Inflation was exhibiting signs of tentative moderation towards the end of 2022, leading many to believe the interest rate outlook in 2023 would moderate and therefore provide some guidance on asset pricing. It hasn’t quite worked out as hoped. Persistent inflation and challenges in the banking sector have put pressure on central banks’ interest rate policies, which has made for a pretty volatile first three months of the year.
January provided much-needed relief, as investors were glad to put 2022 behind them and most regions and asset valuations rose. However, the strong gains posted in January were impacted by improving economic data posted in February. In theory, improving economic data should be good for stocks. However, there were concerns that this positive data would fan the flames of inflation, leaving investors with a lingering belief that the US Federal Reserve would likely keep rates higher for longer than expected.
In mid-March, echoes of the 2008 banking crisis caught investors by surprise, as Silicon Valley Bank (SVB) in the US struggled to raise fresh capital to meet deposit outflows, forcing the Federal Reserve to step in to calm markets. Just weeks later, we also saw central bank time in Europe, with the last-minute acquisition of Credit Suisse by UBS, brokered and enforced by the Swiss central bank. Eleventh-hour central bank recuses in March, saw markets manage to eke out gains by month's end.
Asset classes
The aggregate of government global bonds ended Q1 virtually unchanged, despite the major central banks continuing to raise rates. Yields rose in February due to stronger-than-expected economic data, which fuelled concerns that the US Federal Reserve and other central banks would follow through on their intentions to continue to raise rates to cool inflation. The falls in bond prices seen in February wiped out the gains made in January. By mid-March global government bond yields had tumbled as investors sought out safe haven assets in light of the fallout in the banking sector.
As fears of contagion spiked across the banking sector, investors assumed central banks would ease up on rate hikes in March. This wasn’t to be the case as the Fed, Bank of England (BoE), and the European Central Bank (ECB) raised rates later in the month. This saw yields on government bonds remain lower than where they started the year.
The yield on the 2-year Gilt fell from 3.70% at the start of January to 3.45% by the end of March1. The BoE raised rates over the period from 3.50% to 4.25%2. The yield on US 2-year Treasuries fell from 4.43% at the start of January to 4.06% by the end of March2. The Fed raised rates over that period from 4.25 - 4.50% to 4.75 - 5.00%3. The Bloomberg Global Aggregate bond index rose slightly by 0.21% over the quarter (this index consists of investment-grade fixed-rate government and corporate bonds).
It continued to be a challenging environment for property assets during the quarter, with the MSCI ACWI REITS index returning -1.37% in Q1. The asset class continued to disappoint as interest rates on other low-risk securities such as government bonds rose, providing a more attractive, lower-risk opportunity for investors.
Gold got off to a good start in January, like other assets, boosted by optimism that central banks looked poised to slow the rate of interest rate increases. However, it slipped back to breakeven by the end of February, as persistent inflation indicated rates could continue to move higher for longer. The bank woes of March saw the metal shine once more, as investors sought the safe haven of gold. The metal rose 5.90%, recording the highest quarterly and monthly close of $1,986, based on the spot price of the LBMA Gold Bullion Sterling/Troy Ounce index. Gold was the best-performing asset class over the quarter.
Gold aside, commodities, the best-performing asset class of 2022, was by far the worst-performing asset during Q1 with the Bloomberg Commodity GTR Index falling -9.05%. Rising bond yields in February dampened enthusiasm for the asset class as did the market concerns of a recession.
Despite market volatility, equities fared well, holding onto gains of 4.81% based on data from the MSCI World Index. Rate-sensitive technology was a real bright spot in the asset class as it received a boost on anticipation that rate rises would slow in the months ahead. The MSCI ACWI Information Technology and Communication Services index rose 17.16% over the period.
Regions
European markets were by far the stand-out regional performer in Q1, despite participating in the broad market sell-off in mid-March, led by the tensions in the banking sector. The Euro Stoxx index rose 10.87%, with the UK market up a mere 3.16% in comparison and the third-best performing region. European markets continued their rally which began in late 2022, driven higher in part by relatively cheap valuations. It was expected there would be a widespread depression in Europe due to the conflict in Ukraine and the resulting energy crisis (continental Europe has historically been reliant on Russian imports of oil and gas). However, this has been largely avoided due to a mild winter in the region. Moreover, the surprise economic expansion reported in Q4 raised hopes that the eurozone may avoid a recession. The lifting of Covid-19 restrictions in China has also provided a boost to the economy, resulting in the reopening of luxury goods trading by the French and Italians, as well as benefiting Germany's industrial sector.
