Markets & Investment Update

This note contains an overview of our market views, what we are watching, and our portfolio strategy. Any reference to portfolio positioning relates to our flagship discretionary portfolios. Clients with bespoke or advisory portfolios should consult their Client Advisor for the latest update on your portfolio.

The dust settles after a few volatile market sessions
In the absence of major economic releases last week, markets took a breather after a sharp fall on Monday, almost paring losses on Friday. The sell-off was due to a trifecta of dynamics triggered the previous week:

First, a batch of weaker-than-expected US data for the manufacturing sector and the job market spurred fears that the US economy may be slowing more than expected. As such, markets were quick to think that the US Federal Reserve (Fed) would significantly cut interest rates in 2024. The market impact was positive for bonds but negative for the US dollar (USD) and equities.
Second, the Bank of Japan surprisingly increased interest rates, which supported the Japanese yen (JPY). The strength of the JPY combined with the weakness of the USD left investors involved in the so-called “carry trade” facing currency losses. What this means is that some investors had previously borrowed JPY, as interest rates were low in Japan, to buy US dollars where interest rates are higher, and some even borrowed JPY to buy US equities. So, when the JPY strengthened against the USD, investors had to cut their losses by selling US assets to buy back Japanese yen. The unwinding of this carry trade further amplified the fall in both USD and equities, and the appreciation of the JPY, which resulted in additional losses for Japanese equities.
Third, and last, all the above-mentioned dynamics were further exacerbated by thinner market liquidity, as is often the case during the summer months.

Our take on the economic cycle
At the start of 2024, our view was that growth would slow, and this view is playing out. After months of resilience and strength, the US economy is moderating to a more normal pace of growth. The manufacturing sector has been depressed for months (it’s also true globally) and the labour market has been moderating since the end of Covid. That said, private consumption, the main engine of growth in the US, remains strong. In a nutshell, US data are mixed. Our proprietary cycle indicator has alternated between expansion and late cycle phases for some time, but it’s not signalling recession. That said, as valuations got demanding in the US (though not frothy), the recent weakness in the labour data led to investors questioning the longevity of the economic and earnings cycle and whether the Fed has held interest rates in restrictive territory too long, jeopardising the ‘soft landing’ (slower inflation and slower growth but no recession) it intends to achieve. One data point doesn’t make a trend, but the recent uptick in the US unemployment rate was due to the rising labour supply exceeding demand for workers (partly driven by a surge in immigration) rather than outright job losses.

Nonetheless, the US labour market showing some signs of cooling highlights a shift in markets’ attention. The focus was previously on inflation, and it’s now on economic and employment growth, given that inflation is slowing towards the central banks’ target. Growth concerns led markets to expect more cuts from the Fed. But if you think about it, the market was only pricing in one Fed rate cut just a month ago when services activity in the US contracted outright. It’s now expecting four-to-five rate cuts when services activity is growing again (and the employment and forward-looking new orders components of the key surveys are pointing to continued, albeit moderate, growth). Expectations of interest rates cuts have been quite extreme in 2024. We’ve held a steadier view, expecting the Fed to cut in September and December. Overall, we think that the outlook has not materially changed, but we do acknowledge that the balance of risks has somewhat tilted to the downside. Perhaps the Fed could cut once more, in November. But we do not think it will slash rates as much as the market expects.

Economic growth and inflation data in focus this week
This week sees the release of the July US inflation data (Wednesday). The price index is anticipated to have grown 0.2% relative to June, a level that shouldn’t cause the Fed too much concern. Given that the resilience of the US economy mainly comes from domestic demand, if signs of labour market weakness are feeding through to activity, we may see this in the retail sales report (Thursday). That said, consensus expects retail sales to have picked up in July compared to June. Weekly job claims, which declined more than expected last week, will be again in focus on Thursday. This week’s data could help assess whether recession fears are overblown, which we believe to be the case.

In the UK, inflation could have risen slightly above the Bank of England’s target (Wednesday) but shouldn’t stand in the way of a further rate cut later this year. The June monthly GDP print (Thursday) is likely to see no growth, after a rise in May. A flat reading would not be a negative outcome, given that rainy weather continued into June. But retail sales (Friday) are expected to have risen in July, confirming that the recovery remains underway.

How we’re navigating volatile markets
In 2024, to navigate an increasingly complex environment (market valuations, questions about the economic and earnings cycle, and (geo)political risks), we’ve gradually increased portfolio diversification through strategical and tactical positions. This should help mitigate these risks as volatility, which has now settled in a low range, could increase again over the coming weeks.

Our strategic investments in high-quality bonds, US Treasuries in particular, are fulfilling their traditional role as a hedge against downside growth risk. Gold has also held its ground recently and, if (unpredictable) geopolitical risks were to rise further, our commodities position would likely benefit, too.

The tactical position we initiated in short-dated European government bonds (in euro-denominated portfolios, while in sterling-denominated portfolios we added short-dated UK gilts), stands to benefit as central banks look set to continue cutting rates. Also, we recently closed our small-cap equity position. After an initial rally, this market has been under pressure lately, as it’s quite sensitive to US economic growth. This was further evidenced last week when small caps in the US underperformed their larger peers in the rebound. Furthermore, the ‘insurance’ instrument we hold in portfolios (where permitted by client knowledge and experience, investment guidelines and regulations) partly protects against significant equity drawdowns. Building robust portfolios that can withstand a range of economic outcomes allows us to stay invested in high-quality assets with attractive long-term potential.

Important Information

Information correct as of 12 August 2024.

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Risk appetite recovers