Quarterly markets review - Q2 2023
A look back on events in Q2, when developed markets led equities higher.
The quarter in summary:
Global shares gained in the quarter with the advance led by developed markets, notably the US, while emerging market stocks lagged behind. Enthusiasm over AI (Artificial Intelligence) boosted technology stocks. Major central banks raised interest rates in the period although the US Federal Reserve elected to stay on hold in June. Government bond yields rose (meaning prices fell).
Please note any past performance mentioned is not a guide to future performance and may not be repeated. The sectors, securities, regions and countries shown are for illustrative purposes only and are not to be considered a recommendation to buy or sell.
US equities ended the quarter higher, with the bulk of the gains made in June. The advance came amid moderating inflation and signs that the US economy remains resilient in spite of higher interest rates. A revision to Q1 GDP growth indicated expansion of 2% (annualised), substantially more than the previous estimate of 1.3% growth.
The Federal Reserve (Fed) raised interest rates by 25 basis points (bps) in May. However, it did not hike rates in June, adopting what economists have termed a “hawkish pause”. The “dot plot” of rate predictions indicated two further rate rises in 2023.
US inflation (as measured by CPI) declined to 0.1% (month-on-month) in May, easing from a 0.4% increase in April amid a continued decline in the cost of energy. This brought down the annual rate to 4.0%, below expectations of 4.1%. The economy more broadly remains in good health. The US unemployment rate increased in May to 3.7% from 3.4%, a larger than expected move but the labour market nonetheless remains historically tight.
There was some investor caution around US debt ceiling concerns at the beginning of the period under review. However, Congress approved legislation that suspended the debt ceiling in the first days of June, in a deal that included concessions on spending expected to have little effect on economic growth.
The information technology (IT) sector led the stock market advance in the quarter. Fervour around AI and the potential for a boom in related technology drove chipmakers, in particular, higher. The consumer discretionary and communication services sectors also performed strongly. Underperforming sectors included energy and utilities.
Eurozone shares posted gains in Q2 with the advance led by the financials and IT sectors. Underperforming sectors included energy and communication services.
The IT sector was boosted by semiconductor stocks. This came in the wake of higher-than-expected sales projections from some US chipmakers, which helped demonstrate the growth potential stemming from AI. Late in the quarter, the Dutch government confirmed that high-end chip manufacturing machines will require a licence to be shipped overseas, which could lead to reduced exports to China. The Netherlands is home to some leading chip equipment makers. Among financials, banks outperformed as their near-term earnings are expected to be strong.
The European Central Bank (ECB) raised interest rates twice in the quarter, taking the main refinancing rate to 4.0%. Headline inflation declined during the period, with annual inflation estimated at 5.5% in June, down from 6.1% in May. However, the core inflation rate (which excludes energy, food, alcohol and tobacco prices) crept up to 5.4% in June from 5.3% in May.
Growth data showed that the eurozone experienced a mild recession over the winter, with GDP declines of -0.1% in both Q4 2022 and Q1 2023. Forward-looking data pointed to slowing momentum in the eurozone economy. The flash eurozone composite purchasing managers’ index (PMI) fell to 50.3 in June from 52.8 in May. That represents a five-month low and suggests the economy may be close to stagnation (50 is the mark that separates expansion from contraction in the PMI surveys).
UK equities fell over the quarter. The large UK-quoted diversified energy and basic materials groups were the most significant detractors amid broad-based weakness in commodity prices and concerns over the outlook for the Chinese economy. Sterling strength also weighed on these resources sectors, as it did other significant US dollar earners such as consumer staples.
A number of domestically focused areas of the market also underperformed as the Bank of England (BoE) raised rates twice – in May and June. The 0.5 percentage points (pp) increase in June represented a reacceleration in rate hikes after an initial decision to slow the pace in March to 0.25 pp increments.
The reacceleration decision came following stronger-than-expected UK jobs market numbers, wage growth and core inflation readings which strip out volatile energy and food prices. This data suggested the BoE remained some way off getting on top of inflation on a sustainable basis, which resulted in the sharp sell-off in UK gilts (rising yields) over the period.
