2023 Markets Review, Portfolio Positioning & Outlook

Executive Summary 

• 2023 has been another challenging year with further instability in the Middle East, market volatility and economic uncertainties. 
• Equities in many cases have made good ground and bonds have made some headway after the huge challenges of 2022. 
• We are cautiously optimistic as we head into 2024, with inflation figures falling and the prospect of interest rate cuts in the second half of next year. 
• The persistent inflation of the past year appears to be receding due primarily to the central bank’s monetary tightening. 
• There is still healthy growth in some economies, such as the USA which itself may avoid a recession in 2024, albeit with much lower growth than that seen in 2023. 
• The Bank of England and other central banks may need to shift from battling inflation to encouraging growth, and the balance between growth, inflation and interest rates will likely shape the 2024 market outlook. 
• Strategists mostly think that the rally is likely to continue for equity markets in 2024. Value has come back into bond markets and with current yields it should mean decent returns to come, even if we don’t have significant cuts in interest rates next year. 

2023 

• We wrote in last year’s review that we expected better returns from markets after the exceptional drawdowns seen in many bond and equity markets across 2022. 
• As we enter the last few weeks of the year the market’s view is that the central banks are now done with hiking rates and that inflation is slowing, which has fuelled one of the strongest bond market rallies in November that has been seen in many years. 
• Government bond investors had been potentially facing an unprecedented third calendar year of losses until the November rally, which also saw strength in investment grade credit and many of the equity markets. 
• Investors have begun to anticipate a quarter-point cut by the US Federal Reserve when it meets next May, whilst the Bank of England is seen as cutting rates in August by a similar amount. 

Our Portfolios 

Our positioning in fixed income markets has worked well in 2023. We have been underweight in exposure to UK government debt which has been a weaker performing bond market and our fixed income funds have generally performed well. We made some changes to our portfolios in the summer and more recently to take advantage of the opportunities that higher yields now offer in bond markets. However, we are conscious of potential challenges, such as high levels of government debt and sticky inflation and so we have retained exposure to alternative investments. Many of our underlying fund managers have been raising the 

quality of the bonds they hold in order to mitigate potential risks in a rising default environment, which may follow as the economy reacts to significantly higher interest rates. Historically a rising rate environment has been associated with problems for borrowers and in some cases an inability to pay back the debt they have borrowed, and this looks likely to be the case again over the next few years. We have also seen fund managers buying longer dated bonds in order to lock in these higher yields for longer as they expect cash rates to fall next year. 

Our alternative investments, which enjoyed considerable success in 2022 have had a more challenging year. Two of our absolute return funds have generated negative returns this year as they struggled to make money in the volatile market conditions, especially those in the Spring following the collapse of a number of US and European banks. Nevertheless, we have reviewed our holdings extensively and recently made changes where we have been disappointed. These changes reduce costs, heighten diversification, simplify our holdings and can also potentially benefit should interest rates remain higher for longer than is anticipated. 

Most of our equity funds have added value this year. Actively managed funds in general, funds with biases to high quality and fast-growing companies and funds which focus on medium and smaller-sized companies have continued to struggle for most of the year, as they did in 2022. The economic uncertainty in 2023 has meant that medium and smaller-sized companies, many of which are deemed more sensitive to economic conditions than larger businesses, have struggled to keep up with their larger counterparts. This has especially been a noticeable pattern in the USA with what have been dubbed the “magnificent seven” driving most of the country’s market returns. We continue to believe it is right to retain our biases to both high quality and medium and smaller-sized companies. High quality companies, with dominant market positions and strong balance sheets, are well-placed to weather economic downturns. 

We continue to believe that holding a balance of active and passive funds is the best approach to investment management. We are conscious that active managers have struggled for some time but would highlight that they tend to add most value through recessionary periods as they can avoid low quality and economically cyclical businesses. They can also tactically hold higher levels of cash compared to passive funds. If we see a return to form for the active fund management community this would be of significant help to our portfolios, and we think that active managers should start to add significant value as we enter 2024. In fact, one of the recent changes in our portfolios was the move to use only active managed solutions in our UK equity exposure, where appropriate. This is because the opportunity set appears to be very healthy for active managers now that the decade of free money has ended, which supported all businesses regardless of their quality. Many strategists and fund managers believe that with higher costs of debt there will be clear winners and losers, presenting great opportunities for those not simply buying the entire market. 

