MARKET INSIGHT – August 2023

MARKET INSIGHT

Prime Partners’ monthly analysis of global economic and financial market news.

Market participants at a crossroad.

At first glance, July resembles the previous six months of the year in many respects. Equity markets were on the rise, with the US indices outperforming, still buoyed by the major technology stocks, whose excellent health is confirmed by the Q2 results already available.

On the purely economic front, US figures have once again defied numerous forecasts of a slowdown in activity, and are now forcing investors to consider the scenario of an imminent recession as unlikely.

Finally, after the Fed’s latest rate hike of 0.25%, which was widely anticipated by the markets, the end of the rise in interest rates now seems closer than ever. The US central bank can already congratulate itself on a job well done, as inflation has fallen sharply in recent months in the USA without any marked economic slowdown.

As an investor, it is always disturbing to fail to understand why the markets do not follow a seemingly logical scenario. 2023 is a good illustration of this, particularly in the United States, where the central bank’s restrictive policy had led us, like many others, to anticipate a year of transition for the financial markets, with returns that we certainly hoped would be positive, but not particularly impressive. Seven months on, we can see that this is not the case, and that the 2023 vintage for equities is so far much better than expected. There is no need to repeat what we have written here over the last few months.

The rally in equities has been extremely narrow, particularly in the US, where the infatuation with the technology sector and the first tangible benefits in companies’ order books (led by semiconductors) of the use of artificial intelligence explain most of the S&P 500’s performance, and even more so that of the Nasdaq.

Europe, for its part, is logically a little behind its American counterpart, with the old continent’s equity indices dominated by less technology-intensive sectors. However, despite this relative “weakness”, few were expecting the Stoxx 600 index to post gains flirting with 14% by the end of July.

It therefore seems important to us to revise our scenario somewhat with regard to monetary policy, which has a considerable influence on all asset classes, as can be seen at every central bank meeting and also whenever a central banker speaks.

The US economy looks set to avoid a recession this year. Growth is very real, the job market remains tight and the purchasing power of American consumers is once again on the rise, as the wage increases of recent quarters have enabled them to increase their spending against a backdrop of decelerating inflation.

For the time being, the services sector is maintaining a satisfactory pace, given the level of interest rates. Price rises have not put off consumers, who prefer to pay more for certain leisure activities than they did before Covid, while cutting back on other expenses if necessary.

US industrial activity, meanwhile, remains in recession, demonstrating that the restrictive financial conditions imposed by the Fed are indeed being transmitted to the real economy. The same is true of Europe, including Switzerland, and China. However, it is interesting to point that in some sub-segments, we are now witnessing a consolidation rather than a further deterioration.

As an investor, it is always disturbing to fail to understand why the markets do not follow a seemingly logical scenario.

Finally, it should be noted that companies do not wish to make the same mistake twice by adjusting their headcount too quickly, at the risk of having difficulty recruiting in a few quarters’ time.

Europe is following a similar dynamic, but to a different degree. European consumers also favor certain expenses over others, leisure in particular, but on average have seen their salaries rise by less than their American counterparts over the past year. Inflation is also slowing in Europe, and the ECB’s mission has so far been a success, even if it is lagging slightly behind the Fed in terms of executing its plan to rein in prices. This is due to the fact that wage growth came later in Europe than in the United States.

European industrial activity, which remains key to some of the region’s economies (Germany in particular), is clearly at recessionary levels, while services are admittedly in good health, but without being able to offset the manufacturing slowdown to the same extent as in the US. This is an essential difference between the American and European situations.

Added to this Europe/USA comparison are the usual structural brakes on the old continent, where the repercussions of the ECB’s policy can be transmitted at different speeds to the economies of the member states, leading to more disparate results. Finally, the appetite of European consumers is generally less vigorous than in the US, particularly where credit is concerned. The Germans, for example, are much bigger savers than the inhabitants of southern Europe.

As we have seen, it is becoming realistic to say that the US economy has taken the lead in the post-Covid race toward a soft landing, despite a very restrictive monetary policy.

Consequently, there are several hypotheses to consider for the second half of the year. The first is that core US inflation will continue to fall, against the background of a fairly robust economy. In this context, we expect the Federal Reserve to keep rates unchanged. What is more, they could remain at current levels until next spring, as the Fed wants to be sure of the direction of inflation, which is still well above its 2.0% target.

A second hypothesis relates to the Eurozone economy, which looks set for a more pronounced slowdown than is currently the case. We will need to keep a close eye on economic figures this autumn, to determine whether we are moving from mixed signals depending on the sector to clearly weaker and, above all, more homogeneous activity data. The continuation of the second-quarter earnings season and, more importantly, the guidance given by companies will be very closely scrutinized by market participants, especially in the more industrial segments of the European economy. The central bank also seems to have this risk in mind, hence a more pragmatic and less dogmatic message regarding its future rate policy.

Going forward, we find it advisable to revise somewhat our scenario regarding central banks, and to distinguish between the current dynamics at work on either side of the Atlantic.

Finally, it is worth keeping a close eye on the situation in China, where the reopening of the economy has not had any far-reaching effect, and where problems now seem to run far deeper, much to the dismay of the authorities. With a very high rate of youth unemployment and stimulus measures that have so far focused mainly on the supply side, the Chinese economy is struggling to convince us of an imminent rebound in activity, while other emerging countries, led by India, are showing signs of great dynamism.

Our diversified allocations have benefited from the enthusiasm for equities during the first seven months of the year, in particular thanks to a good exposure to US technology stocks. The fixed-income portion of our portfolios also profited from the good performance of certain segments of the bond market, such as high yield and convertibles. Finally, our alternative holdings also made a positive contribution to performance in our mandates, thanks to actively managed products whose investment universe offers more tactical opportunities in 2023 than last year. Our exposure to gold completes the positive and diversified picture of our current asset allocation.

Needless to say, being at a crossroads does not mean taking the path of reckless optimism, but rather putting into the proper perspective some of the fears we had at the start of the year regarding economic activity and the delicate steering performed by central bankers. We therefore need to remain agile in an environment that is ultimately more buoyant than we expected, and continue to be sufficiently exposed to it in a diversified fashion.