Second quarter review: further gains for global equities
Stock market performance was characterised by narrow leadership. Government bond yields rose.
The second quarter got off to an uncertain start with investors unsettled by continuing concerns about the health of the US regional banking system, the possibility of a US debt default and a hawkish tone from the Federal Reserve.
Despite this, the period as a whole was positive for equity markets, with the MSCI ACWI index rising 3.3% over the quarter and the S&P500 gaining 5.6%1. Volatility as measured by the VIX index also remained well below 10-year averages, suggesting the market was less concerned with the more challenging macro-economic backdrop.
It is worth noting however that the headline figures mask significant divergence in performance between sectors and styles and that for much of the period market breadth was incredibly narrow. 85% of the performance of the S&P500 over the second quarter came from just 7 stocks. All of these were mega-cap technology companies which benefitted from investor exuberance about artificial intelligence. The sector generated strong flows from retail investors, with institutional investors following suit.
Another way to illustrate the importance of these technology stocks is to compare the performance of the S&P500 to its “equal-weighted” counterpart. The performance of the S&P500 reflects the weight of companies in the index, so the performance of the biggest companies has the biggest impact on the overall index. This is not the case for the equally-weighted index.
While the S&P500 was up 5.6% over the quarter and 11.2% on a year to date basis, the equally-weighted index was up just 0.8% and 1.6% over the same periods. The dominance of these large cap technology stocks in terms of market leadership has been remarkable, with the largest 5 companies in S&P500 now making up close to 30% of the index.
Largest 5 companies now represent close to 30% of the market cap of the S&P500
Source: Goldman Sachs
Towards the end of the quarter, we started to see some broadening of market leadership and a recovery in more economically-sensitive cyclicals and small cap stocks. Equity investors are again betting that a soft landing will be achieved as inflation falls and robust labour markets combined with ongoing consumer demand allow for continued economic growth. It remains to be seen whether or not this optimism is justified, especially given the cracks we are starting to see in economic data.
Our underweight equity position was a headwind in the first half of the year, but we are maintaining our positioning. Equity market valuations have re-rated and offer little support (particularly in the US), while corporate earnings and margins could start to come under more meaningful pressure. Furthermore, investor positioning in equities is now extended and sentiment has moved close to being overly-optimistic. This leaves equities at risk of a correction if we were to see signs of more meaningful economic weakness in the second half of the year. This could present an opportunity to increase our exposure.
With inflation still elevated and central banks maintaining a hawkish tone, government bonds fared less well. Interest rates and interest rate expectations both continued to rise over the quarter. US Treasuries fell 1.4% (in USD terms), whilst the longer duration UK gilt index fell by close to 6% as the extent of the inflation challenge facing the UK became more apparent. UK interest rates currently stand at 5%. The market is pricing in close to another 5 hikes by the end of the year, looking for a peak in interest rates at around 6.2%. While the market has consistently underestimated central banks’ determination to bring inflation under control, at these levels we see good value in UK government bonds which can offer diversification if a weaker growth environment forces a change in the direction of monetary policy.
The expectation of higher UK rates also had implications for listed infrastructure and renewables as well as some listed private equity companies. Higher discount rates resulted in investment trust share prices falling and discounts to NAV widening. This space also saw selling pressure as institutional investors looked to rebalance portfolios back towards fixed income given increasingly attractive yields. While painful in the near term, we are maintaining our exposure given the ability to access attractive long-term return streams (with high inflation linkage for several infrastructure names) at increasingly attractive valuations.
While equities were seemingly able to look through near-term growth risks, commodities had a tough quarter. Brent crude prices fell by 6.1% whilst industrial metals like copper (-8.6%) also fell given concerns over weaker global demand. We remain constructive on the long-term outlook for the commodity complex and continue to believe that the transition to renewable sources of energy will drive demand for certain industrial metals supporting pricing. We maintain our exposure in the near term, despite the potential for further volatility.
1 Performance data is sourced from Lipper as at June 30 2023. Data is total return and GBP denominated unless stated otherwise. Past performance is not a guide to future performance and may not be repeated.