First the worst, second the best? A look at at the second quarter of 2023: Bonds, Inflation, and Equity Returns

The second quarter (Q2) of 2023 witnessed significant developments in global financial markets, characterised by the underperformance of bonds versus equities, concerns regarding inflation, and divergent equity returns across various regions. This update provides an overview of the Q2 market performance, sheds light on the factors influencing inflationary trends, and explores the diverse returns observed in equity markets worldwide.

Bonds

Bond Market Performance and Inflation Concerns: During the second quarter, corporate bonds outperformed government bonds, particularly in the United States. 

A bond in the investment context is essentially a loan, where the investor is the lender. Government bonds, also known as gilts, allow governments to borrow money to finance public spending. Corporate bonds allow companies to invest in their business or undertake new projects by raising funds from investors.

While corporate bonds experienced a minor decline of 0.2%, government bonds fell by 1.3%. The underperformance of government bonds can be attributed to increased interest rates resulting from higher inflation and central bank policies. Additionally, the UK faced challenges due to higher and sticker inflation than developed market peers, which negatively impacted its bond market performance compared to other regions.

Corporate Bond Yield Spreads: Analysing corporate bonds necessitates considering their yield spreads over government bonds. A yield spread is the difference between the yield, or interest, on different types of debt instruments, in this case corporate bonds v government bonds. In Q2, yield spreads narrowed due to a reduction in the number of bonds issued, resilient corporate fundamentals, and positive economic growth outlooks. However, despite the declining spreads, rising government bond yields prevented corporate bonds from generating positive returns.

Inflationary Challenges and Central Bank Actions: Inflation concerns continued to be prevalent in Q2 in the US, Eurozone, and the UK, prompting central banks to act. Although headline inflation decreased due to falling energy and food prices, core inflation remained relatively stable, posing a challenge to central banks' targets. The Federal Reserve and the European Central Bank responded by increasing interest rates to curb inflationary pressures. The US Federal Reserve shifted its focus to tackling inflation, driven by robust economic growth and favourable employment rates.

Inflationary Challenges in the United Kingdom: The UK faced higher inflation compared to other regions, primarily influenced by import dependencies for food, drink, and energy, and labour shortages resulting from Brexit. The shortage of staff and lower labour mobility within the UK, increased wages - further fuelling inflation. Unlike the US and Europe, core inflation (which excludes energy and food components) in the UK continued to rise which is a challenge to the Bank of England’s objective to reduce inflation to 2%.

The Bank of England faced the task of curbing inflation, which was considerably higher than in other regions. In response, the bank implemented an unexpectedly large 50 basis point interest rate hike (0.50%) at the last meeting. Market participants anticipate another 0.50% hike in August, highlighting the Bank of England's proactive approach to address elevated inflation. The sustained rise in UK government bond yields reflects the central bank's hawkish stance (supporting interest rate rises) necessitated by inflationary pressures.

Equities

Divergent Returns in Equity Markets: The second quarter of 2023 exhibited diverse returns in global equity markets. Chinese and ASEAN (Association of South East Asian Nations) equity returns were notably poor, reflecting the weakened state of the Chinese economy. China's manufacturing sector contracted consistently throughout the year, indicating a potential balance sheet recession characterised by decreased investment and manufacturing demand. This downward trend had a significant impact on commodities, as China's reduced construction activity resulted in declining internal commodity prices and global commodity market weakness.

On the contrary, Latin America demonstrated strong performance, fuelled by stock-specific news and favourable macroeconomic fundamentals. Brazil's state-owned oil company, Petrobras, experienced remarkable growth, boosting the Brazilian stock market and wider Latin American indices. Political stability and positive economic outcomes, including falling inflation and interest rates, contributed to Latin America's overall resilience.

In developed markets, Japan stood out with robust returns, primarily driven by undervalued companies with high cash balances. Japanese firms, which had previously been unloved, embraced more shareholder-focused approaches, resulting in increased investor interest. Additionally, the weakening of the Japanese yen positively impacted revenues for Japanese companies with significant overseas operations.

In the United States, large-cap growth stocks – so the biggest companies with a market capitalisation value of more than $10 billion - were the primary contributors to respectable overall returns. However, the market demonstrated a significant internal divergence, with large-cap growth stocks outperforming other segments. This divergence, reminiscent of the tech bubble era, highlighted the challenges and complexities faced by investors. While the NASDAQ index continued to rise, regional banks faced a crisis, reflecting changing narratives and market sentiments.

A Multipolar Landscape

Throughout these market movements, a notable shift towards a multipolar world was evident. Economic cycles became less interdependent, with certain regions thriving while others struggled. This growing multipolarity increased the importance of understanding specific regional dynamics when assessing market performance. Factors such as political stability, macroeconomic fundamentals, and industry-specific conditions played crucial roles in determining market outcomes.

Conclusion 

As the world becomes increasingly multipolar, which means that there are several countries that set the conditions for the global economy, investors must adapt to changing narratives and shifting economic cycles. Understanding regional nuances, such as political stability, macroeconomic fundamentals, and industry-specific factors, will be crucial in identifying investment opportunities and mitigating risks in this dynamic financial environment.
While challenges and uncertainties persist, the second quarter of 2023 demonstrated that a nuanced approach, guided by comprehensive analysis and a deep understanding of global and regional dynamics, is essential for successful navigation of financial markets. 

Note: This Market update is for general information only, does not constitute individual advice and should not be used to inform financial decisions. Additionally, past performance is not a guide to future returns. Investment returns are not guaranteed, and you may get back less than you originally invested.