Reflections of the CIO…

After the broad based, ‘upwards only’ momentum of the first quarter of this year, the second quarter market performance was a little bit more volatile, finishing with a mixed result in the final month of June. There now appears to be much more nuance in the overall investment environment, with investors paying attention to a wider range of local factors, in contrast to previous months when a wave of positive sentiment was lifting nearly all assets, seemingly regardless of their individual merits.

The market mood does remain very much ‘risk on’,  but at the same time we can now also see a higher degree of volatility around this rising trend. A resilient global economy, led by the USA,  is the main positive influence, driving solid corporate results and helping to keep investor expectations bullish. So far at least, this part of the picture has remained unchanged. The main sources of volatility are elsewhere, centring instead on the political and inflationary arenas.

Longer term inflation readings are still falling overall, but the nearer term trends are harder to interpret and consequently harder to price. This is keeping bond markets more nervous than their equity cousins, with prices flip flopping month by month as the future path for inflation, and hence interest rates, is constantly reassessed. This pattern is expected to continue for several more months at least, until there is sufficient data available to form a higher conviction opinion.

Geopolitically, the hot spots in the Middle East and Ukraine continue to bubble away with little real movement on the core issues. The oil price did rally sharply after a weak May, but we think this had more to do with seasonal buying patterns than anything else. Gold was broadly unchanged. At the more local level the elections in France had a negative influence on European assets, given that nobody had seen the event coming in advance and few agreed with President Macron’s strategy. Across the Atlantic, a poor performance by President Biden in a televised debate has sparked uncertainty over whether he might withdraw from the race entirely or, by staying in, boost the chances of a Trump presidency. Both the French and US bond markets reacted to their specific news events and, although the immediate effects were short lived, the potential for events in the political arena to feed directly into market performance is very real and something we need to carefully consider, especially as we move closer to the US elections.

As we move into the summer proper, we would expect the current pattern of more volatile returns to continue. A few more months of inflation data plus another corporate earnings season and a sharpening focus on the US elections will provide plenty of data points for investors to mull over. The underlying dislocations and patterns of performance remain as they were at the beginning of the year. Larger, higher quality growth companies are outperforming smaller, more value style investments. US assets are generally outperforming assets outside of the USA. The dollar remains strong and equity market leadership remains very narrow – not just in the USA where the ‘magnificent 7’ technology companies have been driving index returns for many months – but also across the Pan European market, where a similar group of six very large companies is also driving the lion’s share of market performance.

These trends have been in place for months and have not yet shown any serious signs of mean reverting. However, as the valuation gaps continue to expand and expectations for the future climb ever higher, the risk reward picture is becoming more skewed. We have been gently adapting to this shift by shifting money away from the more extended market themes described above and towards assets which have been relatively out of favour. We have been doing this partially as it is sensible from a risk management point of view, but also because we see more upside in the long run from assets with low expectations priced in. It is a nuanced process, with no big changes month on month, but one which we think will bear fruit as we head into the second half of the year and beyond.