DPMS Portfolio Commentary May 2024

Despite a somewhat rocky start to the year, Q1 2024 proved to be very strong across equity markets due to improving profit growth expectations, falling inflation, optimism around interest rate cut timing and excitement around Artificial Intelligence (AI) in the Technology sector. Whilst some elements of inflation proved to be stickier than first thought, markets have shrugged this information off and continue to look to the future with a period of rate cuts from Central Banks albeit at a later staged than initially thought.

Interest rate cut forecasts continue to dominate the economic discussion with markets looking forward to the first rate cut since 2020 at the onset of the coronavirus pandemic. Central Banks remain vigilant on monitoring the constituent parts of inflationary data and ensuring that any decision-making is backed up by falling headline inflation towards the 2% target. Whilst the US economy has held up very well despite higher interest rates (more on this below), The Federal Reserve (The Fed) now faces a difficult decision of going back on previous messaging around rate cut timing. US markets had initially expected a rate cut by the end of March at the start of the year, this has been pushed much further back into late Q3 2024 at the earliest. The European Central Bank (ECB), however, look poised to begin their rate-cutting around the end of Q2 or start of Q3 2024 with the Bank of England to follow shortly thereafter. With economic strength came a slight increase in bond yields in the US, which resulted in a small reduction in bond prices, but we expect this to be a short term jump. The UK and Europe did face similar yield rises but not by as much due to weaker economic performance.

Energy inflationary pressures remain at the forefront with the tensions in the Middle East between Israel, Iran, the Houthi rebels, Palestine and Syria. Future tensions may cause further spikes in oil price and increasing shipping costs, which may spill over into inflationary data. This is particularly pertinent for the UK and Europe due to their reliance on importing oil to provide energy.

US equity performance was very strong due to the strength and resilience of its economy, strong reported earnings from companies, planned share buy backs and the continue rise of AI.  AI promises greater efficiencies in the way we work which has resulted in lofty valuations of AI related companies. We wait to see how these companies are able to commercialise their AI technologies as we enter a new age to justify their higher valuations as shown on the valuations of the top 10 S&P500 shares in the index which includes tech & AI heavy companies such a Apple, Microsoft, Nvidia, Alphabet (Google), Amazon and Meta.

Due to recent pressures of higher-than-expected inflation, April saw a small correction in US equity prices but as we enter May the index is back to historic highs. The Fed has a difficult decision ahead of them – proceed with previously promised rate cuts and risk fuelling further inflation or wait until inflationary data helps to support any interest rate cuts at the risk of slowing the economy.

Market performance was weaker for the Eurozone and the UK as higher interest rates continued to exert a negative pressure on corporate earnings but the optimism around rate cuts was still warmly received. Corporate earnings may continue to struggle under a higher interest rate environment which may result in weak sentiment and PMI figures, however, recent figures in April suggest the economic position is improving in both regions particularly for Manufacturing. A technical, but shallow, recession is possible for Europe as we have seen in the UK but we remain relatively positive about this as we expect rate cuts and falling bond yields to occur sooner in both the UK and Europe. The ECB have indicated that their first rate cut may come as early as June or July 2024 although they will continue to monitor economic data and adjust their decision-making accordingly.

Source: Bloomberg, European Central Bank & Bank of England, J.P. Morgan Asset Management. Market expectations are calculated using OIS forwards. Past performance is not a reliable indicator of current and future results. Guide to the Markets -UK.Data as of 29 April 2024.

Given the inflationary pressures from 2022 and 2023, price increases have largely been passed on to the consumer which is expected to result in significant earnings per share growth in 2024 as shown below. Although global growth is expected to be fairly neutral in 2024, company profits are still expected to increase which, when combined with expected interest rate reductions, could result in positive market sentiment as we move through the year. Negative shifts in rate expectations (such as pushing back rate cuts or cutting by a smaller amount) may temper this.

Given the near term outlook, we have made some changes to our UK Equity exposure, introducing the JPM UK Equity Core and Chelverton UK Equity Growth funds to increase our exposure towards the Growth equities which include a greater allocation to mid and small-cap companies, which we expect to benefit strongly from cuts in interest rates. Mid and small-cap valuations remain highly attractive given difficulties in the UK economy over the last few years and present a great buying point given the optimism of further rate reductions this year to assist economic recovery throughout 2024.

US Equities have continued a period of strong performance due to its overall Tech and Growth bias in a period of optimism around AI and rate cuts. Inflation has fallen from its heights of c. 9% in July 2022 down to 3.2% in February, although an uptick in the March figures to 3.5% unsettled the markets albeit for a short period. The US Central Bank continues to assess rate cuts with a more cautious stance when assessing economic date and has held interest rates at 5.5% for April. We continue to expect that US consumers will continue to be resilient and bolster their economy, though eroding levels of personal savings, higher mortgage rates, a strong labour market and geopolitical risks may cause some difficulties – this may also mean a longer period of time before the US considers rate cuts. Therefore, we are retaining our preference for larger US companies with an overall Growth bias to avoid default risks and protect against earnings downgrades whilst capturing the momentum economic strength that a rate cut may provide. We have replaced our iShares US Equity Index with the JPM US Research-Enhanced Index fund to benefit from a level of active management given with the strength of JPM’s analysis within the S&P 500 index whilst ensuring that costs remain low.

