Why diversification mattered in the first half of 2023

Diversification was the watchword for investors in the first half of the year, as stock markets pursued some quite divergent paths. In an environment of high inflation and interest rates, the search for assets with secular growth attributes became more intense.

Technology stocks in the US and Europe powered ahead, taking headline market indices such as the S&P 500, Nasdaq and, to a lesser extent, the Euro Stoxx 50 with them¹. The idea that AI would prove a source of additional growth for a wide range of companies overtook concerns about the effects of high interest rates.

Businesses with the bulk of their profits far out into the future are usually especially vulnerable to the rise in the “risk free” returns that come from higher interest rates. However, that didn’t seem to matter so much over this period.

Shares in the gaming chipmaker NVIDIA soared and the stock market value of Apple breached the $3 trillion mark for the first time. Meta and Tesla were among the companies to see their shares more than double in value².   

While some believe recent trends have the makings of an investment bubble, AI will undoubtedly be a factor in raising sales for specialist chipmakers and increasing the efficiency of a wide range of businesses, not just social media companies. As a result, current trends may have further to run.

The downside is that share valuations in the US are back at pre-pandemic levels, with the S&P 500 for instance trading on 21 times historic earnings³. That suggests the US market might now be vulnerable in the face of an about-turn in investor confidence. There’s also the narrowness of the recent market advance to think about, which hasn’t always been a good sign historically.

Japan’s renaissance as a destination for foreign capital proved one of the biggest surprises of the year so far. While still well short of its 1989 record high, the Nikkei 225 returned to its best levels in 33 years at an astonishing pace⁴.

Tokyo’s change in fortunes could be put down to Japan’s unique blend of reasonable growth prospects, moderate inflation and low valuations. Semiconductor stocks and factory automation equipment makers were among the market leaders.

A central bank wedded to maintaining a negative interest rate for at least the next 18 months as it reassesses its monetary model further distinguishes the country from its international peers.

Japan differs significantly from most other countries in that inflation there is considered to be an asset. For much of the past three decades, the country has been mired in reticent consumer behaviours and bouts of deflation. Only recently has the landscape changed, how permanently, we do not yet know.

Positively, Japan’s services sector is now driving employment higher, in a labour market which was already short of workers. Japan’s unions won overall pay gains of 3.7% in spring negotiations, meaning wages now have a chance of growing in real terms this year⁵.

By comparison, the FTSE 100, with its dearth of AI related stock stories, turned out to be a lot less exciting. BP and Shell proved a drag, as oil and gas prices corrected after an extraordinary year. A production cut by OPEC and its allies in June failed to revitalise oil, as markets eyed the potential for Russia to continue selling as much energy as it can.

Other sectors with large representations in the index lagged behind as well. Retail-heavy banks, though boosted by the rising gap between savings and borrowing rates, were hamstrung by expectations of an increase in mortgage defaults. Diversified metals miners such as BHP and Rio Tinto wilted as China’s economic recovery hit a soft patch.

Meanwhile, led by a handful of mega-cap companies, European bourses made substantial headway. They racked up the best performances of all developed markets in the first quarter, before Japan took up the lead. Falling gas prices – to which Europe is especially sensitive – as well as the fading shock of the war in Ukraine provided some of the boost.

Expectations of a consumer recovery in China after the ending of Covid lockdowns acted as an additional fillip. Several of Europe’s leading premium and luxury goods exporters now consider China to be their “home market”, given the significant proportion of sales they make there.

As in Japan, attractive market valuations were another positive, particularly among investors alarmed at the rapid rise in stock prices stateside. Europe’s renewed alacrity prompted Goldman Sachs to coin yet another acronym – “GRANOLAS” – loosely standing for Europe’s largest listed companies.

Like New York’s “FANG+” technology businesses, the GRANOLAS are world leaders in their field and generally more expensively rated than the market overall. Europe’s largest listed companies are: GSK, Roche, ASML, Nestle, Novartis, Novo Nordisk, L’Oréal, LVMH, AstraZeneca, SAP and Sanofi.

China itself got off to a good start, as the ending of Covid lockdowns inspired investors to look ahead to a powerful release of pent-up consumer demand. However, this initial optimism faded quickly and shares moved into retreat, as economic data – particularly from the property sector – pointed to a further challenging period.

Deteriorating US-Sino relations and the government’s continuing reluctance to apply a meaningful stimulus to the economy were other factors behind the retrenchment. A revitalised property sector may be the key to switching on consumer spending, which is now the main driver of China’s economic activity.

For investors with balanced portfolios, government bonds suffered from the flipside to buoyant investor sentiment. While stock markets shrugged off current worries, bonds fell amid the stark reality that inflation remains stubbornly above central bank targets in most regions.

Rising interest rates tend to depress the prices of bonds across all maturities, but especially those maturing in the short term. Inflation is of most concern to holders of long dated bonds, owing to its cumulative, negative effects over time.

Despite this, the case for investing in bonds in the second half of the year is much stronger. The lagged effects of interest rate rises are bound to depress inflation over the next few months, intensifying calls for rates to be cut as we move closer to the end of the year.

In the US, that’s already happening. Personal Consumption Expenditures (PCE) – the preferred inflation measure of the Federal Reserve Bank – slipped to 3.8% in May. That’s still way higher than the Fed’s 2.0% target, but it does confirm an improving trend since January, when PCE inflation was running at a 5.4% annual rate⁶.

Conditions remain a fair bit trickier in the UK. Investors progressively priced in a higher terminal rate for the Bank of England’s Bank Rate over the period, particularly after inflation stayed stuck at 8.7% in May. However, even here, the outlook remains one of improvement out into 2024-25.

Falling inflation and the prospect that interest rates will follow suit mean the current yields on offer in government bond markets – for example, 4.4% from 5-year Treasuries or 4.9% from 5-year gilts – now look attractive for investors with a medium term investing time horizon⁷.

Source: 

¹ Bloomberg, 07.07.23 

² Bloomberg, 07.07.23 

³ Bloomberg, 07.07.23 

⁴ Nikkei Asia, 04.07.23 

⁵ Nikkei Asia, 24.05.23 

⁶ Bureau of Economic Analysis, 30.06.23 

⁷ Bloomberg, 07.07.23 

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. Investments in emerging markets can be more volatile than other more developed markets. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Select 50 is not a personal recommendation to buy or sell a fund. Tax treatment depends on individual circumstances and all tax rules may change in the future. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.