We continue to focus our efforts in making our portfolios the best that they can be, which is a relentless pursuit, but it has been pleasing to see Square Mile winning awards this year for 

Research, for Client Service and recently as Wealth Manager of the Year which is testimony to the quality of the collective efforts of all of our staff. 

Outlook 

2023 has been a better year but that would not have been difficult after what was an exceptionally poor 2022. We are now looking forward to 2024 with some optimism as we retain high confidence in the outstanding quality of our fund holdings and their management teams. Our portfolios are built for the long-term and are characterised by quality companies and attractive valuations. 

For those of you who like predictions, we once again include the Goldman Sachs’ forecasts for the end of this year and the next 12 months: 

2023 vs 2024 EOY Forecasts 

GBP/USD: 1.22 -> 1.25 

FTSE 100: 7,700 -> 7,900 

UK 10-year gilt yield: 4.0% -> 4.0% 

UK CPI: 5.6% -> 2.6% 

UK core CPI: 3.2% -> 2.8% 

S&P 500: 4,000 -> 4,700 

The months ahead could continue to be volatile, but it looks like a much better opportunity set for many parts of the bond and equity markets across 2024. 

2023 Quarterly Market Reports 

Q1 Macro Backdrop 

The balancing act being performed by central banks between taming inflation and avoiding recession got even harder in March as a new fault line emerged in the banking sector. The crises at Silicon Valley Bank and Credit Suisse were idiosyncratic and largely self-inflicted – the former had been without a Chief Risk Officer for most of 2022 whilst pursuing a highly risky investment strategy and the latter had lurched from one well-publicised disaster or scandal to another in recent years. Bank runs occur when depositors lose confidence that their money is safe. However, the banking system as a whole is substantially more robust than it was before 2008’s financial crisis. 

Thanks to a mild winter and tumbling gas prices, easing of supply chain pressures and year-on-year base effects, we expect headline rates of inflation to continue to decline. Despite February’s unexpected blip, Prime Minister Sunak’s pledge to halve the inflation rate by the end of 2023 is still very achievable. ‘Core’ inflation, though, which excludes energy and food, is proving much stickier. In the US, the headline inflation rate has dropped from a peak of 9.1% in June last year to 6.0% but core inflation has fallen only from 5.9% to 5.5%. 

This is in no small part because labour markets, consumer spending and economic growth have so far remained surprisingly resilient even as interest rates have soared from 0.1% to 4.25% in the UK and from 0.25% to 5% in the US in little more than a year. Unemployment rates continue to be close to 50-year lows in both the UK and the US. Wage growth, though, in real (after inflation) terms is currently still negative and this is prolonging the cost-of-living squeeze. 

It is almost inevitable that there will be further casualties as a result of the abrupt withdrawal of the punchbowl of abundant and ultra-cheap debt from which governments, companies and investors had been binging for more than a decade. We can only speculate as to where the next fracture might occur, but central banks might be forced to put financial and economic stability first and let up in their fight to crush inflation. 

Bond Markets 

After a torrid 2022, bond markets delivered welcome gains to investors in the first quarter of 2023, but only after subjecting them to another white-knuckle rollercoaster ride. Up by almost 5% at the beginning of February, the UK government gilt market (excluding index-linked gilts) slumped to be down by 1.5% a month later before rallying strongly to finish the quarter with a gain of just over 2%. 

During January bond markets powered ahead as falling inflation stoked optimism that peaks in interest rates would be lower than previously thought and that an economic ‘soft landing’ could be achieved. However, a blockbuster US jobs report in February coupled with stronger-than-expected economic data and fresh warnings from central banks that the battle against inflation had not yet been won reversed all of January’s gains and more. Bond markets rallied 

once again, though, in March as the failure of several banks rekindled fears of recession due to tighter credit conditions. This revived hopes that central banks would be cutting interest rates before the end of the year. 

