Quarter 3, 2023 Market Commentary

• Published on October 9th, 2023

Quarter 3, 2023 Market Commentary

Past performance is not indicative of future results. The information mentioned is for illustrative purposes and should not be considered a recommendation to buy or sell.

After strong gains for shares in the first half of 2023, global equities posted a negative return in Q3. Government bonds also declined in the quarter, with yields rising. Commodities were notable outperformers, with energy gaining due to oil production cuts from Saudi Arabia and Russia.

US

US equities weakened in Q3. Initially, investors were optimistic that the Federal Reserve (Fed) had achieved a soft landing for the economy and that the rate-tightening cycle was ending. However, enthusiasm faded in August and September as it became clear that higher rates might persist. This shift followed a revised Fed “dot plot,” showing policymakers' interest rate forecasts.

The US labor market remained strong overall, but the unemployment rate rose by 0.3 percentage points to 3.8% in August, with 514,000 more unemployed persons, reaching 6.4 million. The US composite flash purchasing managers' index (PMI) marginally fell to 50.1 in September from 50.2 in August, indicating the economy is cooling.

Inflation, while ticking up in August, remains on a downward trend. Comments from Fed policymakers suggest another rate hike is likely before the year ends, with the dot plot showing a higher median rate for 2024 (5.1% vs. 4.6%).

Energy stocks were relatively resilient, one of the few bright spots in a quarter where most sectors declined. The IT sector, including the "Magnificent Seven" companies (Apple, Microsoft, Alphabet, Amazon, Tesla, Nvidia, and Meta), was notably weak, along with real estate and utilities.

Eurozone

Eurozone shares fell in Q3 due to concerns about the negative effects of interest rate rises on economic growth. However, data released at the end of the period showed eurozone inflation slowing to a two-year low of 4.3% in September, down from 5.2% in August, potentially allowing the European Central Bank (ECB) to halt interest rate hikes.

The consumer discretionary sector saw steep declines due to concerns over higher interest rates affecting disposable income. The information technology sector also faced pressure, with near-term concerns over consumer spending affecting demand for chips, despite long-term enthusiasm for artificial intelligence.

The energy sector gained amid higher oil prices from production cuts. Financials also outperformed, benefiting from rising rates. Real estate posted a positive return.

PMI data showed the eurozone private sector in contraction, with the composite reading edging up to 47.1 in September from 46.7 in August. The ECB raised interest rates twice in the quarter.

UK

UK equities rose over the quarter. Large diversified energy and basic materials groups outperformed, rebounding from previous weaknesses and benefiting from sterling’s weakness against a strong dollar. A sharp recovery in crude oil prices buoyed energy groups.

Domestically focused areas of the market also recovered, driven by improving UK consumer confidence and hopes that base interest rates had peaked. Market interest rates stabilized as the sell-off in long-dated gilts moderated, and long-term fixed mortgage rates fell. These trends contrasted with the bond market sell-off seen in other major developed economies.

Mid-cap consumer discretionary stocks, particularly housebuilders, recovered well. Travel and leisure companies, such as pub groups and transport operators, also outperformed. Domestically focused banks and UK-exposed real estate companies recorded reasonable share price performances.

While overall inbound merger and acquisition activity remained low, there were several deals among small caps, further supporting UK small and mid-cap equities.

Japan

The Japanese equity market showed resilience during the Q3 correction, triggered by rising interest rates and bond yields in the US and Japan. Large growth stocks in Japan were impacted, with the Nikkei 225 index declining by 4.0%, but smaller stocks held up well, and value stocks surged. The TOPIX Total Return index achieved a modestly positive return of 2.5%. The gap between growth and value stocks widened significantly, reflecting a shift in market trends.

Quarterly earnings results, announced from late July to August, were solid, supported by a weaker yen and strong domestic demand. The Bank of Japan (BOJ) made policy adjustments in late July, endorsing a gradual increase in Japanese government bond (JGB) yields. BOJ Governor Ueda suggested an end to negative interest rates by the end of the year or before the next spring wage negotiation. Inflation remained solid, and the yen's continued weakness supported market expectations.

With rising rates in Japan and potentially more from the US, higher-valued stocks saw corrections, particularly in the growth and semiconductor-related sectors. Financial stocks, including regional banks, performed well, as did the energy and auto sectors.

Domestic-oriented mid and small-cap stocks performed well until August. However, political tensions between China and Japan over the release of wastewater from Fukushima affected expectations for Chinese tourist demand in September.

Asia (ex Japan)

Asia ex Japan equities declined in Q3. Most markets in the MSCI Asia ex Japan Index ended the quarter in negative territory due to concerns over the Chinese economy and fears of global economic growth slowing. Hong Kong, Taiwan, and South Korea were the weakest markets, while Malaysia and India achieved growth.

