July Market Review
Welcome to our ‘July 2023 Insights’ report where we provide you with the means to keep informed of the latest economic and investment market conditions. These are difficult times as we transition from a very cautious/pessimistic view to that of cautious optimism. Again, being cognizant that all Investment Markets are pre-emptive in their outlook which can be difficult when dealing with the current position of Investment Assets. As always, our aim is to keep you updated on such matters leading to better investment decisions and by extension more acceptable returns on employed capital.
Robust Start to 2023
The global economy continues to show resilience as we pass the halfway point of the year. Structurally low unemployment, a strong jobs market and a high savings rate are fuelling continued growth in consumer spending. Tighter credit conditions have yet to bite across Europe and the United States despite one of the fastest paces of interest rate increases on record. In an effort to curtail the worst inflation in decades, Western developed central banks have moved aggressively to tighten monetary policy. This has helped exert downward pressure on inflation but has also brought about a meaningful slowdown in global growth and some financial accidents, including several US regional bank failures. Elevated inflation levels likely mean central banks will have to remain hawkish for longer, although there are signs that inflationary pressures are starting to ease. China is emerging from its Covid lockdown at a slower pace than expected but heading in the right direction, nonetheless.
Against this backdrop, equity markets continue to track their constructive outlook for 2023 and have already added +10% year-to-date. Fixed income is also benefitting as central bankers near the end of their rate hiking cycles and inflation expectations begin to moderate. US Treasuries have rallied +2% since January in euro terms while EU government bonds have added +3%. The US dollar may have topped for the year, in line with our expectations for the currency. The US dollar should continue to weaken in the months ahead as foreign exchange markets discount the increasingly challenging funding requirements facing the US government as they must finance record peacetime deficits in both their trade and budget accounts.
What Can We Expect As We Enter the Second Half of the Year?
Many of the Investment Managers, with whom we interact with, continue to see signs of improving economic conditions, which should support further gains for equities in the months ahead, albeit with increased volatility. In short, many Managers believe we are at a policy peak, that disinflation is underway, and that a relatively brief global economic slowdown is occurring, but markets are likely to soon look past this episode and begin to discount a future economic recovery.
There are two potential risks on the horizon that may sour the emerging positive outlook. The first relates to China, the world’s second largest economy and a major contributor to global economic growth. Should the pace of economic growth in China begin to slow and leading indicators in the region begin to roll over, we will have to turn more cautious in our outlook. Chinese equities have underperformed in recent years reflecting an economy coming to terms with a slowdown in its over-inflated construction sector. China has focused on funding capital investment projects for years to spur economic growth at the expense of domestic consumption. The result has been very large trade surpluses, which are good news as long as the country and its population reap the rewards. This has not been the case in China to date. The capital account is closed and the Chinese currency has not appreciated to any great extent.
The second risk relates to the potential for a Federal Reserve induced recession later this year or in 2024 as tight monetary policy (11 Interest Rate increases since 17th March 2022) finally impacts consumer spending after a long and variable lag. The record tightening in the US, UK and across the Eurozone has yet to impact the developed economies and financial markets to any great degree but it remains a key downside risk and one to which we are paying close attention.
Let’s turn our attention next to equities to assess their recent performance and discuss what may lie ahead for this important asset class for the remainder of the year.
Bonds
Annualised performance data in euros at 2nd June 2023
Manager expectations of low neutral rates and a return to near-target inflation reinforce a positive outlook (Pimco) for core and high quality fixed income. After rising sharply last year, starting yield levels – historically strongly correlated with future returns – for high quality bonds are close to longer-term averages for equity returns, potentially with significantly less volatility and more downside protection than equities. This is helping us to construct prudent, resilient portfolios without relinquishing upside potential. Many Managers have a bias toward high quality, more liquid investments and remain cautious about more economically sensitive areas. They expect increasingly attractive opportunities across private markets over time, particularly in light of the changing banking landscape.
All-in yields are attractive, and the macro backdrop is increasingly supportive. Easier financial conditions, as the Federal Reserve (Fed) pauses, should also support corporate credit.
Equities
Annualised performance data in euros at 30th June 2023
There is no doubt that global stock markets are enjoying this period of strong economic growth, robust consumer spending and falling inflation. The rally this year has confounded those of a bearish bias and also those, including us, with a more constructive view on the market. We expected a rising but volatile equity market in 2023 but have been surprised to see double digit gains for the S&P 500 at the end of June. We will take it. The broader NYSE Primary Exchange Index comprising over 3,000 publicly listed companies has gained a more modest +4% year-to-date. European equities have added +10%, UK equities +3% while emerging markets have gained +2%.
Japan has been one of the standout performers in 2023 and has already rallied +11% year-to-date in euro terms. Japan is belatedly undergoing major corporate governance reform and has introduced shareholder friendly initiatives, which are driving the boom in Japanese equities. An increasing number of corporates are returning capital to shareholders for the first time in decades. Berkshire Hathaway has recently invested in Japan to take advantage of this recent trend. The country is also experiencing a pickup in inflation and a weaker currency, which together are driving consumer demand at home and Japanese exports abroad. Japanese equities have traded at a discount to their global peer group for a long time, so we believe this trending move higher could last for quite a while yet.
Should we continue to expect higher equity prices for the remainder of the year? Despite the risks highlighted at the start of this report, we remain comfortable in the view that positive returns are achievable for the remainder of the year. Whilst the traditional caveat of increased volatility, is never too far from our lips, the collective positioning of aggressive assets, within Funds has been shown to be too negative the underweight in Equities remains in place today but has started to unwind.