The outlook for bond markets looks finely balanced. If recent problems in the banking sector are a cause or precursor of economic troubles ahead, then bond yields could fall (and bond prices therefore rise) further. If, however, the financial squall blows over and the narrative returns to the fight against inflation then bond yields might be too low and prices vulnerable to a setback. Compared to a year ago, though, investors in bonds are now at least being paid a reasonable rate of return just to own them. 

Equity Markets 

Mirroring the performance of bonds and for the same reasons, stock markets got off to a barnstorming start to the year, global stock market indices rising in January by more than 6% and the UK market up by 4.5%. In February, rising bond yields presented a headwind for growth stocks (and therefore US shares in particular) but the more ‘old economy’ UK stock market inched higher. 

All major stock markets, though, fell sharply at the beginning of March as the failure of Silicon Valley Bank and rescue of Credit Suisse evoked memories of 2008, prompting a wave of risk aversion amongst investors. With its heavy weighting in banks, returns from the UK equity market at its low point were negative year-to-date. However, swift action by the authorities and the absence of contagion meant that investor confidence was quickly restored. Over the quarter as a whole, global equities were up by more than 7% in local currency terms and UK equities by just over 3%. 

Although the immediate danger to financial stability seems to have been contained, we expect volatility to be an ongoing feature of stock markets in 2023. The battle between inflation and economic growth is ongoing and, although share valuations are generally much lower than they were, they are still not compellingly cheap. The outlook for corporate profits also remains uncertain. As we noted three months ago, though, it is quite possible for corporate profits to grow in a recession. This is because economic growth is measured in real terms after inflation but corporate profits can be boosted by inflation if margins are maintained. 

We expect stock selection to be important in 2023. Companies most at risk are those which will need to refinance high levels of debt on their balance sheets. In contrast, companies with dominant market positions, and hence pricing power, are best placed not only to raise prices at least in line with inflation but also to weather any forthcoming economic downturn. We continue to emphasise both characteristics in portfolios which use actively managed funds. 

Currencies 

Compared to bonds and stocks, currency markets were relatively calm in the first quarter of 2023. Sterling was the strongest major currency, appreciating by almost 3% against the 

dollar and by just under 1% against the euro. In times of crisis money floods usually into the dollar. The weaker trend in the US currency so far in 2023 therefore suggests that investors remain fairly sanguine about the overall backdrop and are not fearful that recent stresses in the banking sector are set to snowball. As a reminder, exposure to foreign currencies in the portfolios we manage comes mainly from investments in overseas equity markets. Foreign currency exposure in the bond funds we use is generally hedged back into sterling. 

Alternative Investments 

Gold also followed the track in bond markets (the metal performs best when interest rates in real terms are falling) and benefited additionally from its safe haven status as confidence in banks was jolted. Over the quarter, the price of gold was up by almost 8% in US dollars and by 5% in sterling terms. The problems in the banking sector unsurprisingly also sparked a renewed flurry of interest in cryptocurrencies, the price of bitcoin rising by a staggering 72% in dollar terms in the first three months of 2023. Despite this gain, bitcoin is still almost 60% below its November 2021 peak. Given the lack of regulation, cryptocurrencies remain a speculative asset class which is unsuitable for use in the portfolios we manage. Yet another quarter has passed without the FCA pronouncing how it will resolve the mismatches in both the liquidity and the valuation frequency of daily dealing funds and the bricks-and-mortar properties in which they invest. The daily dealing UK property fund sector therefore remains in limbo. 

As always, funds in the absolute return sector produced a wide range of returns ranging from a gain of almost 8% to a loss of nearly 6% in the quarter. This only underlines the disparate range of strategies, objectives and risk profiles in the sector. In 2022, returns ranged from +30% to -20%! Despite higher yields making bonds more attractive than they were, we continue to believe that absolute return funds can provide an uncorrelated stream of returns and therefore have an important role to play in diversified portfolios which use actively managed funds. The selection and combination of complementary funds, though, is critical to success in any allocation to the sector. 

