Our view on the investment markets

Market Review

July 2024

Whilst politics was often making news headlines, for investment markets the second quarter focus continued to be primarily on economic growth and inflation data and considerations of how soon major central banks would be looking to cut interest rates.

Economies have largely proved to be more resilient than feared in the face of high interest rates, and alongside broadly positive corporate data has enabled most equity markets to achieve further gains over the quarter. Inflation has continued to trend downwards towards more normal levels and some countries have already seen interest rate cuts, but sticky inflation in some areas has softened the scale and pace of previously expected rate cuts, and led to another mixed quarter for fixed income markets.  

The key US economy continues to see growth, but has shown some signs of slowing down from a position of relative strength, whilst there have been signs of improvement in 2024 for some of the previously weaker economies such as the UK, parts of Europe and China.

Improvements across energy, food and goods components has seen headline inflation levels improve significantly from the 40-year highs we saw in 2022, with the UK consumer price inflation figure for May returning to the 2% target. Importantly, the direction of travel for interest rates is now lower and the European Central Bank added to the list of cuts in June, but still elevated inflation in areas like the service sector and wages has held the UK and US back from reducing rates yet, although some movement is expected in the second half.

Geopolitical conflicts continued but saw little impact on markets, with immediate attention more focused on elections. The possibility of the far right winning the French election created some adverse market reactions and the first US Presidential debate raised some questions about their November election, but in comparison the UK election called for July was seen as a relatively benign event.  

Equity markets continued their good start to 2024, with second quarter gains being led by emerging markets, the US and the UK. Whilst not benefitting from the ongoing strength of the technology sector and optimism over the potential of artificial intelligence, the UK FTSE All-Share index still achieved a second quarter gain of 3.7%, which took first half returns to 7.4%.

International equities overall saw sterling terms gains of 2.9% in the quarter and 12.4% for the half year, with the dominant US market and its large technology sector continuing to drive this area forward. Japanese equities have also been strong, but weakness in the Yen has impacted their returns to a UK investor. A better quarter for emerging markets saw their 2024 returns exceed 9%, whilst Asia Pacific ex-Japan remained a relative laggard.

Fixed income markets saw a relatively flat quarter, with the sticky inflation elements, delayed rate cuts and concerns over the level of bond issuance to fund fiscal deficits continuing to hold government bonds back, with UK gilts falling -0.9% and -2.5% for the first half. Index-linked gilts saw larger losses, whilst 6-month returns moved to flat for corporate bonds, 2.8% for high yield bonds and 2.2% for emerging market debt.

UK commercial property has seen both rental growth and improving prices in areas other than the office sector, with good levels of income support helping deliver an expected overall first half market return of around 2%.

The returns on cash deposits have continued to benefit from the UK bank rate being held at 5.25%, although rate cuts are expected to begin later this year. 

Market Outlook

Multiple 2024 elections and ongoing geopolitical issues continue to produce a lot of background noise and uncertainty for markets to navigate, but to date they have continued to remain relatively focused on the progress of inflation reduction, economic and corporate growth and the scope for central banks to begin reducing interest rates, whilst also remaining excited about the potential benefits of artificial intelligence.

Previous worries about weakening global economic growth have largely subsided, as most economies look set to benefit from consumers seeing above inflation wage increases, relatively low unemployment, supportive fiscal policies and the likelihood of lower interest rates. Overall growth will likely remain a little below trend, but is becoming more balanced as the relative strength of the US economy softens and the weaker economies such as the UK, Europe and China are expected to see growth continue their recent recovery.

The period of interest rate increases in response to the recent period of significant inflation is seen as behind us, and with inflation now much lower we have already seen some countries lower their rates. There are still areas where inflation has remained sticky, especially in areas where elevated wage increases have a larger impact such as the service sector of the economy, and this is why central banks have been delaying the amount of rate cuts that were anticipated at the start of the year. Once they gain sufficient comfort that inflation is fully back under control, we are still expecting a series of cuts over the next few quarters, with the UK bank rate expected to move to the 3-4% range from the current 5.25%. Whilst this should still provide a useful low risk option for savers alongside other investment assets, cash is unlikely to match their medium to long-term return potential.

With the last few years having seen a major pandemic, conflicts in Europe and the Middle East, 40 year high inflation and a significant increase in interest rates, equity markets have been remarkably resilient. It has been a more difficult period for most bond and property markets, although it has seen a welcome improvement in the yields available on assets such as government and corporate bonds.

Key to this equity market resilience has been how well economies and companies have coped in the face of much higher interest rates, and the rapid improvement in inflation which has facilitated the expected turn in the interest rate cycle. The dominant US market has also seen significant benefits from the growth of its large technology sector, which has been boosted by excitement over companies that are seen as beneficiaries of the rapid growth of artificial intelligence (AI).