Gilt yields are important for the UK domestic economy as they influence “swap rates” which lenders use when pricing fixed-rate mortgages. As a consequence of questions around the UK inflation outlook, these rates approached levels last seen during the “mini Budget” crisis of autumn 2022. This weighed heavily on some domestically focussed areas of the market such as housebuilders.
Following the June rate reacceleration, however, yields on longer dated gilts did initially fall (prices rose). This was taken to suggest a greater belief from investors the BoE is able to tame inflation, albeit at the possible cost of triggering a recession.
The strong momentum for Japanese shares accelerated in June and the TOIPX Total Return index rose by 14.4% in local terms for Q2. The Japanese yen weakness also continued and it hit the levels of 188 yen and 144 yen against sterling and the US dollar respectively in June. This pulled down foreign currency denominated returns from the Japanese equity market.
The market hit the highest level in 33 years with the Nikkei reaching to 33,700 yen in June. That has partly been driven by continuous buying from foreign investors since April. In addition, the gains have come amid ongoing expectations of corporate governance reforms and structural shifts in the Japanese macro economy. Yen weakness and strength in the US market further supported a risk-on mode in the Japanese equity market. Despite the fact that the market level valuations, such as price-to-earnings ratio, are reaching a fair level, there seems scope for upwards earnings revisions, supported by yen weakness, in the coming months.
The Bank of Japan (BoJ) held the first policy meeting under new governor Kazuo Ueda in April and the second in June. There was no change to policy, which suggested their dovish stance continues. On the other hand, the US Fed is likely to continue to raise interest rates, therefore yen weakness was also accelerated. While the BoJ maintained their cautious stance on the continuity of inflation and wage growth in Japan, the macroeconomic figures continued to suggest solid progress.
Asia (ex Japan)
Asia ex Japan equities recorded a negative performance in the second quarter. China, Malaysia, and Thailand were the worst-performing index markets, while share prices in India, South Korea and Taiwan gained.
Chinese equities were sharply lower in the second quarter as the economic rebound, following the country’s reopening after the Covid-19 crisis, started to cool. Factory output in China has started to slow due to lacklustre consumer spending and weak demand for exports following interest rate rises in the US and Europe. Hong Kong shares prices also fell in the quarter, as a cooling of the Chinese economy weakened sentiment towards Hong Kong stocks too.
Shares in India achieved strong gains, driven by foreign inflows and steady earnings, and as encouraging economic data boosted sentiment towards the country. Equities in Taiwan advanced, driven by gains in technology stocks as investors rushed to buy AI-related stocks. Investor enthusiasm for AI-related stocks also boosted share prices in South Korea, which also ended the second quarter firmly in positive territory. The Philippines and Singapore ended the quarter in negative territory, while Indonesia achieved a modest gain.
Emerging market (EM) equities delivered a small gain over the quarter, which was behind that generated by developed markets. Tension between the US and China was a contributing factor behind EM underperformance, as were concerns about China’s anaemic economic recovery. US debt ceiling uncertainty added to the negative mood, although this was resolved in early June.
Hungary, Poland and Greece were the top-performing index markets despite rising recessionary fears in Europe. Central European markets began to anticipate rate cuts as inflation eased, and Hungary cut rates in June. Meanwhile, Greece’s outperformance came as the ruling New Democracy party won a second term in office in May, signalling a continuation of market friendly policies.
Brazil was also a top performer amid easing fiscal policy concerns, optimism about potentially imminent rate cuts and a better-than-expected Q1 GDP print. Improved macroeconomic data and signs that accommodative monetary policy will be ongoing were also supportive in India, which gained strongly in the quarter.
Colombia was up too, as were the UAE, Peru, Saudi Arabia and Mexico. Korea and Taiwan outperformed led by technology names on optimism about AI growth.
China underperformed amid concerns over a weaker-than-expected recovery. Kuwait and Qatar also lagged. South Africa was among the worst performers as the country’s power situation continued to deteriorate, with severe consequences for economic growth. Turkey posted the largest loss in US dollar terms. This came as President Erdogan won re-election in May, extending his two-decade rule.