Q2 Macro Backdrop 

As has been the case for some time now, markets remain fixated on inflation and what this means for interest rates. US headline inflation dropped to 4% in May, largely due to lower energy prices. Core inflation, excluding volatile items like energy and food, slowed to 5.3%, the lowest since November 2021. UK inflation fell in April to 8.7% (though above expectations) but was flat in May. Rising prices in air travel, recreational goods and services (especially admission fees to live music events, computer games and package holidays) and second-hand cars offset falling fuel costs and slowing food inflation, although the latter is still running at a fairly heady 18.3%. Crucially, core inflation reached 7.1%, the highest since March 1992 and above market expectations of 6.8%. Inflation in the Eurozone fell to 5.5% in June, down from May’s 6.1% print, but core inflation also picked up to 5.4%. 

Generally, whilst we are seeing prices reducing in some areas others are proving more stubborn, and the path forward isn’t necessarily a clear one. One reason could be wages, which have been moving higher and are supported by tight labour markets. Year-on-year 

wage inflation in the UK including bonuses was 6.5% in the three months to April 2023, and excluding bonuses 7.3%. Another reason could be that some, though by no means all, companies are using the inflationary backdrop to increase prices and improve profit margins. 

Monetary policy has naturally followed suit, with interest rates continuing to rise worldwide. In June the Bank of England raised interest rates by 0.5% to 5% and the European Central Bank by 0.25% to 4%. Whilst the US Federal Reserve paused their hiking cycle it was notable, they indicated rates may need to move higher later in the year. One important outlier to this has been China, which is flirting with deflation and actually marginally reduced rates in the last month of the quarter. 

The full impact of high rates on consumers is still unclear. Savings made during the pandemic, coupled with higher wages may offset some inflationary effects, but these saving are being drawn upon and the delayed impact of higher mortgage rates could yet to have been fully felt. This will be very important for the global economy and corporate earnings in the quarters to come. 

Recession concerns persist, with the Eurozone in a small technical recession and UK GDP only slightly rising in the first three months of the year. While some cracks are appearing in the US economy, strong consumer spending and a robust labour market indicate no immediate recession. 

Bond Markets 

Global bond markets have posted positive returns this year thankfully, after a dismal 2022, despite significant volatility in US Treasuries following the country’s numerous regional banking issues. However, the UK government bond market fell on the disappointing inflationary backdrop and expectation that interest rates may need to either move higher than expected and/or stay higher for longer. 

Central banks remain committed, at this point, to prioritising the fight against inflation over supporting economic growth. That being said, we believe the end of the monetary tightening phase is approaching and therefore the majority of valuation adjustment has already been seen in bond markets as demonstrated by dramatically higher yields. Therefore, where appropriate, we have increased duration (a measure of interest rate sensitivity) in portfolios, to capitalise on this. This should prove beneficial when markets start to assume interest rates have peaked and/or need to be cut, especially if the economic outlook deteriorates. 

Equity Markets 

So far this year returns have generally been positive across the board. Japan has been the best performing major equity market in local currency terms, helped by a weak Yen, which is good for exporting companies but reduces returns for overseas investors. The US market has also been one of the best performing, although it has been narrowly led as AI (artificial intelligence) mania resulted in a favouring of the nation’s very largest companies, such as Apple and Amazon. In fact, the returns from these few, admittedly colossal, companies have driven the majority of US market returns in 2023. After a healthy first quarter European 

markets had a quieter second but are still firmly up this year. Nevertheless, a stronger pound, encouraged by the Bank of England’s more forceful approach to monetary policy, dampened returns from Europe and the US for UK investors. The UK produced a muted return, with a limited technology related presence and lacklustre performance from mining and energy stocks. Asian and emerging market equities have lagged this year, largely due to disappointing Chinese economic data, where investors were anticipating a better reopening narrative. 

