential terminal deposit rate of 3.75%. This is the rate that the market believes the ECB will pause at, as it seeks to bring inflation down to its 2% goal.

The UK has the most hawkish view, with a surprising 0.50% rate hike in June and the expectation that more rate hikes will come. This is likely the result of more persistent inflation, which the Bank of England (BoE) is laser focused on keeping in check.

The clear outlier across major economies is Japan, with its central bank maintaining ultra-loose monetary policy with a negative short-term rate. This dovish approach has been out of kilter with other economies and resulted in capital flight from Japan and depreciation of the Yen.

Market expectations for central bank policy rates %

QWhat has been driving financial markets?

The uncertainty across the macroeconomic environment has filtered through into financial markets, with assets usually considered less risky, like bonds, going through a phase of high volatility.

In March we saw the failure of Silicon Valley Bank and other US regional banks due largely to companyspecific issues, but exacerbated by the rise in interest rates and the subsequent impact on the value of their bond investments. This was shortly followed by the takeover of Credit Suisse by UBS, which further contributed to volatility in the bond market, particularly in the banking sector, with the fear of contagion and more widespread failures.

Looking to equities, volatility has been more muted compared to bond markets, but has not been without challenges. Looking at the MSCI World, a leading global equity index, performance has been driven by a small number of names, with 54% of the returns of the index attributed to the top 10 most valuable companies. This is the highest level seen in the past 20 years. Driven by tech giants like Microsoft, Apple, Alphabet, Amazon, this has resulted in US equities continuing to be the most expensive compared to other regions. On the other hand, the UK and emerging markets (including China) are among the cheapest.

The chart below shows the contribution of the top 10 stocks in the MSCI World index to the overall return of the index. This emphasises the impact these leading shares have on the performance of the index as a whole.

Total contribution to MSCI World return of top 10 stocks

Source: MSCI, FactSet, SJP. Discrete data as of 31 May 2023

Past performance is not indicative of future performance.

Please note it is not possible to invest directly into the MSCI World Index and the figures shown do not take into account any charges applicable to the appropriate investment wrapper or any relevant tax charges.

Source: MSCI, FactSet, SJP. Data as of May 31 2023

The chart above shows the historical ranges of forward-looking price to earnings ratios, a key corporate valuation indicator for equities, across different regions. This metric can be used to assess how cheap or expensive stocks are. The purple dots represent valuations as of May 2023 and blue dots the median. This demonstrates that US equities are seen as expensive, currently within the top quartile of their valuation range over the past 20 years. On the other hand, UK and Chinese equities appear to be cheaply valued compared to other regions and their own history, both in the bottom quartile of their respective historical valuation ranges.

QWhat does this mean for investors?

The concentration in the equity market, with returns being driven by a small number of leaders, has led to a particularly challenging period for active managers. Unless managers have held these top performers at significant weights, they would have struggled to beat the market. The top 10 out of the 2,883 (0.35%) constituent businesses in MSCI ACWI account for 18% of the total market capitalisation. As an active manager, taking positions in these widely covered stocks, is unlikely to be where they perceive they have any informational advantage. It is therefore common for them to have less exposure to these companies than the market average.

Another important factor is valuation. Currently, the top 10 companies, on average, have a high price-to-earnings ratio of 45 times their forecasted earnings for the next fiscal year. The high prices of these top companies deter many value-oriented managers, who prefer to invest in companies that seem reasonably or undervalued.

Looking to fixed income, which includes bonds, higher interest rates have led to more attractive valuations. However, the uncertainty around the severity of a recession poses a few risks. Investment Grade bonds - which are issued by companies with lower credit risk - often suffer downgrades in their credit ratings during a recession. High Yield bonds - issued by companies with weaker financial standing - typically experience an increase in defaults during economic downturns, as these firms battle to fulfil their debt responsibilities.

The chart below illustrates how US and European companies are faring in the High Yield space, showing the default rate over the previous 12 months. Defaults are on the rise but haven’t yet reached the levels seen at the start of the pandemic in 2020. Additionally, the current default levels are significantly lower than the highs seen during the Global Financial Crisis in 2009, or the disruption in the European bond markets after the introduction of the Euro.

The pandemic related spike in default rates in 2020, has led to many investors arguing that less robust businesses have already been forced to default. Consequently, the health of the remaining market is strong, and our fund managers are finding today’s yields fair compensation for default risk, when compared to the end of 2021. Generally, companies appear to be well positioned to service debt by looking at their earnings compared to the interest they owe on their debt.

