The second quarter of 2023 was a strong one for investments. That should come as something of a surprise given that this was a quarter in which central banks were taking most, if not all, of the opportunities to raise interest rates.
Higher interest rates are a headwind for investments. They represent what can be earned by leaving money uninvested. Investments will outperform cash deposits over the long run, but in a high interest rate environment they are starting from a lower valuation. In order to make gains when interest rates are going up, normally investors would need to be very confident about company profits.
Back to normal?
The good news is that speculation has been mounting that the painful interest rate cycle might be nearing its end. Given two opportunities during the period to change interest rates, the Federal Reserve skipped one, and hiked by just a quarter of a percentage point in the other. Interest rates are at the same level at which they plateaued for just over a year between 2006 and 2007. Having said that, for now it seems that at least one more US interest rate increase is likely. But like most central banks, the Federal Reserve will now scrutinise incoming data for indications that maybe it has already done too much and that the economy may yet start to falter.
Supporting the case that interest rates are near their peak is that several sources of inflation have reversed and are now weighing down on prices. Many of the supply chain issues which contributed to inflation during 2022 are resolved. Meanwhile, commodity prices, which are usually among the most impactful drivers of inflation, have generally been dropping. The oil price fell over the course of the quarter as investors fretted about lower demand during an anticipated, but elusive, recession. The Organisation of the Petroleum Exporting Countries (OPEC), a cartel which now coordinates with Russia, restricted production of crude oil to try to support its price, which has been weighed down by concerns that the economy may be oversupplied with oil. Similar weakness was evident across industrial metals.
A sour taste
Food prices also fell, although there was little evidence of it in the UK where food price inflation over the last 12 months has been around 20%. In Europe, food prices have been inflated since the Russian invasion of Ukraine and by unfavourable regional weather conditions. UK food importers have historically relied on being able to sell at lower prices through their reliance on short-term supply contracts; however, that left them vulnerable to shortages in the face of poor harvests. Since then, importers have been migrating to longer contracts at higher average costs. The UK, which is the sixth-largest food importer in the world, may also still be suffering from additional import frictions since the European Union Withdrawal Agreement in 2020. Although energy and agricultural commodity prices have begun falling, price growth in the UK is moderating slower than had been hoped.
Although commodity prices have been weighing down inflation recently, prices of many commodities would be lower still were it not for the disruption caused by the war in Ukraine. June saw a counter-offensive by the Ukrainian army and a shocking rebellion by parts of Russia’s mercenary army, the Wagner Group. Recent events have made the Russian leadership appear weak and will embolden the Ukrainians. However, the beneficial impact on gas, oil and food prices is likely to be limited. There is no obvious globalist opposition to president Vladimir Putin within Russia, yet internal fighting could indirectly raise global commodity prices once more if it led to lower Russian or Ukrainian production. Although the UK has banned imports from Russia, previously imported food is now sold to countries not observing Western sanctions and is thereby lowering global prices. Should those exports be interrupted by a Russian civil war, it would cause global food prices to rise once more.
The European Central Bank and the Bank of England both took their respective opportunities to raise interest rates. Inflation in these economies has shown some frustrating signs of persistence. This was particularly the case in the UK where core inflation continued to rise through the quarter. Core inflation excludes volatile food and energy prices, which have an outsized impact on the overall rate, despite being largely beyond central bank control.
One of the reasons UK inflation has been slow to fall is because the UK’s price cap system effectively delayed both the increase and subsequent decline in energy prices. At current gas prices, this should mean the annual rate of inflation slows quickly towards the end of the year.
The larger challenge is the difficulty of finding people to fill jobs, partly driven by an increasing number of potential workers being unable to work for health reasons. Over the long term, this can be addressed through healthcare, education, training and investment. In the short term, however, policymakers need to dampen consumer demand with higher interest rates.
The Bank of England’s interest rate setting committee must try to judge whether the action it has already taken will be sufficient to bring down inflationary pressures in the future. However, with inflation surprisingly strong throughout the quarter, by the bank’s July meeting it became necessary to take more of a risk with growth in order to slay the inflationary dragon.
In theory, the UK should be one of the more interest rate-sensitive economies, as it has relatively short-term fixed-rate mortgages. Although the share of homes that are owned outright has been increasing over many years, a slew of mortgage deals are due to end over the coming months, two years after the stamp duty holiday that helped many onto the housing ladder. With mortgage rates having risen sharply since then, the second half of 2023 is expected to be a difficult one for the housing market and UK mortgage holders.
A brighter future
As mentioned, rising interest rates are a headwind for most invested asset classes. Expectations of future interest rate increases cause bond prices to fall. So far this year, the Bank of England has appeared to be doing too little to control inflation. As a result, future interest rate expectations rose and the price of UK government bonds (gilts) fell. At the bank’s July meeting, an unexpected half percentage point increase in interest rates provided reassurance, and bond prices, paradoxically, recovered a little. Overall bonds laboured over the quarter, reflecting largely anticipated interest rates in many markets and uncertainty over whether peak interest rates are in sight.
Rising bond yields are painful but they offer the promise of a brighter future. Bonds are now offering attractive returns and, in some instances, remarkable tax efficiency which make them worthy of serious consideration for many investors. Inflation-linked bonds can now be bought at prices which guarantee a rate of return in excess of inflation, something which has been very unusual in recent years.
A selective rally
Fears that interest rates may rise will weigh most directly on bond prices, but company shares have some of the same properties. Investing in both shares and bonds involves giving away money now in the expectation of getting more back in the future; the difference is that these amounts are largely known from bonds, whereas they can only be estimated from company shares. Shares, however, had a strong second quarter. The shares which are usually most vulnerable to rising long-term interest rate expectations – technology shares – were the best, paradoxically leading the market higher.
In fact, this was an unprecedentedly narrow market, meaning that seven of the largest US companies, comprising 15% of the global equity market, have actually risen by an average of 50% so far in 2023. This far outstrips the broader market which, without those seven shares, would have experienced single-digit returns.
These are companies seen as benefiting from the use of artificial intelligence, a technology cited by an unprecedented number of companies in the transcripts of their first quarter financial results. Subsequently, the stock prices of chipmakers, cloud storage and other technologies increased.
This narrow market should rightly prompt investors to question whether some of the risers can justify inflated valuations, while at the same time consider whether those who have been left behind offer better prospects.
Without the crest of interest rates in sight, and with the spectre of a recession looming, investors have been defensively positioned. However, those who were too pessimistic are faced with a particularly difficult dilemma. So far this year, the market has overcome the threat of the US debt ceiling potentially not being lifted, as well as the failure of several banks.
Conditions have not been perfect for investors and risks have remained; but, over time, many such concerns have historically been overcome by the stock market, and its ability to finance great companies, jobs and products while growing investors’ savings. Investing will often feel like an emotional rollercoaster. There are times when future returns can be enhanced by taking a cautious approach. But with the market’s historic resilience, excessive caution will eventually be regretted. In the words of Plato:
“We can easily forgive a child who is afraid of the dark; the real tragedy of life is when men are afraid of the light.”
The value of investments, and any income from them, can fall and you may get back less than you invested. This does not constitute tax or legal advice. Tax treatment depends on the individual circumstances of each client and may be subject to change in the future. Neither simulated nor actual past performance are reliable indicators of future performance. Investment values may increase or decrease as a result of currency fluctuations. Information is provided only as an example and is not a recommendation to pursue a particular strategy. Forecasts are not a reliable indicator of future performance.