Economic and Market Overview
The second quarter saw interest rates rise in the key developed economies, whilst inflation remains above central banks’ target, a key concern for the policy makers. The inflation data remains a dominant point of attention for the markets as it attempts to figure out how much higher rates are likely to go. The rates are nearing its peak in the US as inflation fades, meanwhile, the UK is expected to raise rates further as inflation remains relatively sticky but expected to come down. Commodity prices, a key contributor to inflation experienced a decline during the quarter – oil prices eased off with the expectation that demand is expected to drop as major economies gradually enter into a recessionary phase. The UK avoided entering a recession at the start of the year, while growth in the US remained positive. However, the Euro Area entered a small technical recession. On the political front, the US debt ceiling drama and recent escalation in Russia-Ukraine conflict were key factors that kept markets volatile during the quarter. June saw a counter-offensive by the Ukrainian army and a rebellion by parts of Russia’s mercenary army, the Wagner Group. Meanwhile, the OPEC and its partners (OPEC+) decided on June 4 to maintain its production cut targets for 2023, but agreed to set a new, lower target for 2024.
Global equities gained during the second quarter with US & Japanese equities outperforming and China underperforming. Japan’s Nikkei 225 Index took a leading position during the quarter under review with 18.4% return and above 27% on YoY basis. The US equities barometer, S&P 500 Index, surged 8.3% in the second quarter and DJ Islamic Markets Index increased by 7.27% while EU STOXX 600 posted 0.9% only. The US equity market performed strongly during Q2 and the first half of 2023 – mainly due to growth stocks in the technology sector, driven by Chips and Artificial Intelligence (AI) enthusiasm. Year-to-date US equity market returns have been driven by just seven companies, namely Apple, Microsoft, Alphabet (Google), Amazon, Nvidia, Tesla and Meta (Facebook). These stocks make up nearly 26% of S&P 500 index. However, the Chinese Shanghai Index declined by 2.2% and UK FTSE 100 Index dropped 1.3% during Q2 2023. During periods of uncertainty, investors generally prefer safe haven assets, however, they dropped in value in the second quarter. DJ Commodity Index plunged almost 5%, crude oil declined by 6.6%, gold dropped 2.4%. Moreover, DJ Sukuk Index ended the second quarter almost flat.
The UK households are facing challenges from increased living costs and higher interest rates. Inflation rate remained steady at 8.7% in May 2023, unchanged from the previous month. However, the core inflation, which excludes volatile items such as energy, food, alcohol and tobacco rose to 7.1% in May, the highest since march 1992 and above market expectations. On the policy front, the Bank of England (BoE) raised interest rates twice in the second quarter. During its recent meeting in June, BoE raised its policy rate by 50 basis points to 5%, marking the 13th consecutive hike – the market had anticipated a smaller 25 basis point rate hike. With higher rates and further rate hikes to come, the UK stock market suffered with notable underperformance for the property sector in particular. The Bank of England (see charts below) estimates over 3 million households will experience increase in monthly costs by Q4 2023 and many more thereafter. As fixed-rate mortgage deals expire and households renew their mortgages, the average cost of mortgage payments will continue to increase. Higher monthly mortgage costs are likely to negatively impact both consumer spending and the housing market – and perhaps improve Labour party’s electoral prospects! On the growth front, the UK economy expanded 0.1% on quarter in the first three months of 2023, the same as in Q4 2022.
During the quarter, the US Fed key policy rate was raised to the range of 5%-5.25%. The Fed raised rates by 25bps during its May meeting, whilst keeping it constant during its recent meeting in June. After the FOMC decision, Fed Chair has reinforced several times the need to raise rates further this year. Over the past year we have seen inflation come down. The annual inflation rate in the US slowed to 3% in June of 2023, the lowest since March of 2021 and compared to 4% in May and expectations of 3.1%. The slowdown is partly due to a high base effect from last year when a surge in energy and food prices pushed the headline inflation rate to 1981-highs of 9.1%. With core inflation (4.8% in June) still above Fed’s target and tight labour market, the possibility of further monetary tightening or at least maintaining restrictive policy for relatively longer period seems likely. Meanwhile, the US economy grew by an annualised 2% on quarter in Q1 2023, well above forecasts of 1.4%.
Apart from the headwinds driven by uncertainty about the economy and fears of a recession resulting from the tough monetary policy and credit tightening, the risk that US could default on its bills to be paid in June mostly dictated the markets in May. During the quarter, we saw debates over raising the debt ceiling from all sides. Republicans had refused to raise the country’s borrowing limit unless Democrats agreed to cut spending, leading to a standoff that was not resolved until weeks of intense negotiations between the White House and House Speaker Kevin McCarthy. The final agreement, passed by the House on Wednesday, 31st May and the Senate on Thursday, 1st June suspends the debt limit until 2025 – after the next presidential election – and restricts government spending. It gives lawmakers budget targets for the next two years in hopes of assuring fiscal stability. On 3rd June, President Biden signed into law bipartisan legislation that suspends the $31.4 trillion debt ceiling, narrowly avoiding an unprecedented U.S. default that could have pushed the economy into a recession and financial crisis. Historically, the debt ceiling has been raised every time the US borrowings reached to that level. Congress has always acted when called upon to raise the debt limit. Since 1960, Congress has acted 78 separate times to permanently raise, temporarily extend, or revise the definition of the debt limit – 49 times under Republican presidents and 29 times under Democratic presidents. Congressional leaders in both parties have recognised that this is necessary.
