September proved to be a reality check on the markets and the potential cost of a more resilient U.S. economy in the form of a slower fall in inflation and cash rates that remain elevated for an extended period. The dominant market sentiment revolved around the "higher for longer" theme, which led to a drastic repricing in the bond markets, causing bond yields to reach new highs. Consequently, equity markets witnessed a broad sell-off, with the correlation between stocks and bonds turning positive.
The MSCI World index fell by 1.70% and the emerging market index by 0.20%. Meanwhile, the Bloomberg Aggregate Bond index fell 2.9% . In fixed income, 10-year government bond yields continued to hit fresh cycle highs, including in the US (4.61%) and Germany (2.93%).
The US Federal Reserve decided to maintain the interest rates at 5.5%. Although this met market expectations, the Fed hinted at additional rate hikes in the near future, emphasizing a prolonged elevated rate stance. The Federal Open Market Committee (FOMC) said it remained highly attentive to inflation risks, citing the fact that the labour market and economic activity remains strong. A potential government shutdown loomed towards month-end, but it was avoided thanks to a US Senate agreement, ensuring government funding until mid-November. Headline inflation year-on-year (YoY) came in above expectations, recorded at 3.7% which was higher than the 3.2% figure recorded in the previous month.
Core inflation YoY came in at 4.3%, which was in line with expectations and lower than the previous figure of 4.7%. Elsewhere, data out of the US was largely mixed, with the labour market showing signs of resilience. Initial jobless claims fell to a seven-month low, but the unemployment rate was higher than the 3.5% forecast, recorded at 3.8%. Brent crude oil rose by 10% to $95 p/b, following the extension of production cuts by Saudi Arabia.
In Europe, both the European Central Bank (ECB) and the Bank of England adjusted their interest rates upwards by 25 basis points. The ECB increase of 25 basis points - its tenth consecutive increase as the benchmark deposit rate went to an all-time high of 4.0%. The ECB indicated its cycle of increases was near its end. Eurozone inflation fell from 5.2% in August to 4.3% in September, its lowest level for nearly two years. Core inflation (which excludes energy and food) fell to 4.5%, from 5.3%. The bigger than expected fall in inflation means that it is likely the ECB will now leave the eurozone’s benchmark interest rate on hold at 4%. The economic outlook has weakened in recent months with industrial production falling, slowing trade with China, and squeezed consumer spending due to high inflation and rising borrowing costs. The flash purchasing managers’ composite index (PMI) for the eurozone rose slightly to 47.1 in September, from 46.7. The index, which measures activity at both services and manufacturing companies across the eurozone, is below 50, indicating businesses are contracting.
China's economic outlook appeared more promising. Recent data showed better-than-expected retail sales and industrial production figures.
The forward-looking manufacturing NBS PMI returned to “expansion” territory in September (50.2), while non-manufacturing activity also grew at a faster pace (51.7).
Real estate distress remained in focus – notably, Evergrande remains a recurring concern – but Beijing has been eager to signal support, this time by easing banks’ reserve requirement ratios. In Japan, the Bank of Japan kept its policy stance unaltered, maintaining its widened Yield Curve Control.
Reflecting on the market volatility, we've upheld our prudent investment strategy.
However, we are more positive about Japan and have therefore increased our allocation to Japanese equities. We’ve financed this partly at the expense of the allocation to European equities and partly from the cash position. The economic outlook is bleak in Europe and we think earnings forecasts are too optimistic. Given the declining rate of inflation and poor outlook for growth, we now believe there’s a higher chance of central banks cutting interest rates earlier than expected. In our view this makes monetary policy less of a direct negative factor for equities. We continue to hold an underweight, however, and this derives largely from the weak economic growth that we anticipate.
Please find attached our last Asset Allocation Update for October.