The third quarter can be viewed as two distinct halves. Markets started the period in a strong position generally, as the consumption-led recovery continued through from the previous quarter. Inflation also began to descend, which was a favourable development for economies and contributed to a tightening in corporate bond spreads. Central banks also persisted with rate hikes to demonstrate their commitment to bringing inflation down.
However, sentiment turned in August. Core inflation was failing to fall in line with headline inflation, with the former mainly driven by wage inflation. Companies throughout developed economies have been under pressure to deliver wage hikes amid tight labour markets. This, combined with a resilience in consumer spending, has kept service sector inflation higher than central banks would have liked.
Cracks also appeared in the European consumption recovery theme. Manufacturing data first started to decline gently but is now firmly in recessionary territory in Europe, which was already suffering from a manufacturing recession and the aftermath of past European Central Bank hikes. As most corporate debt in Europe is on floating rate terms, the lag in impact from monetary policy changes is much shorter than in the US. The consumption-led recovery in key markets is also fading. Consumer savings accumulated during lockdown are nearly exhausted, while energy prices are rising again, putting disposable income under stress. Risks are also appearing in housing markets; European house prices have declined sharply and there were also concerning signs in the US, where mortgage applications fell to their lowest level since 1995.
Central banks have updated their messaging to indicate that the end of the hiking cycle is in sight, but stopping short of any mention of imminent rate cuts. In particular, the US Federal Reserve – which has delivered 525bps of hikes since March – and the Bank of England are now waiting for these hikes to fully filter through. Due to the higher-for-longer inflation dynamic and the expectation that interest rates will be maintained at these high levels for an extended period, we have seen a general sell-off in bond markets. As interest rates on government bonds reached multi-decade highs, total returns on most fixed income assets were put back into negative return territory for the year to date. Higher rates have also started to filter into both the corporate bond market and equity markets, due to higher borrowing costs.
Over the quarter, the fund generated a slightly positive return and outperformed its benchmark.
During the quarter we reduced our exposure to the financial sector, which allowed us to realise some of the gains from its outperformance earlier in the year. In particular, we eliminated exposure to some of the expensive insurance-sector subordinated bonds, such as Zurich Re and Sumitomo Life, and sold some bonds issued by French banking group Credit Agricole. Conversely, we added duration back in the fund mainly by buying long-dated US Treasuries.
In terms of currency exposures, returns were supported by general weakness in sterling as investor concerns around the UK economy grew. The fund benefited in particular from the strengthening dollar, which had been helped by safe haven flows and a general consensus that interest rate cuts are being pushed back, which seem to have been priced more into the dollar than other currencies.
The narrative from central banks is that their economies will achieve a soft landing, with inflation moving back to target levels within the next few years without a significant recession or sharp rise in unemployment. We think the probability of their success is declining, due to the concerns emerging in Q3.
We expect corporate spreads to start coming under some pressure over the next few quarters as companies struggle to pass on higher costs to the consumer and demand for goods and services slows down. Interest rates will most likely stabilise and come back down as a recession becomes more likely.
Headline inflation will continue to decline as commodity prices stabilise. Core inflation is proving to be stickier than previously assumed by central banks and will likely take more time than they expect to get back to target levels. We predict that inflation will remain elevated until 2025, as wages have picked up. While we don’t expect a sharp rise in unemployment, a recession would help in the battle against inflation.
The value of investments may fall as well as rise and investors may not get back the amount invested.
The views expressed in this document are those of the fund manager at the time of publication and should not be taken as advice, a forecast or a recommendation to buy or sell securities. These views are subject to change at any time without notice.
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