Can you shed some light on the volatility we’ve seen in the markets this quarter, especially after the hopeful end we had to Q2?
Q2 concluded on a hopeful note, largely propelled by a select few companies, predominantly in the tech and AI sectors. The prevailing sentiment suggested we had navigated through the worst, with interest rates peaking and anticipated to decline by Q1 2024.
However, Q3, especially from mid-August, unfolded a different story. The Federal Reserve (herein referred to as FED) became the focal point for investors as it hinted at a prolonged period of high interest rates, extending beyond prior market anticipations.
While expectations leaned towards a recession in the developed world by Q3, the reality has been nuanced. Germany, Europe’s largest economy, has entered a recession, but the spotlight remains on the US, which has so far not only dodged a recession but also witnessed a dip in inflation, stable employment and ongoing economic growth. Thus, the narrative shifted from an anticipated downturn to a new mantra: “higher for longer” regarding interest rates.
How have markets adapted to this rhetorical shift?
Equity markets, particularly sectors sensitive to interest rate fluctuations, have experienced significant impacts. Growth companies and the real estate sector, both sensitive to interest rate adjustments, have been notably affected.
During the period under review, the S&P 500 IT Sector Index lost 5.6 per cent, while the S&P 500 Real Estate Index shed nearly nine per cent. The energy sector, conversely, witnessed double-digit gains in Q3, driven by Russia and Saudi Arabia’s decision to curtail production, inadvertently fuelling inflation.
Some sectors, especially those whose products are considered non-essential are also feeling the pinch as consumers increasingly find themselves having to make choices about which products they can afford to buy.
What should equite investors keep in mind?
Some analysts maintained a bearish stance even during Q2’s rally, citing the fragility of the market and its susceptibility to shock. This is supported by the fact that the markets have more or less moved in accordance with speculation on when the FED will start to bring interest rates down. This is partly why we’ve remained very cautious this year.
Hopefully, central banks get it right and guide the economy towards a soft landing
While investment strategies depend on individual investment objectives, risk tolerance and time horizons, among others, investors should steer clear of small-cap companies, particularly in economic downturns, due to their heavy reliance on debt, external funding, lack of pricing power and limited global reach.
What about the bond market?
The bond market, still exhibiting an inverted yield curve, has mirrored the belief that peak interest rates were behind us. However, recent signals from the FED have altered this perspective.
The curve is starting to flatten as long-term bond yields have risen more than their short-term counterparts, indicating a swift evaporation of long-term optimism. This move is presenting bond investors with attractive interest income opportunities, following years of very low interest rates.
The high-yield bond market, despite the looming recessionary fears, has demonstrated a robust performance, becoming one of the best-performing sectors this year. Companies have managed to refinance their debt, pushing it further into the future, which has sustained demand for these high-yield bonds.
We’ve been hearing a lot about China recently, both in terms of its economic performance and its relationship with the west. Do you foresee additional volatility ahead?
China is struggling on an economic front as we’ve seen with the problems with its real estate sector. Beijing had up till now been happy to prop the sector up, but it appears that this is no longer the case. China’s slowdown is already sending ripples through the global economy, and this could yet increase.
The European luxury market, which has traditionally been driven by affluent Chinese consumers, is feeling the pinch as China’s economic woes unfold. This downturn is not only a domestic issue for China but poses a substantial concern for various global sectors, especially those like manufacturing and automotive, which are very sensitive to negative economic data coming out of China.
Despite the apparent diplomatic strains, it’s pivotal to note that the economic ties between China and the West remain strong and intertwined. The complexity of these relationships means that disruptions in China’s economy have broad, impactful repercussions on global markets, potentially being a source of heightened volatility in the months ahead.
Given all of this, what sort of portfolio strategy should one be adopting going forward?
GM: Some fund managers are ultra bullish on an immediate free fall recession. For example, some believe that central banks will get it wrong and have exited high-yield positions and reallocated their portfolios towards long-term sovereign bonds. The strategy would have performed well during the second quarter, but as soon as the fed signalled a sustained period of high interest rates, it started to lose momentum.
At the current yields, short-term government bonds and other high-quality assets offer downside protection and attractive income return. As always, it requires a blend of caution and strategic risk management but for us the primary goal is to protect the value of the portfolio during these volatile times.
The rhetoric from Q3, especially regarding interest rates and economic tightening, is likely to permeate through Q4 and well into the next year and will result in a preference for quality over riskier assets.
Hopefully, central banks get it right and guide the economy towards a soft landing.
In the meantime, we will continue to benefit from opportunities in the bond market which is presenting us with the opportunity to add quality and increase interest income in our investors’ portfolios for the years to come.
This interview does not intend to give investment advice and the contents therein should not be construed as such. The company is licensed to conduct investment services by the MFSA, under the Investment Services Act. Investors should remember that past performance is no guide to future performance and that the value of investments may go down as well as up. For further information contact Jesmond Mizzi Financial Advisors Limited of 67, Level 3, South Street, Valletta, on Tel: 2122 4410, or email gabriel.mansueto@jesmondmizzi.com