In June, the ECB raised interest rates by another 25bps, bringing the rate on main refinancing operations to 4%, the highest level since the 2008 financial crisis, and the rate on the deposit facility to a 22-year high of 3.5%. Also, President Lagarde stated that the ECB had more ground to cover and would likely continue raising rates in July. The consumer price inflation rate in the Euro Area decreased to 5.5% in June 2023, down from 6.1% in the previous month. However, inflation in Germany increased to 6.4% year-on-year in June 2023, rising from the 14-month low of 6.1% recorded in May. Amongst the developed economies, the Euro Area was the first to enter a small technical recession after its economy shrank 0.1% on quarter in the first three months of 2023 and the last quarter of 2002. In Q1, among the bloc’s biggest economies, the GDP contracted in Germany (-0.3%) and the Netherlands (-0.7%) while expansion was recorded for France (0.2%), Italy (0.6%), and Spain (0.5%).
The Chinese economy grew by 2.2% on a seasonally adjusted basis in the three months to March of 2023, picking up from an upwardly revised 0.6% growth in the fourth quarter. This was the third straight quarterly expansion, coming after Beijing lifted COVID curbs last December. In contrast to the western developed economies, China eased its monetary policy to boost economic activity. The People’s Bank of China (PBoC) slashed two key lending rates for the first time since August 2022 at the June fixing, as authorities seek to prop up growth. The one-year loan prime rate (LPR), which is the medium-term lending facility used for corporate and household loans, was lowered by 10bps to 3.55%; while the five-year rate, a reference for mortgages, was trimmed by the same margin to 4.2%. Inflation remains low in China relative to developed economies. The annual inflation rate edged up to 0.2% in May 2023 from April’s 26-month low of 0.1%.
Amongst other major economies, Japan has been in the light given its stock market performance this year due to a number of factors including interest from foreign investors anticipating progress on corporate reforms, relatively ‘cheap’ valuations, easy monetary policy and long-awaited return of inflation. The Bank of Japan kept its key short-term interest rate unchanged at -0.1% and that of 10-year bond yields at around 0% in its June meeting by unanimous vote. The annual inflation rate in Japan unexpectedly declined to 3.2% in May 2023 from April’s 3-month high of 3.5%. Meanwhile, the Bank of Canada unexpectedly raised the target for its overnight rate by 25bps to 4.75% in June 2023. On the political front, in June the Turkish president Recep Tayyip Erdogan took oath of office for a new five-year presidential term, extending his rule into a third decade. This is despite the economy facing a cost-of-living crisis, where inflation stands at 38.21% in June and the currency having depreciated by over a third against the US dollar since start of the year. The Central Bank of Turkey raised its benchmark one-week repo rate by 650 bps to 15% on June 22nd, pushing borrowing costs to the highest since November 2021. Markets were expecting a bigger increase to 21%.
To summarise, we are experiencing higher interest rate and slow/negative growth environment in the US and Europe. Japan still maintains a low rate policy, whilst China is easing its monetary policy to encourage economic growth. Inflation is gradually moving downwards, but still remains above central banks’ target – a key concern for policy makers.The US stock market and the big ‘seven’ stocks in particular have performed really well over the past months, however, we can see growing divergence between the big ‘seven’ (forward PE ratio over 30) and the rest of the S&P 500 index (forward PE of around 15). But it’s important to remember that many risks remain for the economy and markets. Multi-decade highs in inflation, high interest rates, geopolitical tensions and rising recession risks pose a challenging environment. The impact of higher interest rates will increasingly be felt across the economies and restrictive monetary policy risks further exposing financial vulnerabilities, in particular in economies with high debt. Uncertainty over the evolution of Russia-Ukraine war and its global impact remains a concern. As active investment manager, we remain vigilant on prevailing risks and continue to manage risks and adjust portfolios where appropriate.
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Data as of 30 June 2023. This article is for information only. Please do not act based on anything you might read in this article. Past performance is not a reliable indicator of current or future returns. This article contains general information only and does not consider individual objectives, taxation position or financial needs. Nor does this constitute a recommendation of the suitability of any investment strategy for a particular investor. It is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any trading strategy to any person in any jurisdiction in which such an offer or solicitation is not authorised or to any person to whom it would be unlawful to market such an offer or solicitation.
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