Whilst the UK did enter a very shallow technical recession, falling inflationary figures (down to 3.2% for March) continue to build optimism for rate cuts in early Q3 2024. We expect this to be particularly beneficial for the Growth Style as well as mid and small-caps as described in our fund switch rationale above. Valuations remain attractive for the ‘unloved’ UK market but manufacturing PMIs have started to pick up and signal early signs of an economic recovery. We have also reduced our Value company bias in favour of Growth to benefit from possible rate cuts from the Bank of England expected in Q3.

The Eurozone’s position continues to look similar to the UK but inflation continues to fall at a faster rate (down to 2.4% for March). Because of this, we now expect that the European Central Bank (ECB) will be the first Central Bank to cut rates. Recent communications from the ECB have suggested their rate cutting cycle may begin with a June, subject to inflationary data continuing to head towards their 2% headline target. Due to this, we retain our preference for Growth-focused equities with a small allocation to small-caps as we expect to see a strong recovery for the region. This will be most likely confirmed once we have more definitive signals from the ECB that rates will start to be cut.

Asian equity performance remains mixed as China’s domestic growth and property region woes continue to provide challenges for the region despite some more encouraging stimulus being provided from the Beijing government. Whilst China is still struggling to find its way in the post-COVID world, valuations are very cheap and, should a solution be found to salvage the property sector, a strong recovery may come. Indian equities have continued to gain momentum with strong performance, with the exception of a single-day market correction due to unsustainably high valuations, mixed stress testing results, removed leverage options in mid/small-caps and some profit booking. We remain positive and excited about the country’s growth story as we expect it to be a strong beneficiary of the global supply chain moving away from China, whilst retaining similar structural dynamics with a fast-growing, domestically-focused population and economy.

Japan continues to attract attention from global investors following its significant shift towards western corporate governance standards. For the first time since October 2010, the Bank of Japan upped its base rate to 0.1%, a signal that the Japanese economy is starting to grow after decades of stagnation. It also now means that every Central Bank across the globe has positive interest rates. Japan continues to offer access to global companies and Asian consumers and has recently benefitted from the movement of investors’ funds away from China. We continue to maintain an overall balance towards Style across Asia, Emerging Markets and Japan whilst pinpointing the strengths of each economy from Stylistic and Geographic diversification.

Corporate and government bonds continue to offer attractive risk return prospects in the near future with rate cuts on the horizon with more stable returns expected now we are expected to have passed the end of a rate hiking cycle. A glimpse of this was seen in Q4 2023 with a strong surge in bond prices, but this reversed slightly early in the year with higher-than-expected inflation data. Prospects still remain that capital values will increase as bond yields fall in line with rate cuts throughout 2024. Rates are currently expected to fall by 0.50-0.75% across developed markets in 2024 but may be challenged by any inflationary data difficulties.

Given this expectation, alongside the defensive characteristics of fixed interest versus equities, the Vizion Wealth Investment Committee has agreed to increase our exposure to European Bonds within our fixed interest allocation through the introduction of the medium/long-duration Franklin Sustainable Euro Green Bond ETF. The ETF tracks a European Green Bond Index but has a slightly longer duration profile and higher credit quality due to a higher exposure to government bonds, which we expect to translate to a stronger level of return in the event of rate cuts in the Eurozone area. This change comes with the reduction of our Global Emerging Markets Bond allocation, which tends to perform well if the US Dollar starts to weaken. Given that we expect rates and inflation to remain higher given the strength of the US economy in addition to geopolitical uncertainty, we do not expect this to be a short term trend.

Whilst Cash rates continue to be high, we still do not consider it to be worthy of a larger allocation in the long-term. As explained in previous updates, if economies are resilient and perform better than forecast, we would expect equities to outperform and offer a greater return than cash as we enter recovery. With inflation and bond yields expected to fall, this should translate to receiving good levels of bond yields along with potential capital upside that should offer a greater return than cash, which is expected to become less attractive as base rates fall. The graph below uses the historic performance of US bonds vs Cash as an example:

Whilst banks do remain competitive in their offerings of around 4-4.3% for instant access accounts, around 4.5-4.8% for 1-year fixed rates and around 4-4.3% for 3-year fixed rates, these rates are being reduced in line with interest rate expectations. Transact, as our platform of choice, are the only platform in the market to pass on all interest on overnight client cash earned from 7 major banks and this returned 4.88% AER for instant-access cash savings in January, February and March (offering full FSCS protection for each bank), please let us know if you wish take advantage of this. We do not charge any fees on cash within designated cash wrappers.

Overall, the changes to the portfolios are tilted further towards a higher level of optimism for fixed interest funds and mid & small-cap funds, particularly in the UK and Eurozone. We retain our tactical biases towards what we deem to be stronger sectors within each geographical region as we look towards the first interest rate cuts of the year. Our portfolios remain well-positioned for long-term growth by focussing on potential opportunities in both the equity and bond sectors. If you would like to discuss any aspect of your investment portfolio or risk profile, please contact your financial adviser.