Annualised performance data in euros at 30th April 2023.

The recent disinflationary trend has weighed on the commodities sector. Energy prices have fallen sharply this year while agricultural commodities and industrial metals have flatlined. When looking for signs of a turn in this sector, we believe China will ultimately be the catalyst. As China slowly re-opens after their covid lockdown, we should start to see a gradual pickup in commodity demand later this year. Chinese construction activity has started to increase, Chinese households are awash with cash and Chinese exports are also accelerating. This combination should lead to higher commodity prices. When you add to the mix our expectation for a continued decline in the U.S. dollar, there is potential for a recovery in agriculture, industrial metals, and energy prices. Perhaps this will be a 2024 event.

As the saying goes, economic activity is energy transformed. If Jerome Powell delivers a soft landing in the United States and if the Chinese re-opening gathers pace, this should be reflected in the price of crude oil. This could be the key risk for markets in 2024 in our view and one we are watching closely. A sharp rise in energy prices could tip the global economy into a prolonged slowdown or recession next year. We continue to recommend holding an allocation to energy in client portfolios, either via commodities or equity exposure.

Bonds

Annualised performance data in euros at 30th April 2023.

U.S. 2-year yields (black line on chart) peaked at just over 5% in March 2023 and have since declined by over 100 basis points to 3.9% at the time of writing. Given that U.S. monetary policy (red line on chart) tends to follow the 2-year yield with a lag, many Managers are growing increasingly confident that Jerome Powell will soon communicate to the market an end to his interest rate rising cycle. If Powell has managed to deliver a soft landing for the U.S. economy while increasing interest rates by 500 basis points and also taming inflation, it would be a very significant achievement. Interest rate decisions impact the economy and markets with a long and variable lag, so the jury is still out on whether he has delivered on his objectives. However, so far, the outlook remains promising.

U.S. Treasuries should also continue to benefit from the disinflationary trend in the United States. 10-year Treasuries yield 3.4%, while 2-year Treasuries yield 3.9%. The U.S. yield curve has inverted and the bond market is signalling that inflation is becoming less of a concern. If U.S. economic growth continues to moderate and Fed policy becomes less restrictive, U.S. government bonds should rally. The copper-to-gold ratio (red line on chart), the market’s best barometer of inflation expectations, is also confirming that the peak in inflation is behind us for now. Note in the chart below that the copper-to-gold ratio tends to lead U.S. 10-year bond yields and the current trend remains down, which suggests that rates of inflation should continue to decline during the second half of the year.

In Europe, many Managers continue to favour EU inflation-linked bonds over EU fixed interest rate bonds. Europe has more of a structural inflation problem due to an overreliance on imported oil and natural gas. Our preference is therefore to receive index-linked coupons on our EU bond investments, which reset every six or twelve months when coupons are paid.

 

Equities

Annualised performance data in euros at 30th April 2023.

The key takeaway from the ECB President’s recent speech in our view is that central bankers will continue to intervene in markets to ensure they fulfil their primary objective of delivering price stability. This means that during inflationary periods, they will tend towards increasing interest rates and reigning in growth in the money supply, where possible, to control inflation, acting as the market’s ‘bad cop’. During periods of weaker growth and falling inflation, they will intervene to lower interest rates and increase the money supply to encourage more risk-taking behaviour, acting as a ‘good cop’.

Now, it’s always easier to act as a ‘good cop’ and print than a ‘bad cop’ and remove the punchbowl when excess abounds. As such, Managers expect central bank balance sheets will continue to grow over time and provide a tailwind for equities, as there tends to be a strong positive correlation between equities and the Fed balance sheet.

 

Let’s examine the trajectory of total assets on the Federal Reserve’s balance sheet over the last two decades for example. As a consequence of the Great Financial Crisis of 2008, the Fed’s balance sheet doubled from $1 trillion to over $2 trillion (a small change by today’s standards). Their balance sheet continued to rise for much of the 2010s thanks to their continued Quantitative Easing programme, peaking at over $4.5 trillion mid-decade, before the Fed intervened again in 2018 to lower total balance sheet assets to just under $4 trillion. Then the covid crisis occurred and in response, the Fed’s balance sheet ballooned, more than doubling in size to almost $9 trillion in 2022.

Over the last twelve months, largely due to the recent inflation scare, ‘bad cop’ Fed Chair Jerome Powell has made a valiant attempt to curb financial market speculation and deliver price stability by sharply raising interest rates and selling central bank balance sheet assets. The consequences of his actions are now being felt as U.S. regional banks come under pressure.

In the last month, Powell has in fact been forced into an about-turn, boosting the Fed balance sheet by al- most $400 billion. An additional monetary stimulus may not be too far away, particularly if inflation continues to fall.

This is the environment in which we find ourselves today. It is not easy for an equity investor. Periods of volatility in both directions have become the norm. However, over time, Managers believe it should continue to pay to remain invested across a broad range of equity market sectors and regions, particularly if we are close to the end of the interest rate rising cycle, which is the general consensus view. Outside the United States, many regional markets have traded sideways for a very long time. European equities for example, have made very limited progress in over twenty years. The path forward will continue to be volatile but the direction for equities should be gradually higher over time.

 

Market Comment

On 17th April 2023, ECB President Christine Lagarde gave an important speech at the Council on Foreign Relations in New York where she discussed how recent transformative changes including the Russian invasion of Ukraine, the weaponisation of energy, the sudden acceleration of inflation and the growing rivalry between the United States and China were harming the global economy. She said that central bankers had for decades focused on regulating demand without having to pay too much attention to supply-side disruptions.

However, according to Lagarde, past decades of stability may now be giving way to lasting instability, resulting in lower growth, higher costs, and more uncertainty around trade. Lagarde highlighted a world that is becoming more multipolar, which may, over time, prove consequential to the US dollar as the world’s global reserve currency. She voiced her concerns about escalating geopolitical risks and the challenges ahead for central bankers focused on delivering price stability as their primary objective.

Ultimately, a multipolar world increases the risk of slowdowns in global economic growth, while supply-side disruptions tend to lead to rising prices for goods and services.

These trends in GDP growth and inflation are the primary drivers of long-term returns for equities and fixed income, which is why they are so important to understand. For now, global growth and inflation trends remain favourable. Inflation, although high, is moderating while GDP growth remains positive in real and nominal terms. As we have previously reported, we continue to expect disinflation in an increasingly multi-polar world as the dominant theme for 2023. There are risks on the horizon, which we continue to monitor.

Despite the risks noted above, Madame Lagarde must be pleasantly surprised by how global equity and fixed-income markets are performing this year. Year-to-date, global equities have returned over +5% with European equity markets leading, +9%. Energy prices continue to contribute to the gradual decline in rates of inflation with crude oil falling over -10% and natural gas prices falling -54% in the first four months of the year. Eurozone government bonds and Euro inflation-linked bonds have each added +3%, while UK and US inflation-linked bonds are flat year- to date.