Inflation progress will likely continue to be a key driver of investment returns, and whilst there are still pockets of inflationary concerns such as wages and shipping costs, overall it is forecast that inflation is expected to settle down at levels close to central bank target rates. Alongside resilient economic growth and lower interest rates, this has the potential to continue to provide a relatively positive fundamental backdrop for most investment assets. Key risks to this scenario comes from inflation remaining stickier than expected and also if any of the geopolitical tensions escalate or elections result in less market friendly policies.   

The substantial fall in many bond prices in recent years has been painful for investors, but the resulting improvement in yields has meant that fixed income assets are once more offering their traditional attractions of both reasonable income and return potential and also useful diversification benefits within mixed asset portfolios. Lower inflation and interest rate cuts will especially help this area, but high levels of government debt in many countries and heavy bond issuance to fund fiscal deficits will likely act as a headwind for returns.  

With 10-year UK government bonds (gilts) now offering yields of over 4% alongside the risk reduction benefits they provide in many potential stress scenarios, we have been rebuilding exposures in our portfolios. Other fixed income options such as investment grade corporate bonds, high yield and emerging market debt offer even more income to compensate for their greater risk. These additional yields over gilts (known as spreads) are narrow by historic standards, but default risks are relatively low and overall yields of around 5-8% offer some attractive levels of income.

Equity markets have also been caught up in the ebbs and flows of inflation and interest rate expectations, with occasional short-term reactions to political and geopolitical events, but the improving growth narrative and expected rate cuts has continued to drive many markets to all-time highs. After such a strong run for equities since the selloffs of 2022 the edge has been taken off some of the previous valuation attractions, but despite some notable exceptions in areas such as the fast growing leading US technology stocks, many equities continue to be priced at or below their long term average valuations.

There are always risks when it comes to investing and political and geopolitical risks are nothing new, although we have to acknowledge that they are somewhat elevated currently, and issues such as a shift away from the benefits of globalisation towards economic fragmentation and rising trade tensions and tariffs does pose a potential risk to growth. However, resilient economies and looming rate cuts should continue to support markets and there are other potential positive structural drivers from developments in areas like AI, decarbonisation and healthcare. With their long track record of delivering above inflation growth, we retain our longer term conviction in equities and their ability to offer reasonable income and growth potential for patient investors who are able to cope with any shorter term volatility.

The sector composition of the UK market and its lack of technology exposure has seen it behave quite differently to other markets in recent years, and it has also been impacted by the long term headwinds of investors reducing their UK exposure and elevated political risks since Brexit. Having been out of favour for so long valuations are now at notable discounts to other markets, even allowing for the relative lack of growth stocks. With the UK now potentially seen as politically relatively stable, and with an improving domestic economy and a market that offers global exposure with an attractive dividend yield and is attracting corporate takeover interest, there is the potential for investor sentiment to turn towards the UK.

Within international equities the US remains the dominant market, having benefitted greatly over the last decade from their above average exposure to growth and technology stocks, the strength of the dollar, resilient consumer spending and substantial fiscal packages. As a home to many excellent companies the US continues to form a substantial part of our global portfolios, but with a significant election looming and valuations above all other regions, we continue to look to diversify exposures towards other more attractively valued equity markets.

Europe has seen challenges from its previous reliance on cheap Russian gas and exporting goods to China, but like the UK offers many good companies and is seeing an improving economic outlook and offers reasonable valuations. Asian and emerging markets offer a wide range of countries with different attributes and attractions, but performance has been held back by the strength of the dollar and weakness in China due to their disappointing economic recovery from Covid, property market weakness and tensions over their relationship with the US. Whilst emerging markets overall continue to see elevated risks, they still offer superior economic growth and relatively attractive valuations, which offer the potential for good longer-term performance.

Having stabilised in recent quarters, the UK commercial property market is set to benefit from the improving economy and lower interest rates. The office sector may continue to struggle, but growth elsewhere and good income support has the potential to deliver mid-single digit overall UK property returns for 2024. Overseas real estate and infrastructure are being introduced to relevant portfolios to provide additional diversified sources of returns.  

In conclusion, whilst economies have proved surprisingly resilient and inflation continues to return to more normal levels, there remain potential challenges to this improving environment from areas such as escalating political or geopolitical risks or stickier inflation further delaying rate cuts. However, if inflation continues to subside as expected we should see a welcome turn in the interest rate cycle which often proves a useful catalyst for market sentiment across many investment asset classes. The previous increase in interest rates sees both returns on cash and the yields available on fixed income assets offering much improved value and they now provide useful attributes alongside equities in mixed asset portfolios. The strong run for equities has softened their shorter-term attractions, but many UK and international equities remain relatively attractively valued given an improving corporate environment. Overall, suitably diversified portfolios containing equities and fixed income (and property and infrastructure where available) still offer the potential to deliver reasonable medium to longer-term investment returns.

Paul Glover
Chief Investment Manager
July 2024