Companies certainly have challenges today and costs are rising across the board. However, it is difficult for us to warn of a looming recession when unemployment rates remain at record lows. Tighter monetary conditions are a concern and we are on watch for signs of a slowdown and pick up in stock market volatility. We are watching the financial sector closely. A strong economy needs a strong financial sector. US regional banks have struggled this year due to a large exposure to commercial property on their books coupled with having to deal with the recent surge in interest rates. We do not want to see the regional banking sector breaking to new lows.
We have noted in past reports that outside the United States, many regional markets have traded sideways for a long time. European equities for example, have made very limited progress in over twenty years. The path forward will remain volatile but the direction for equities should be gradually higher over time.
Alternatives
Annualised performance data in euros at 30th June 2023
We tend to focus on commodities when discussing investments in the ‘Alternatives’ market. If there are other investments or sectors outside the traditional equity and fixed income asset classes that you would like to hear more about, please do let us know.
This month, we return to China and the energy sector in our analysis of the commodities sector. We know that China is the world’s leading consumer of commodities and therefore a key determinant in the direction of commodity prices over time. During times of strong economic growth in the region, the Chinese yuan tends to appreciate versus the US dollar. As crude oil is priced in dollars, an appreciating yuan has the effect of exporting inflation from China overseas. This tends to drive the value of the US dollar lower (versus the yuan) and the US dollar price of crude oil higher. Conversely, during times of weak Chinese economic growth, the yuan falls in value versus the US dollar. This results in China exporting deflation abroad, driving the value of the US dollar higher (versus the yuan) and the US dollar price of crude oil lower.
Trends in the Chinese yuan, the Shanghai Stock Exchange Composite Index and the US dollar value of crude oil often exhibit a strong positive correlation, which can be seen in the next chart.
It is therefore very important to focus on growth trends in China when assessing the relative value of commodities as a potential investment. Crude oil prices averaged $50-$60 per barrel from 2015 to 2019. The Covid shock of 2020 led to a sharp decline in energy prices, followed by a strong recovery in 2021. Crude oil prices are now stabilising in the region of $73/barrel. If crude oil prices continue to decline into the $60’s and below in the months ahead, it will be strong signal that global economic growth is slowing down.
Sector in Focus
Exploring the benefits of Family Partnerships in Ireland
Family Partnerships are powerful estate planning tools that enable the smooth and tax-efficient transfer of Assets from one generation to the next. The benefit of a family partnership is that it enables parents to transfer assets into the partnership that they believe will accumulate in value over time. Whilst this action may entail a level of tax, by picking the most appropriate assets and properly managing their set up, Clients can retain control over such assets, limiting the exposure to gift or inheritance tax for their children in the future.
Family partnerships have emerged as a favoured & tax-efficient structure in Ireland for managing and transferring wealth within a family unit. In this piece, we delve into a number of tax advantages associated with family partnerships, highlighting why they have become a highly sought-after option for wealth management and succession planning. We would emphasise the necessity of seeking specific Tax advice on this matter from a qualified Tax Specialist.
- Capital Gains Tax (CGT) Planning: Family partnerships provide excellent opportunities for capital gains tax planning. By transferring assets into the partnership, any future gains on those assets can be shared among family members. This allocation allows for the utilisation of multiple annual exemptions and lower tax rates available to individual family members, resulting in significant savings on capital gains tax. The ability to strategically distribute gains can lead to substantial tax advantages when considering the long-term growth of family assets.
- Succession Planning: Successful intergenerational wealth transfer is a key consideration for many families. Family partnerships serve as an effective vehicle for succession planning, ensuring a smooth transition of assets and wealth to the next generation while potentially minimising inheritance tax liabilities. By transferring assets to the partnership, the value of the partnership interests can be gifted or sold gradually over time, reducing the impact of inheritance tax. This gradual transfer of assets allows families to exercise control over the succession process and protect their wealth for future generations.
- Income Tax Planning: One of the most notable tax advantages offered by family partnerships is the ability to distribute income among family members in a tax-efficient manner. Through the strategic structuring of the partnership, income can be allocated to family members who fall into lower tax bands, effectively reducing the overall tax liability. By employing this strategy, commonly referred to as income splitting, families can optimise their tax burden while ensuring a fair distribution of income within the family unit.
- Estate Tax Planning: Estate tax, commonly known as Capital Acquisition Tax (CAT), is a significant concern for many families. Family partnerships provide an effective means of estate tax planning. By transferring assets into the partnership, the taxable value of the estate can be reduced. This reduction can be achieved through discounts for minority ownership interests and lack of marketability, resulting in potential savings on estate tax liabilities. The ability to minimise estate tax burdens ensures that the family’s wealth remains intact and can be passed down to future generations as intended.
- Flexibility and Control: Family partnerships offer unparalleled flexibility and control over the management of family assets. The partnership agreement can be customised to meet the specific needs and goals of the family, allowing for efficient utilisation of available tax reliefs, exemptions, and allowances. This flexibility empowers families to optimise their tax positions, ensuring they can take advantage of the various tax benefits offered by the Irish tax system. Moreover, maintaining control over family assets within the partnership structure provides families with the autonomy to shape their wealth management strategies in alignment with their long-term objectives.
In summary, family partnerships in Ireland offer a multitude of tax advantages that make them an appealing choice for wealth management and succession planning. Careful consideration and professional guidance are essential to fully harness these tax benefits and ensure compliance with relevant regulations.