Reflections of the CIO…

Since the end of the first quarter of this year markets have, overall, been meandering sideways. Some months, like April, are characterised by across the board weakness and others, such as May, are the opposite. This emerging pattern is one of sideways drift, as investors and asset markets search for both conviction and catalysts as we enter the summer months.

Looking back at May in isolation, it was a clear rebound month for equity markets, driven mainly  by a healthy economic environment and resilient sentiment. A few data releases here and there did point to a cooling down in the important US economy, but the more closely watched indicators still continue to illustrate ongoing strength. Bond markets, by contrast, have had a much tougher time this year, as wildly over optimistic expectations for interest rate cuts have been steadily dialled back in the light of economic strength and stickier than expected inflation numbers. As we write in early June, for example, investors now only look for one interest rate cut in the USA this year, compared to six or so in January.

May was also a month punctuated by a wide variety of political election news across the globe, covering countries as diverse as Mexico, South Africa, India and the UK. Apart from the UK, where the calling of a surprise early election did not cause much of a reaction in markets, elsewhere there have been several large knee jerk reactions in currency and stock markets to the local results. We do not want to draw too deep a point from these election results or the initial market reactions, but it is also clear to us that even in regions where the outcome was ‘expected’, the electorates still managed to spring surprise ‘twists’ on pollsters and investors. It is a lesson we will keep in mind as we head into the important US elections in Q4, where volatility around the event could be particularly high.

Other trends of note in May included the continued outperformance of larger, higher quality, growth companies compared to smaller, lower quality, value-like corporations. Some of these performance gaps are the widest we have seen for many years, prompting us to think about how and when we should be moving more aggressively in portfolios to exploit the dislocations. Our starting point overall is one where we have no particularly large exposure to one factor over another, making the June asset allocation process a good point to focus in on which particular dislocations are attractive tactically as well as strategically. An example would be UK assets, which look very cheap compared to the rest of the world after a long period of de-rating. The corporate sector is already acting on this opportunity with the UK seeing a marked pick up in merger and takeover activity. With the economy seemingly having passed through a modest slowdown and forward indicators looking for current positive momentum to continue in the months ahead, we suspect there are probably enough catalysts about to be increasing our UK exposures across mandates. If we do, we will update you after the asset allocation meeting in June.

As we wrote in last month’s report, the summer period is still expected to be one where markets wrestle with a wide range of particularly tricky issues. An uncertain interest rate policy in the USA, plus tougher comparisons for inflation and earnings, probably imply a more muted market performance in the next quarter or two, compared to what we have enjoyed year to date. Beyond this period, we should be in an environment of synchronised interest rate cuts in developed nations, an environment which should be very supportive for riskier assets. However, we are not there yet and for the moment we think it prudent to continue to wait for a clearer view of underlying inflation and growth trends before making changes to portfolios.