Q2 2023 investment commentary
Is UK inflation coming down?
Inflation has remained stubbornly high so far in 2023 in part due to energy prices, but mainly continued supply chain issues which have pushed up the price of food. Food inflation had risen by 19% in April 2023 9 which was the highest sector in that month. This unrelenting rise in food costs has meant that whilst inflation has dropped slightly, these decreases are less than originally expected. Inflation in the UK currently sits at 8.7% 10 compared to 10.4% at the end of Q1, whereas in Europe inflation fell to 6.1% in May 2023.11 The US has continued to fare better than Europe and the UK with its current inflation sitting at 4% at the end of May 2023.
Despite the doom and gloom associated with the high levels of inflation, there are some positive signs that UK inflation may decelerate for the remainder of 2023. The Bank of England has named three changes that might influence inflation over the coming year. Firstly, wholesale energy prices falling considerably - which may not have filtered through to energy bill savings yet - will have an impact on inflation. Secondly, the Bank believes that supply chains will become more efficient, leading to a sharp fall in the price of imported goods. The final disheartening factor is that individuals will have less money to spend, so there will be less demand for consumer goods and services in the UK.
At the start of the quarter interest rates sat at 4.25%, and on the 22nd of June, the Bank of England made the bold choice to hike interest rates to 5%. The hope is that the increase in interest rates will lead to reductions in inflation, with the Bank of England expecting inflation to fall quite quickly to around 5% by the end of 2023. This optimism is not mirrored across the market with The National Institute of Economic and Social Research (NIESR) estimated annual CPI being 5.4% at the end of 2023. This forecast is pessimistic in comparison to forecasts from the Bank of England and the government's budget watchdog.
What's the difference between core and non-core inflation?
Non-core inflation considers sensitive elements such as food and energy prices which fluctuate rapidly. Core inflation excludes food and energy prices with a view on more consistent price movements – such as wages, productivity and long-term supply and demand imbalances. It is these core costs that central banks will use when setting their monetary policy for the long term.
So, until we have a better predictability of the non-core elements, investors should continue to take a cautious approach going forward. The current headline inflation rates reducing can be largely attributable to declines in energy prices. Whereas core inflation tends to be much more ‘sticky’ than non-core as it is embedded in the mindsets of the economy, and therefore it will take longer to eradicate.
Mortgages and the Shaky Property Ladder
New mortgages in the first quarter of 2023 were down 16.1% compared to the previous quarter, and 40.7% less than a year earlier. The downward trend indicates that purchasing a property may be less obtainable in these current conditions, compared to recent history.
At the end of June, two-year fixed-rate mortgages in the UK rose to above 6%. This rise in interest rates has caused some lenders (e.g. TSB) to temporarily withdraw their mortgage offers sold via brokers to re-price these deals. With interest rates now having increased to 5%, housing affordability seems even further from reality.
Whilst the overall cost of purchasing a property is impacted by these mortgage rate increases, it is far from the full picture. Affordability of home purchasing has been a topic of discussion in recent years, with the number of middle-aged (45-64) tenants increasing by 70%.3 Of this 70%, 4 in 10 would like to purchase their own home, and only 2 in 10 are actively saving for a deposit. The task of saving for a deposit can be difficult alone, but it is only part of the reason for the change in the property landscape. If you do manage to save a deposit, probably between 5-10% of the property price, the next step would be to secure a mortgage. This is perhaps the more challenging part of the equation.
According to the ONS, the average weekly salary in the UK for June 2023 was £630 (£33,280 annualised). 4 In 2022, full-time employees in England could expect to spend roughly 8.3x5 their annual earnings buying a home. This multiple has been on the rise since 1997 and with the continued strain on the cost of living brought on by inflation, it looks set to continue.
Will the UK enter a recession this year?
However, inflationary and interest rate increases continue to put pressure on both returns and household budgets. With mortgages and food prices continuing to rise, the monthly budgets for households are becoming much tighter. Unfortunately, these headwinds do not show signs of easing just yet. This being said, predictions suggest that this may change towards the end of 2023, hopefully creating positive conditions in early 2024.
Q2 2023 asset class performances
While we have had in the second quarter the Dance Macabre on both sides of the Atlantic with Boris Johnston’s resignation and Donald Trump’s indictment, the equity markets have remained level in the UK and quarter one’s US bull market now feels uncertain going forward.
In the UK , inflation is playing a pivotal role in the economic environment. For the US, it only just missed a historic debt default with both the Democrats and Republicans coming together to ensure that the US government’s borrowing limit is suspended until 2025. This action was vital as the alternative would have caused a global economic fallout which could have been devastating.
In the first quarter, there were some positive gains across the equity markets, followed by the second quarter providing some stability for investors. Global equities returned 3.32% over the quarter, with certain regions driving positive returns. The US market was the standout, returning 6.99%. Most of these positive gains were attributed to a handful of stocks, specifically in the technology sector, which could suggest that near-term improvement in economic growth could be down to a bubble.
Developed markets returned 3.56% illustrating that emerging markets were a dampener to overall global returns. This quarter, emerging markets returned -2.11% with China’s reopening after Covid-19 restrictions failing to translate into broad economic strength. The impact on the surrounding markets that rely heavily on Chinese demand has caused more modest returns for the region. Finally, UK markets have also seen lacklustre returns of -0.49% for the quarter. With inflation not reducing as quickly as expected, markets were left underwhelmed. The European markets also contributed a muted performance with returns of 0.59%.
Bonds continued to have a rough run this quarter with the difficult inflation and interest rate environment. Government bonds have also struggled in developed markets, and the European Central Bank reaffirmed the need to increase interest rates further before the end of 2023. With the UK interest rate increases, alongside the US debt ceiling issues earlier this quarter, it seems most government bonds have struggled in this current environment.
Other riskier, non-investment grade bonds are also continuing to struggle as tightening credit conditions, paired with increased costs to raise debt, have put pressure on returns. In terms of performance over the quarter, Global bonds (hedged to £) returned -0.46%, while UK government bonds returned -6.21% and overseas government bonds fared slightly better returning -4.29%.
With inflation proving to be a long-standing issue, global property returns continued to be stifled. Returning -0.57% this quarter has provided some reprieve from the lower returns seen in the first quarter of 2023. As central banks continue to issue interest rate increases over the remainder of the year, it may be 2024 before we see this area of the market turnaround.
Our investment philosophy is focused on building portfolios that take a globally diversified market-cap approach, so the performance of our portfolios is relative to the general market and can be predicted with some degree of confidence. This is opposed to active strategies which may perform contrary to the overall market.
As can be seen in the chart below, the OpenMoney 2 & 3 model returned 2.05% & 3.57% over the quarter, continuing the positive growth seen in Q1. The OpenMoney 1 model, which is around 67% invested in fixed income, returned -0.32%, which is down on the first quarter. However, this performance mirrors the returns seen in global bond markets.
OpenMoney cumulative portfolio performance as of 30 June 2023
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Source: Timeline Portfolios (formerly Betafolio Ltd), 2023.