Chinese stocks saw sharp declines in August, particularly in the property sector, as investors doubted Beijing's stimulus measures would be sufficient. Although China's official PMI manufacturing index rose in August, it marked the fifth straight month of contraction. China sought to boost confidence by cutting stamp duty on share transactions and slowing initial public offerings in Shanghai and Shenzhen.

Hong Kong shares also fell sharply, with trading in the troubled Chinese property company Evergrande suspended in September. South Korean shares declined due to weaker factory output and slowing retail sales, which spooked investors. Taiwanese shares tumbled on fears that Chinese property debt issues could trigger a financial crisis.

Emerging Markets

The MSCI Emerging Markets (EM) Index ended Q3 in negative territory despite a strong start, impacted by concerns that a strong US economy would keep interest rates higher for longer. Ongoing weakness in the Chinese economy and concerns about the property sector further affected risk appetite.

Poland and Chile posted the largest declines, with Chile hurt by falling lithium prices and Poland by political uncertainty ahead of October's parliamentary elections, leading to an unexpected interest rate cut. Taiwan and Korea were also notably weak. Mexico underperformed due to mixed macroeconomic data, while South Africa continued to struggle with its electricity crisis. Thailand and Saudi Arabia lagged the index.

China underperformed as indicators pointed to a lackluster economic recovery and persistent property sector problems. Limited policy stimulus was announced to address these issues, but macroeconomic data released toward the end of the quarter was more positive than anticipated. Brazil also lagged despite improving economic data and central bank rate cuts.

Colombia, Hungary, and the Czech Republic outperformed, as did India and the UAE. Egypt and Turkey posted the best returns, with Turkey's two rate rises seen as a sign of a shift toward more orthodox monetary policy.

Global Bonds

Q3 saw the US economy demonstrating resilience, with a robust labor market and signs of improvement in the manufacturing sector. However, concerns over rising US debt issuance weighed on the Treasury market. In August, Fitch Ratings downgraded the US's triple-A rating to double-A plus, citing the growing debt burden and an "erosion of governance."

Despite a significant rise in oil prices, year-on-year core inflation measures eased across most economies, allowing many major central banks to pause further rate hikes. The Fed and ECB both raised rates by 0.25% in July, with the ECB continuing to hike in September. Despite the Fed and Bank of England keeping rates steady in September, the market anticipated a longer period of elevated rates, driving higher yields and lower bond prices.

Global government bond yields peaked in September before slightly retreating. The US 10-year yield rose from 3.81% to 4.57%, and the two-year yield increased from 4.87% to 5.05%. Germany's 10-year yield rose from 2.39% to 2.84%.

The Bank of England raised the base rate to 5.25% in August, but signs of slowing inflation allowed it to keep rates unchanged in September, helping gilts outperform. The 10-year gilt yield remained relatively unchanged over the quarter.

Corporate bond markets outperformed government bonds, with spreads narrowing across both investment grade (IG) and high yield (HY). European credit outperformed US credit, despite a weaker growth trajectory. Euro IG saw the slowest quarter for net issuance in a decade due to lower new funding needs.

The US dollar strengthened against major currencies, reflecting positive growth momentum.

Convertible bonds, as measured by the Refinitiv Global Focus index, fell by -2.3%, offering downside protection of just 30%. Convertibles did not participate in the significant rally for the "Magnificent 7" stocks as none have outstanding convertibles. September alone showed downside protection of more than 50%, in line with traditional levels.

The primary market for convertibles remained strong, with $22 billion of new issues in Q3. High demand for refinancing is expected from companies unable to attract liquidity in traditional corporate markets.

Commodities

The S&P GSCI index rose sharply in Q3, driven by significantly higher energy prices after oil production cuts by Russia and Saudi Arabia. Energy was the best-performing component, with natural gas the only segment recording a price fall.

The industrial metals component saw modest gains, with price increases for zinc, lead, and aluminum offsetting declines in nickel and copper. The agriculture component ended the quarter negatively, with weaker prices for wheat, corn, soybeans, and coffee offsetting gains in cotton and sugar. Precious metals were the worst-performing component, with declines in gold and silver prices.

Digital Assets

Bitcoin and Ethereum fell by -11.5% and -13.6% respectively in Q3, although Bitcoin remains up 63% year-to-date, one of the best-performing assets in 2023. Volatility, correlation with equities, and correlation among the top 30 tokens have all significantly decreased compared to last year.

US regulatory news was a key driver of price movements, with SEC actions prominently featured. Regulatory enforcement against Coinbase and Binance and subsequent legal rulings influenced the market. Regulatory filings for spot ETFs by major asset managers introduced significant price action around potential approval dates.

The excitement around a spot Bitcoin ETF stems from the potential SEC approval, signaling market acceptance and liquidity for a US-based spot product.

September marked the one-year anniversary of Ethereum's transition to a ‘Proof of Stake’ consensus mechanism, reducing computational work and eliminating its carbon footprint. The network has operated as intended, with staking assets becoming popular among crypto investors for enhancing returns.