It’s tempting to say that the market rally has been all about US large-cap growth, with over half of index gains driven by a narrow selection of the very largest tech stocks, seen as beneficiaries of an Artificial Intelligence revolution; perhaps bringing uncomfortable echoes for investors who remember the 1999 Dotcom Bubble. AI may well be a new revolution, but with valuations rocketing, markets have now priced in a lot of good news.

This impression seems to be underlined when we look at global sector performance: huge gains year-to-date for Information Technology, Consumer Discretionary and Communications, with the Energy sector - a rare positive performer in 2022 - in negative territory this year, and defensives like Healthcare and Utilities flat.

But one can no longer argue that the rally is : as concerns over the bank failures have eased, as the economy and labour markets have so far held up relatively well and as markets still see a peak in US interest rates ’s clear that the rally - be it new bull market or huge bear market rally - is not just a US phenomenon: Japanese and Latin American stocks sharply outperformed in the last quarter, and have now returned 29% and 19% year-to-date; European stocks made only small gains in Q2 but still show 13% gains this year: for USD-based investors, the small rise in the Euro vs the Dollar puts returns from Europe ex-UK almost on a par with broad US equities year-to-date.

The bullishness isn’t universal: fading optimism over the post-COVID reopening meant negative returns from Chinese equities, which dragged down Emerging Markets as a whole, and weak returns from UK equities (up 3% to the end of June, with more domestically-oriented mid-caps marginally negative over the period) suggest investors remain cautious about the prospects for the economy. Investors’ decisions about their exposure to the big tech stocks has clearly been a decisive factor in performance, but broader country and stock selection has also been an important differentiator.

On the whole, returns from bonds have been modestly positive this year: global bonds have returned 3% this year in USD terms. Last quarter, we highlighted a mismatch between market expectations of the Fed interest rate peak and the Fed’s own expectations: this has largely resolved in Q2, as bond markets shifted to price in more interest rate hikes and a much longer wait for rate cuts. As recently as May, bonds had been pricing in a rate cut in summer 2023, and at least one more by the end of the year. By quarter end, markets had shifted, pricing in a rise in rates over the summer and pushing back expectations of the first cut well into 2024. As a result, US Treasuries saw small losses across all maturities in Q2 as the more hawkish Fed position was largely priced in, but have still delivered positive returns this year.

With credit default rates remaining quite low, riskier bonds have outperformed: better quality corporate bonds have held up better than governments, and both emerging market and high yield (“junk”) bonds have done well, making positive returns in Q2 despite the rise in government bond yields. Riskier bonds in Europe also performed well, for example Italian government bonds returning 5% year-to-date, as concerns about credit risk in the Eurozone abated.

While well short of equity returns, positive returns from bonds in 2023 so far remind investors that, after last year’s painful reset of global yields, a well-diversified multi-asset portfolio can see helpful contributions from fixed income as well as from equities and other risky assets.

The UK, again, has been an exception, as inflation remained stubbornly sticky. Yields on short-dated gilts pushed even higher than levels seen in the short-lived Truss-Kwarteng government, as markets priced in a meaningfully higher peak in interest rates being necessary to bring inflation under control: good news for savers, but a daunting prospect for the substantial number of households facing an end to cheap fixed-rate mortgage deals over the next year or so. The rise in yields meant that gilts overall lost 6% in Q2, taking YTD returns to -4%, and inflation-linked gilts also underperformed, down 7% in the quarter.

The march higher in UK interest rate expectations drove Sterling higher too: the Pound has been the strongest of the major currencies year-to-date, up 5% against the Dollar, from $1.21 to $1.27 and up 3% vs the Euro. Of course, Sterling strength detracts from returns on unhedged overseas investments for GBP-based investors. The Yen was the weakest of the major currencies, falling 9% year-to-date against the US Dollar, as the Bank of Japan has held interest rates at their lows and continued to intervene to keep domestic bond yields capped: the weak Yen is a boost both for exporters and for Japanese corporate earnings, but it’s a mixed blessing for investors: it helps underpin the surge in Japanese equities this year, but means that returns from Japanese assets for global investors who have not hedged currency exposure are less impressive than the headline number. Emerging market currencies saw some striking moves: substantial falls for the Ruble and Turkish Lira, double-digit gains year-to-date against the Dollar for the Mexican Peso and Brazilian Real.

After sharp rises in 2022, commodity prices have generally weakened: broad commodity indices show returns around -8% year-to-date, with energy, most metals and many agricultural commodities now substantially below their peaks of last summer. The fall in commodity prices has been a key factor driving inflation lower over the past few months. Precious metals are still priced well above last year’s levels: gold flirted again with all-time highs above $2,000/oz in May before retreating to end the quarter slightly lower at $1,920.

Economists have been flagging an impending recession for several quarters. Higher interest rates and short-term bond yields, tighter availability of debt, higher mortgage rates and a struggling manufacturing sector all suggest a recession is quite likely, but it has so far failed to materialise. Although some signs of slowdown persist, household consumption has remained resilient - for now - buoyed by a resilient labour market, significant wage growth and surprisingly strong government spending in the US - after the resolution of another debt-ceiling drama.

