In the first quarter, most asset classes, including equities and bonds, experienced a rally. However, the second quarter brought a more mixed performance for markets. Equities outperformed bonds as investors started to price in a soft landing. All the while, Central Banks continued to raise rates more than anticipated in response to stickier inflation.
The Nasdaq, dominated by US tech companies, stood out with a 13.1% increase in Q2, driven by the excitement surrounding Artificial Intelligence (AI) ventures. A few tech stocks were responsible for the majority of the S&P 500's growth during this period. The concentrated rally in the US during Q2 demonstrated how an emerging mega trend like AI can propel markets upward, even in an uncertain macroeconomic environment.
The key question moving forward is whether AI will contribute to overall market earnings growth.
Sentiment towards equities improved during the quarter as concerns about a banking crisis subsided after the collapse of SVB and Signature. The bi-partisan resolution of the debt ceiling in May went to the wire, but saw a default averted. Despite signs of a slowing global economy, the US economy remained resilient in the face of rising interest rates, and better-than-expected corporate earnings drove positive returns for indices in the quarter. The Federal Reserve decided to keep interest rates unchanged at its June meeting, given that headline CPI fell to 4% and that the cumulative effects of 5% of tightening are yet to be felt. However, Chair Powell hinted that continued strength in the labour market would determine whether this was a pause or a ‘skip’.
In contrast to other developed markets, the UK market underperformed with a 2% decline in the quarter. Lower commodity prices, a strong pound, and concerns about higher interest rates weighed on the FTSE 100. While headline inflation fell from double digits due to energy base effects, core inflation surprised to the upside with new multi-decade highs. Taken together with a strong labour market, this drove the Bank of England (BoE) to adopt a larger 0.5% rate increase to 5% in June.
Further rate hikes are being priced in which has seen fixed-rate mortgage rates rise to around 6%.
While those re-mortgaging in the second half of 2023 are facing a significant increase, the overall impact of higher rates is less pronounced in the short term than prior cycles given the high share of fixed-rate mortgages and those owning houses outright.
The BoE was not the only central bank delivering hawkish surprises. The Canadian and Australian central banks unexpectedly re-started their hiking cycle demonstrating how vigilant central banks have become on any inflation overshoot. The European Central Bank raised rates as expected but raised the prospects of rate hikes continuing for a while longer. On the other hand, the loss of momentum in China saw its central bank enact 0.1% rate cuts. While the authorities talk about stimulus to boost growth prospects, equity markets in China and Hong Kong were down over the quarter. Given current valuations, the upside surprise of any action could be significant. The Bank of Japan has maintained it loose monetary policy. The resulting further weakening of the yen paired with a stronger-than-expected economy and cheap underlying relative stock valuations, drove Japanese equities higher. This has been further supported by investors wanting to diversify away from China, albeit remaining invested in Asia.
In summary, western central banks are closer to the end of their hiking cycle.
The effect of prior increases are expected to have profound economic effects over the coming quarters.
However, given recent inflation overshoots, data dependency will be key. Investors have turned their attention to AI and economic/earnings resilience, which has driven markets higher over recent months. While AI has tremendous productivity potential over the longer run, valuations for its darlings seem stretched. We continue to advocate for a selective approach of quality companies that can display long-term compounding of earnings.
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