The second quarter of 2023 saw a significant drop in market volatility. Government bond yields were on the rise again, although there was some divergence, with the UK and Australia underperforming due to higher-than-expected inflation and a greater resolve by central banks to combat inflation. With the exception of the Bo J, all major central banks kept raising interest rates over the quarter. However, the Fed was the first to pause in June, leaving rates at 5% to 5.25% after more than a year of consecutive rate increases.
Corporate balance sheets remained relatively strong, despite some uptick in default rates. Global high yield outperformed global investment grade as immediate recessionary concerns were pared back. Investment grade bonds are the highest quality bonds as determined by a credit rating agency; high yield bonds are more speculative, with a credit rating below investment grade.
US growth surprised to the upside, with a 'soft landing' scenario now being the market consensus. On the credit front, US investment grade posted negative total returns, but outperformed Treasuries over the quarter. US high yield posted positive returns. The US 10-year yield climbed back from 3.47% to 3.81%, with the two-year going from 4.03% to 4.87%, marking a further inversion of the curve.
The ECB continued to hike interest rates and announced in May that they expected to end reinvestments under their Asset Purchase Programme from July 2023. However, headline inflation has fallen significantly from the peak. Germany’s 10-year yield increased from 2.31% to 2.39%. Euro high yield outperformed investment grade over the period.
Inflation in the UK has taken many by surprise. This prompted the BoE to act more forcefully, raising interest rates by a larger than expected 50 basis points in June. The UK 10-year yield jumped from 3.49% to 4.39% and two-year made even more gains by increasing from 3.44% to 5.26%. On the credit front, UK high yield outperformed UK investment grade.
As sentiment for global growth improved, lower yielding currencies, such as the Japanese yen performed poorly. At the other end of the spectrum, sterling was the best performer, supported by higher interest rates.
Convertible bonds, as measured by the Refinitiv Global Focus Index, returned 5% in Q2. Convertibles benefited from the tailwinds provided by strong performance from “big tech” stocks which were boosted by the AI narrative. However, the universe of convertibles lacks some of the big-hitting tech names and hence finds it difficult to participate more fully in the strong stock gains. The primary market was very active with US$22 billion of new convertibles reaching the market.
The S&P GSCI Index recorded a negative performance in the second quarter. Industrial metals and energy were the worst-performing sectors, while livestock prices rose in the quarter. Within industrial metals, zinc, nickel, and aluminium prices were all sharply lower in the quarter. Within energy, crude oil, Brent crude, heating oil and gas oil all declined, while prices for natural gas and unleaded gasoline were modestly higher.
In agriculture, sharply higher prices for cocoa and soybeans failed to offset prices declines for coffee, sugar, and corn. Wheat and Kansas wheat both ended the month in positive territory. In precious metals, both gold and silver ended the month in negative territory.
During Q2 Bitcoin returned 6.9% whilst Ethereum (ETH) slightly lagged at 6.0%. For the year-to-date, Bitcoin and ETH returned 84.3% and 61.6% respectively.
One of the overarching topics that continues to dominate the digital assets narrative is regulation (or the lack thereof). Q2 brought developments in this regard, and highlighted the divergent paths that different jurisdictions are taking. MiCA, the long awaited European regulatory framework around digital assets, was adopted by the European Union. This gives clarity on several areas including investor and consumer protection, and a comprehensive framework for issuers and service providers.
In the US, different institutions continue to move along on their own (uncoordinated) paths as Congress and the House are legislating on various bills that touch crypto in different ways. Most notably the Digital Asset Market Structure Draft and the Responsible Financial Innovation Act bills, if passed, would clarify the status of digital assets (mostly as commodities). The impact of SEC action against Coinbase was felt by the market in June, with liquidity in altcoins, specifically mentioned in the lawsuits, particularly hard hit.
In anticipation of regulator clarity, some of the largest asset managers globally filed for US spot Bitcoin ETFs which have yet to be approved by regulators. This, together with the SEC lawsuits, further supported Bitcoin’s outperformance over altcoins this year.
The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.
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