The US took the second spot, rising 4.44%, lifted by the performance of technology-led returns.
The UK market was buoyed up by signs the economy performed better than expected in February. During the month, the UK services sector returned to growth and it was reported government borrowing fell unexpectedly in January. However, weakness in the commodities market during February weighed on the UK indices, where energy and materials make up approximately 20% of the index. Despite optimism in February, commodity prices continued to weigh on market returns in March. Even with signs of growth in the UK economy and news reported in March that UK mortgage approvals for February rose more than expected, it wasn’t enough to buoy domestically focused UK mid-caps over the month and ending Q1 virtually flat.
All of the regions covered delivered a positive return over the quarter, with developed markets outperforming emerging markets and Growth as a style outperforming Value, based on the MSCI AWCI Growth and MSCI AWCI Value indexes.
China’s late 2022 rally faltered over the quarter as investors searched for a catalyst to sustain the run, despite a pick up in manufacturing its pace was slowing. By the end of the period, the MSCI China H index had risen 1.78%. The possibility of rates staying higher for longer, supporting a stronger US Dollar, weighed on emerging markets returns, managing a gain of only 1.14%.
TILLIT Universe
Silver led precious metals. Silver is often considered in the same breath as gold, although it tends to be more volatile and more affordable. Like gold, silver is often considered a shield against market turmoil and a store of value. Silver often outperforms gold in such periods, supported by its additional industrial uses.
Allianz Strategic Bond fund proved to be a good diversifier from equities over the period returning 4.62%. The fund is currently loaded with triple-A-rated government-issued bonds.
Biotech funds continued their slide from Q4 2022 into Q1 2023. The sector continued to be hit by US drug pricing and investor concerns. The Biotech Growth Trust returned -13.96%, mainly driven by its bias toward small-cap stocks, which were hit hard in March. For additional context, Index MSCI AC Americas Small Cap was down -5.8% in Q1. Approximately 80% of the Biotech Growth Trust’s assets are currently invested in US companies.
Property continued to struggle in Q1 and it's therefore no surprise to see Threadneedle TR Property Investment Trust among the worst performers over the quarter. However, the returns of the trust are significantly lower compared to the sector's performance. Raising rates and bank liquidity turmoil was a key culprit weighing on investor sentiment.
The market turbulence initiated by the collapse of SVB spooked investors in areas such as financial services and private equity, which has a negative impact on private equity specialists, including Pantheon International. Pantheon has approximately 40% exposure to technology companies and the trust's valuation struggled to recover as the quarter came to a close.
Continued economic turbulence continued to weigh on smaller companies in Q1, which saw both Aberforth Smaller Companies Trust and Artemis US Smaller Companies struggle. However, continued depressed valuations of small-caps should continue to present buying opportunities for the managers of these funds.
Looking ahead
Persistent inflation and cautious sentiment toward the banking sector leaves the market outlook unclear. The outlook is further hindered by The Organization of the Petroleum Exporting Countries (OPEC) and their allies including Russia, stunning markets on the 3rd April by announcing production cuts of about 1.66 million barrels per day. This is likely to hinder any optimism of cooling cost pressures ahead4.
Central banks have to tread a delicate balance between raising rates to combat inflation while calming investors’ nerves about the banking sector. Even if the central banks can convince markets not to worry about bank liquidity, there remains a risk that monetary tightening is taken too far. The current situation has been fuelled by the central banks' tightening cycle and may now become a factor that slows the rate of interest rate increases. It has led to increased volatility and sent shivers through financial markets and could weigh on growth and subsequently on inflation. Currently, bank risks appear to be idiosyncratic with SVB being affected by different factors to Credit Suisse (interest rate risk for the former and a combination of Russian sanctions, mismanagement, and compliance failures for the latter). There is no reason to assume a financial crisis is imminent. However, investor sentiment and overreactions can sometimes be the straw that breaks the camel's back.
Given the inflation and interest rate backdrop, it remains unlikely we are heading back to the types of capital returns investors have enjoyed since the global financial crisis in 2008. If markets are teaching us anything at present, it is the need to be more considered in our investment strategies.
Sources: FE Analytics (quarterly performance figures for funds, regions, asset classes, and sectors 31/12/22 to 31/03/23). Qualitative commentary from TILLIT meetings with fund managers.
(1) Source: UK 2-year Gilt yield and US 2-year Treasury yields
(2) Source: Bank of England interest rates
(3) Source: Federal Reserve interest rates
(4) Source: OPEC cuts
Date of publication: 7th April 2023
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