Historical default rates

Source: ICE BofA Global Research. Data as of May 31 2023

Percentage of high yield bond market

Source: ICE BofA Non-Financial Developed Market High Yield Index, as of March 31 2023

The chart above illustrates the significant shift in yields in the high yield bond market. Just over one year ago, the majority of bonds were yielding under 4%. With the rise in inflation and interest rates globally, this has increased the yields available to investors, with the majority of bonds yielding between 6-10%.

QWhat’s the view of our fund managers?

Schroders

Schroders, manager of the SJP Managed Growth fund, expect a base case of 4.5% CPI inflation and 2.4% global growth for 2023, with a relatively balanced likelihood between various scenarios that could play out to upset this. It believes a ‘soft landing’ is most likely to occur, where a return of workers to the labour market would help moderate wage inflation and boost productivity.

Schroders’ scenario analysis

Risks have become evenly balanced

Cumulative 2023-2024 inflation vs baseline forecast

Source: Schroders Economies Group, 22 May 2023 Group baseline forecast; 2023: 2.4% growth, 4.5% CPI inflation. Scenario probabilities: baseline (69%), bond vigilantes return (0%), soft landing (12%), banking crisis deepens (5%), consumer resilience (8%), supply-side inflation (6%). The forecasts included should not be relied upon, are not guaranteed and are provided only as at the date of issue. Schroders’ forecasts are based on its own assumptions which may change. Schroders accept no responsibility for any errors of fact or apinion and assume no obligation to provide you with any changes to their assumptions or forecasts. Forecasts and assumptions may be affected by external economic or other factors.

This chart aims to outline the various scenarios that Schroders identifies as potential risks to their baseline expectations. Essentially, the chart displays the possible outcomes that could occur with regard to economic growth - which is represented on the horizontal axis - and inflation - which is represented on the vertical axis

TwentyFour

TwentyFour, co-manager of the SJP Diversified Bond and Strategic Income funds, view a ‘softish’ landing to have the highest probability for the rest of the year. It expects to see a reduction in GDP growth following falling inflation, and a modest rise in unemployment. This scenario is somewhere in between a soft landing, where a recession is avoided altogether, and a hard landing, where a recession is caused by a sharp rise in unemployment and would result in a significant fall in growth.

TwentyFour’s macro scenario for 2023

“Softish” Landing - 45% Driven by falling inflation and unemployment rising modestly but enough to drive small negative GDP growth. Potential for a Fed cut supporting risk-off assets but likely not until 2024. Defaults remain under control.

Hard Landing - 35% Driven by sharply higher unemployment leading to a big fall in GDP and a spike in corporate defaults. Fed starts to cut aggressively. Worst-case for risk assets.

Soft Landing - 20%

Driven by a robust labour market and falling inflation, consequently no recession and Fed on hold. Best-case for risk assets but markets would be late cycle and vulnerable to external shocks.

The value of an investment with St. James’s Place will be directly linked to the performance of the funds you select and the value can therefore go down as well as up. You may get back less than you invested.

Key points

Whilst the information in this document hopefully provides a broad picture of the concerns at the forefront of most investors’ minds, our key takeaways when speaking to our network of asset managers and advisers have proven largely consistent. Namely:

‹ Now is an attractive time to be buying high quality credit, such as investment grade bonds, with spreads on offer fairly compensating default risk, and duration having been punished in 2022.

‹ Equity markets are currently extremely narrow, with returns being driven by a few mega cap names. Lofty valuations are concentrated in industries closely tied to technology, and there are broad sections of the market that remain attractively valued.

‹ We believe now is an opportune time for active fund management to demonstrate value, investing outside of well-known businesses and unlocking value for clients.

‹ Given a turbulent political climate, with potential tail risks impacting currency, inflation and macroeconomics, diversification remains key.

This material does not constitute investment advice. It is not intended to state, indicate or imply that current or past results are indicative of future results or expectations. Full advice should be taken to evaluate risks, consequences and suitability of any prospective fund or investment. Where the opinions of third parties are offered, these may not necessarily reflect those of St. James’s Place.

Please be aware past performance is not indicative of future performance.

MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, endorsed, reviewed or produced by MSCI. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such.

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