Whilst a global recession does not look imminent, we do not expect the inflationary or economic journey to be a straight-forward one, and it may be a case of a recession delayed rather than avoided. This is particularly because interest rate increases are a fairly blunt tool with which to tame inflation, aiming to cool demand by making life increasingly expensive for consumers and companies alike. As such, there may be further corporate casualties to come, especially for the more indebted parts of the market, such as commercial property; not an area we are directly invested in. This is one of the reasons why low levels of debt are a characteristic we emphasise in our equity holdings. Yet, we balance this with the fact that equity valuations have improved, and that the growth potential of stock markets means they are one of the few asset classes that can deliver returns ahead of inflation over the medium to longer term. Therefore, we are not positioned aggressively in equity markets, but retain what we would term a neutral level of exposure in portfolios. 

Q3 Macro backdrop 

As it stands today one of the most anticipated recessions ever has yet to materialise. In fact, economic growth, with the exceptions of Germany and Italy, has broadly been positive across the board, although outside the US recent gains have been much more modest in nature. As we are all painfully aware the Western world has undergone one of the fastest monetary tightening phases in history, as Central Banks continue to do battle with the elusive opponent that is inflation. On that front there has generally been more positive news. Inflation in the UK unexpectedly fell to 6.7% in August, below a 7% forecast and core inflation (ex-energy and food) dropped to 6.2%. This therefore allowed the Bank of England to hold interest rates in September, although further rate rises were not ruled out. Whilst inflation in the US picked up to 3.7% in the same month, largely driven by a higher oil price and the impact of year-on-year base effects, core inflation fell to 4.3%, its lowest level since September 2021. This led to the US Fed also holding interest rates in September, though with the suggestion that there could be another hike later this year. The Eurozone’s ECB pushed ahead with its interest rate rise but indicated that this rise was likely the last, given the fragile economic outlook. China, on the other hand, has been flirting with deflation and a debt laden property market headache. The great reopening that was expected as the country emerged from its brutal series of covid lockdowns has failed to appear. This poor economic backdrop has led to interest rate cuts and stimulus measures being implemented. Yet, as we have noted before, one positive here is that China’s deflation could help the West’s inflation, as they offload excess inventory and export goods at knockdown prices. 

There are so many conflicting macro variables at play today that it is not a time to be envious of central bankers. Higher debt servicing costs (for consumers, governments and 

corporations), inverted yield curves, falling savings levels, higher oil prices and weakness in the global manufacturing sector, all suggest a recession is on the horizon. However, tight labour markets and real wage growth has kept the consumer spending, as can be witnessed by Taylor Swift’s summer tour, that had an estimated $5bn impact on the US economy. 

Interest rate rises have a lagged effect, generally 12 months or more, and so the impact of more recent hikes has yet to be felt fully. Our view remains that as these feed through and if we start to see weakness in labour markets (where some cracks are appearing), as companies try to protect margins by cutting staff, this will presage an economic downturn. Whilst we cannot know when, or even if, that will come to pass, it would likely put downward pressure on interest rates, a feature markets are already anticipating for mid to late 2024. There is clearly a risk that inflation proves stubborn, not helped by high wages and recent rises in the oil price, but we do believe that we are at least near the end of the monetary tightening phase in the US and Europe. 

Bond Markets 

As ever the inflation and interest rate dynamic has been most keenly felt in global fixed income markets. The inflation backdrop in the UK has meant that government bond yields have continued to rise, with the yield on UK 10-year bonds touching a level not seen since 2008 in the last quarter. Yet, weak business surveys and the better than expected inflation figure saw yields falling back as investors came round to the view that we are at, or very near, peak rates. In the US, strong GDP growth lent credence to the narrative that interest rates may need to stay higher for longer, and so the yield on 10-year US government bonds has climbed to its highest level since 2007. Outside of government bonds we have seen some gains, as the more encouraging economic environment has tempted investors into corporate debt markets. 

