As I write this, on Wednesday 14th June, all eyes are again on central banks and whether they will raise interest rates again or not.
Tough decision for the Bank of England (BoE)
Here in the UK, investors were somewhat surprised by robust jobs data released yesterday, showing a large reduction in unemployment and an acceleration in average weekly earnings growth. For the 3 months to the end of April, average weekly earnings excluding bonuses, grew at 7.2% and just 3.8% of the population were unemployed.
Despite a recent small reduction in the headline rates of inflation, the historically strong jobs data led markets to believe that a further 0.25% rate rise, from 4.75% to 5.00% is highly likely when the BoE meet again next week. A tight jobs market could serve to prolong the sticky inflation we’re experiencing, and markets were quick to price in additional rate rises. This was most keenly felt in the UK Gilt (government bond) market, where yields increased and are now back at the levels they were following the Truss/Kwarteng budget in October last year (as measured by the 10 Year maturities):
1 year change in % yield on UK 10 year Gilt. Source, Factset
This, seemingly inexorable, rise in government borrowing costs inflicts more pain on holders of debt, whether that be in their investment portfolio, or personally for mortgages, credit cards etc. I’m sure we’ve all read the news stories of lenders pulling new mortgage deals as new inflation or jobs data is released and, in my opinion, the real effects are yet to be felt in the housing market.
More cautious investors, who tend to have higher allocation to bonds will also be smarting after the losses on bonds this year. Bond market volatility is unusually high now and, according to data from FE Fundinfo, Gilts have been more volatile than UK equities over the past year and Index Linked Gilts have exhibited nearly twice as much volatility as Emerging Market equities.
The good news is that this topsy turvy dynamic shouldn’t last forever. Whilst new debt issuance by the UK Government may put a cushion under yields for the next few years, bonds look quite attractive at these yields. Yes, there may be further downside to come but, I think, the risk is asymmetrically skewed to the upside from here. We might just need to be patient.
A “pause” or “skip” from the Fed?
Over in the US, the expectation is for the Fed not to raise interest rates today. Inflation data out of the US yesterday was in line with expectations and may embolden the Fed to take a pause. With all eyes on Fed communications, semantics have come to the fore with the Fed Chair Jerome Powell keen to stress that not raising rates could count as a “skip”, not a “pause”. Whether a skip, hop or jump, markets are certainly hopeful that the tightening cycle in the US is nearly over.
Staying in the US, I thought it worth mentioning the breadth of the recent rally in US equities, or rather the lack of it. The S&P 500 is up 13.79% year to date and, according to the arbitrary measure of a 20% rally off the low, entered a new bull market this week. However, this rally has been overwhelmingly led by mega cap technology stocks and anything with a whiff of A.I. about it. If we strip out the effect of the tech giant, by looking at an equally weighted, rather than market capitalisation weighted, index, the US market is only up 4.11% year to date.
Why do I mention this? Well, many investors would prefer to see a broader range of companies, sectors and market capitalizations rising together to have confidence in a market rally. This narrow leadership, effectively dragging up the rest of the index, might not be the most solid foundation on which to build a new bull market, if indeed we are in one.
How diverse is your tracker fund really?
The big rally in technology names also highlights important questions about diversification in index-based, or passive, investing. If one buys an index fund which tracks the S&P 500, they might expect it to be highly diversified as it holds all 500 companies. Not necessarily. The recent rally means that, as of the end of May, the 10 largest companies constituted 54.1% of the index. Furthermore, 39.5% of the index is Information Technology and a further 13% is Communication Services (the bulk of which is Alphabet and Meta).
The picture isn’t a whole lot better when investing in a UK index. The FTSE All Share is widely accepted to be the best measure of UK equities. However, despite investing in 576 companies, the largest 10 make up just over 40% of the index. The index is also concentrated in terms of sector exposure with over 73% exposed to the top 5 industries. In order of exposure these are Financials 23.24%, Consumer Staples 15.02%, Consumer Discretionary 11.88%, Healthcare 11.74%, and Industrials 11.74%, as of the end of May 2023.
So, some food for thought. As with active management, passive investing requires a deep understanding of markets, indices, and their potential pitfalls.
Until next time, stay well.
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