Despite the constant forecasts of recession on the horizon, it hasn’t happened yet: the US economy has slowed, but by less than many forecasters expected, and inflation is now clearly falling enough to kindle renewed optimism that it can return to more normal levels without a big rise in unemployment. It may yet be a case of the recession being deferred, rather than avoided altogether, but with falling inflation reducing the pressure on consumers, while the jobs market remains healthy, the possibility of an elusive “soft landing” remains.

Why has the global economy been comparatively resilient? Surveys show that manufacturing is probably already in recession in key economies, but the much larger services sectors are more buoyant; growth is slowing, more so in Europe than elsewhere in the most recent surveys, but still positive. Interest rates have gone up a lot in a short period, but the transmission to households and firms is less immediate: in the US, most mortgages are very long-term fixed rates, so while new borrowers face much higher costs, existing borrowers do not suffer in the same way. As so often, the UK is different, with much shorter maturity mortgages putting many households at risk of big rises in debt service costs in the months ahead. Firms face higher interest costs as they renew maturing bonds and loans, but again this process takes time. The speed of rate rises so far means that the global economy hasn’t had to deal with higher debt costs for very long yet: not long enough for their full impact to be felt. And although debt costs are high compared to the decade or so since the Global Financial Crisis, they are unremarkable in comparison to long-term average levels. It remains to be seen whether they are high enough to cause significant damage to the economy. The labour market is usually the last component to falter as an economy slips into recession, but with wages still growing strongly and unemployment at extremely low levels - touching a 50-year low of 3.4% in the US in April - that point has not yet been reached. US labour market data will be closely watched in the weeks and months ahead for signs of weakness.

It is of course possible that the bearish observers are right when they argue that the recessionary hard-landing hasn’t appeared yet, but it’s in the post, as the lagged effect of previous rate rises finally hits home. Indeed, some suggest that previous recessions have arrived just at the moment that investors start celebrating a soft-landing.

The generalised fall in inflation should reduce pressure on central banks to maintain tighter monetary policy. It’s not falling as smoothly or as fast as policymakers would like everywhere, but the trend seems clear. Eurozone inflation has fallen to 5.5% (Spanish inflation below 2% on the latest reading), US headline inflation to 4%, and while core inflation is still higher, it has fallen to its lowest levels since November 2021. The UK faces a more acute inflation issue: a higher peak and a slower fall, with global inflation trends exacerbated by Brexit-related disruption in both labour markets and supply chains, but even here the tide seems to have turned towards falling inflation. Transitory inflation took longer to pass than many first thought, but it is indeed, at long last, passing.

There will be bumps along the way, and central banks will remain edgy about high levels of wage rises that are not yet consistent with inflation coming back to their target levels, but unless wage rises become more thoroughly embedded year after year, or commodity prices surge higher again, it is hard to see the broad trend in global inflation turning decisively higher, particularly in a gradually slowing economy.

It’s not quite where markets expected it to be at the start of the year - or even six weeks ago - but it’s likely that the final Fed rate hike is close. The awkward question remains as to when central banks will feel able to cut rates in the face of a slowdown. There is a clear risk that central banks will feel compelled to hold policy tighter for longer than in previous cycles, in order to make absolutely sure that inflation has been squeezed out. The longer the wait before a significant slowdown materialises, and the further inflation moderates before that slowdown comes, the more this dilemma eases, but it remains a risk to be watchful for.

This has been an “unloved” equity market rally, missed by many, and accompanied by constant debate as to whether it’s a new bull market or just a powerful bounce in an ongoing bear market. Recession has been widely forecast and many voices have called for a further correction in stocks, citing pressure on corporate earnings as the economy slows, the lagged effect of tighter monetary policy, unattractive valuations - especially for the sky-high tech stocks at the top of the index - and the appeal of cash or bonds yielding 5%. Surveys and analysis of investor positioning suggest that attitudes have remained quite cautious, with investors often overweight cash, awaiting a correction or a much clearer outlook before shifting into equities. Yet it hasn’t happened: despite everything, stocks have wrong-footed many investors, charging closer to their 2021 highs, with volatility falling back to pre-pandemic levels.

We all know that past performance is not a guide to the future, and precedents are there to be overturned. Nonetheless, this is only the tenth time since the war that the S&P 500 has gained 10% or more in the first six months of a calendar year, rebounding from a negative prior year. In eight of the previous nine occasions, the index gained in the second half of the year - more often than not, making double digit gains.

Can it last - have markets run too far, too fast ahead of events, with valuations too extended in the face of rising interest rates, higher bond yields and slowing growth? Is a rise in optimism and a fall in volatility simply setting up the conditions for a correction, or a renewed bear market, just as investors start to accept a “soft-landing” narrative?

The outlook is uncertain and stocks are already pricing in significant good news. There is always room for optimism to inflate further if the soft-landing does materialise, just as there is scope for volatility on every data point that might bring this outcome into question. The level of uncertainty suggests it’s not a time to be taking aggressive bets - in either direction. Investors can be prepared with truly diversified portfolios, spreading exposure not only across today’s top performers, but backing styles, sectors and asset classes that may be out of favour, but could offer relief when today’s flavour of the month becomes tomorrow’s hangover.

N.b. All content is based on data at the time of writing on 7 July 2023.