Despite the rise in government bond yields, when compared to what was a brutal 2022 bond markets haven’t done a huge amount this year, supporting our view that a lot of the valuation readjustment has already happened. We are not dismissing the continued inflationary threat but with, in our opinion, interest rates being near the top of their range and given the yields now on offer (UK corporate bond indices are yielding over 6%) it is right to be more optimistic on the asset class from here. We recently made portfolio changes, where appropriate, to increase the interest rate sensitivity of our fixed income holdings and continue to review our overall positioning closely. 

Stock Markets 

Global stock markets traded quite choppily in the third quarter, with a fairly benign July leading to a more lacklustre August and September. Markets continue to grapple with the interconnected forces of inflation, interest rates and economic growth, and remain fairly responsive to news-flow on all fronts. Nevertheless, most markets are in positive territory this year, with Japan top of the charts. Asian and emerging market equities have lagged, largely due to disappointing Chinese economic data. 

One of the best performing markets so far in 2023 has been the US. Although its technology behemoths didn’t gain quite as much favour in the third quarter as they did earlier in the year, the year to date divergence between the top 50 largest stocks in the US compared to the bottom 2000 is c.20%. The dominance of these, mostly AI related, companies is striking and their run up in performance does make the US market appear an expensive one. However, we draw some comfort from the fact that once the top ten largest stocks are removed from the data the US is actually trading at around its long-term average valuation. 

The underperformance of medium and smaller sized companies has also been a theme prevalent in the UK stock market. The third quarter was no exception to this, partly because a higher oil price drove up the share prices of multi-national energy companies, such as Shell, which makes up nearly 9% of the FTSE 100. Even so, whilst it has been larger companies that have generally supported the UK market this year it has still returned less than its major world peers. The UK market generally remains disliked on the international stage, and its medium and smaller sized constituents are actively unloved. The reasons for this may be myriad, and politics has likely played its part, but as such the UK market is currently cheaper (using conventional valuation measures) than the US, Europe and the emerging markets. 

What can be forgotten in the time of Apple, Amazon and Microsoft, is that the UK is home to some great businesses, lots of which are household names. Our UK fund managers, where we use active strategies for portfolios, are excited about the prospects of many. This includes, for example, Domino’s Pizza, which grew total sales by 20% year-on-year in August and has opened 29 new stores. As well as Trainline (the online rail ticketing platform), which is growing rapidly across Europe as deregulation opens up networks to new entrants. To quote our manager ‘whilst there are risks from rail strikes and political change, Trainline offers highly attractive organic growth prospects at a significantly derated share price’. Furthermore, the importance of having healthy and growing capital markets, which boosts growth, employment and innovation, has not been lost on politicians. The Chancellor’s recent Mansion House Reforms could see pension funds voluntarily allocating up to 5% of their defined contribution funds into unlisted UK equities, from the 0.5% that is allocated today. The UK’s AIM market is technically unlisted, and it is estimated could see a boost of up to £50bn of new capital, which is even more significant when one considers the current total size of the AIM market is £75bn. 

Overall, we balance the risks of future economic weakness and a very expensive top end of the US market with the view that valuations elsewhere are more attractive and that those US corporate titans may retain their grip on markets for some time to come. Equities remain, in our view, one of the few asset classes that can deliver returns ahead of inflation over the medium to longer term, an argument that is becoming easier as inflation continues to fall. Therefore, we are not positioned aggressively in equity markets, but retain what we would term a neutral level of exposure in portfolios. 

Sources: FE fundinfo, 29/09/2023 

—

Park Hall Financial Services Limited is authorised and regulated by the Financial Conduct Authority.

The information within this article is for information purposes only and does not constitute investment advice. They represent the opinions of the fund manager and those of Square Mile. It does not contain all of the information which as an investor may require in order to make an investment decision. Any reference to shares/investments is not a recommendation to buy or sell. If you are unsure, you should seek professional independent financial advice.

Past performance is not a guide to future performance. The value of any investment and any income from it is not guaranteed and can fluctuate depending on investment performance and other factors. you could get back less than you invested.

Some investments, e.g. property, may be difficult to sell and will be subject to market conditions at that time. Their value is the opinion of an independent valuer.

Any reference to taxation is dependent on your own particular circumstances which are subject to change.