By Robert Ducker
The recent escalation in the Middle East in the aftermath of the horrible attack in Israel is a key area of concern for investors. First and foremost, the loss of human life is a terrible consequence of war, but we were also reminded of the impact this can have on the global economy, as the US Dollar and Oil inched higher. How this conflict evolves could have severe current and future implications on the global economy.
During the third quarter most asset classes we follow, except for credit, generated negative returns against a backdrop of heightened rates volatility. Economic data is divergent, and inflation remains high but moderating though corporate earnings growth has so far remained resilient. The strength of the US economy has surprised markets, despite fears of a sudden slowdown in Q4 due to: (1) end of student loan mortarium; (2) tighter financial conditions; (3) replenishing of savings by households; (4) UAW strike; (5) higher commodity prices; and (6) Government shutdown.
In the rates market, the “higher-for-longer” narrative explains the sell-off in yields seen in 3Q23, with the US 10-year paper yielding 4.6% by the end of September or 73bp higher than the yield at the end of June 2023. It remains to be seen whether the tightening seen in financial conditions is sufficient or if the FED will hike rates further during the November meeting. We expect some of the recent tightening to reverse once it becomes more obvious that peak rates have been reached. Also, with less headwinds from policy decisions, we would expect investors to find the current yield offered on sovereign paper to be attractive relative to that available for other riskier asset classes.
On the credit front, we found that risks around policy decisions weighed on the safer US credit buckets, as USD investment grade (“IG”) lost 3.1% during the quarter as opposed to a small gain for EUR IG (+0.3%) where potentially the headwind from more tightening by the ECB is less relevant. Bearing in mind the risks to the global economy, the IG space could be preferred by investors relative to high yield (“HY”), despite the yield differential between the two. This is because the spread differential for HY is tighter compared to history, which suggests that protection in the event of continued deterioration in the global economic fundamentals is limited.
On the equity side, the combination of rising real yields and growth eluding both China and Europe weighed on the asset class performance in 3Q23. The only exception was the FTSE 100, where its high allocation to the energy sector benefited from the strong rally seen in oil during the quarter. The sell-off was quite broad and indiscriminative. Using two US indices as a gauge to exclude region preference from the equation, the Nasdaq (growth stocks proxy) lost 3.9% in 3Q23 compared to 2.1% loss for the Dow Jones Industrial Average (value stocks proxy). Also of note is the weakness seen in the German stock market (a China proxy), with the index falling 4.7% during the period. We believe that the upcoming earnings season, as well as a stabilisation in rates, will be a key catalyst for the equity market. In our opinion, equity market performance in Q4 will be impacted by: (1) the uncertainty around the economic outlook, which is growing, and any slowdown in earnings growth would weigh on equities; (2) a strong recovery in China which would be helpful for the European equities, but increased demand for oil and an acceleration in economic activity would likely add to inflationary pressures; and (3) peak rates which could potentially make the fixed income market attractive relative to equity markets.
Commodities rallied strongly, as the S&P GSCI commodity index gained c.14%, recovering from a c.11% loss in 1H23. Within commodities, we note that Brent Oil had a particularly strong quarter, with prices up c. 30% in the period, following a decline of c.12% in 1H23. Also, the US Dollar strengthened during 3Q23, with the Dollar basket up 3.2% during the period after a 0.6% decline in 1H23.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.