While the British weather was dreary, July was all sunshine in capital markets. Global equities returned 2.4% in sterling terms and practically all major stock markets finished in the black. The recent bright spot has helped year-to-date returns too: the top equity indices we track are now all up from the start of 2023 in sterling terms, including previous laggards like emerging markets (EMs). Underlying this optimism has been the consistent slide in global inflation. Markets feel price pressures are much more manageable and, as such, expect central bankers can loosen their tight grips on financial conditions. The table below shows July’s results in full.
Asset class returns as at 31st July 2023
EM equities were the strongest performing through the month, gaining 5% in sterling terms. This is the opposite of what we have seen for most of the year. The strength of the US dollar (which hurts EM companies with large dollar-denominated debts), tight credit conditions and huge disappointment about China’s lacklustre post-pandemic rebound previously meant investors were sour on EMs. But by the same token, a weakening dollar during July – on the back of cooler inflation figures – and new stimulus in China has renewed optimism.
There are certainly reasons to get excited, but we should, as ever, be cautious. EMs are still down over a six-month basis, and the rally is vulnerable to quick changes in sentiment. Short-term hopes are based on a less aggressive US Federal Reserve (Fed), and as such could be spoiled by inflation surprises or hawkish messaging. Longer-term hopes are pinned on a Chinese growth spurt, but post-Covid disappointments show this can be a dangerous bet. We have never doubted the potential of China’s economy, but developments this year call into question whether the government is willing or able to unlock it. Should Beijing boost consumption by as much as it promises, EM and global growth will greatly benefit – but we will believe it when we see it.
July’s best-performing developed market is also one with a disappointing recent growth record. The FTSE 100 gained 2.3% over the month, thanks to lower-than-expected inflation readings and better-than-expected economic data. Corporate earnings reports from Q2 were surprisingly decent, especially in the banking sector. UK inflation dropped to 7.9% in June, below expectations of 8.2%, while the much-watched ‘core’ inflation (excluding volatile elements like food and energy) dropped to 6.9%.
While the fall is encouraging, inflation is still much higher than in the US and Europe, and still almost 4x higher than the Bank of England (BoE) target of 2%. Even so, markets increasingly expect the BoE to back off in its tightening cycle. While the UK’s labour market is tight, the economy is just too weak to stomach significant further tightening. This puts policymakers in an unenviable position, but as many have pointed out, it is both the government and the BoE that have overseen the structural deterioration of Britain’s supply side. The latest signs offer much-needed relief, and are particularly helpful to large-cap stock valuations, which in the UK are somewhat disconnected from domestic growth.
US large cap stocks did not quite match their UK counterparts in sterling terms, but July’s 2% gain came from a much higher base. Investors were buoyed by expectations of a ‘soft landing’, where inflation and interest rates come down but growth stays resilient. That the world’s largest economy recorded 3% inflation for June without dipping into recession (indeed, accelerating away from it in the first half of 2023) suggests this is a definite possibility. But we should not underestimate the Fed’s resolve, or the lasting effects of inflation. The Fed has repeatedly affirmed its tightening bias, and as we have discussed before, the psychological impact of high inflation and a tight labour market could stop us from returning to the pre-pandemic norm of low growth and price stability.
Equity returns were thankfully more broad-based than earlier in the year, when large cap US tech stocks had basically all the growth there was to have (returning an incredible 28.8% year-to-date in sterling terms). US tech still managed to climb 2.8% in July though, in a sign that the artificial intelligence (AI) craze might still have some way to go. While tech valuations look stretched, though, uneven returns in the US mean the rest of its stock market is not as expensive – and hence not as vulnerable – as it might initially look.
European equities were a little more subdued, but still climbed a respectable 1.7%. As elsewhere, inflation cooled, coming down to 5.3% in July according to the latest estimates. Economic data was more disappointing, though. Business sentiment and manufacturing output were weak, even though growth surpassed expectations. The European Central Bank (ECB) raised rates again in July but, thanks to falling inflation and economic weakness, we expect policymakers to pause from now. If they do, European equities might stand to gain in the second half of this year.
Of all the security markets listed above, the largest single return came from Brent crude oil prices, which were up 11.9% in July in sterling terms. This was followed close behind by the wider commodity index, gaining 9.8% on the month. There is some irony in this, given everything else said to this point. Markets’ good mood is predicated on falling global inflation and resilient growth, which itself owes a lot to falling input prices (particularly energy). And yet, at the same time, those input prices rose rapidly during July.
With the volatility in commodity markets – and especially energy – we should not read too much into this. But it raises an interesting point: input prices are no longer sinking, and are in some cases expanding strongly, thanks to where we are in the inventory cycle. If this continues – and especially if demand stays resilient – it could upset the delicate balance that created markets’ current optimism. As central bankers are keenly aware, a soft landing requires prices to stay soft.
The text is taken from The Tatton Weekly and is provided by Tatton Investment Management. The information in this document does not constitute investment advice or a recommendation for any product and investment decisions should not be made on the basis of it.
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