Dynamic Planner’s Investment Committee (IC) met on Monday 24 July with the main task of reviewing the inputs and outcomes from the optimisation process for setting the 2023/24 strategic benchmark asset allocations.

The IC discussed the anticipation of a ‘return to normal’ for financial markets as yield curves should normalize to an upward slope given higher inflation expectations. The US Federal Reserve’s next rate move and its ‘higher for longer’ policy mantra are predicated on high and sticky inflation.

Inflation may have fallen from its peak, but not enough for the Fed to officially pause rate hikes, given its official 2% inflation target. It is unlikely to pivot and cut rates meaningfully within the next two years. However, whilst unstated, a significant slowdown in economic activity or renewed regional banking problems would also get the Fed to take action. On the subject of US banks, the crisis has ebbed since March, but the dangers haven’t gone away.

The dual prospects of slowing global economic and negative earnings growth for the coming quarters raises the risk of ‘intermittent’ rather than ‘deep’ recession. Rising interest rates, unrelenting fiscal deficits and high government debt, reversing QE holdings and high levels of market leverage, due to LDI strategies however, increases the risk of currency and bond market volatility.

Conversely, China, the world’s second-largest economy, officially slipped into deflation for the first time in two years as consumer prices fell 0.3 per cent. Prices had already flatlined for much of 2023, bucking the global inflationary cycle. The property market debt overhang also continues to cast an ongoing shadow over any resurgent growth hopes in China.

UK gilt yields have spiked again in response to unexpectedly strong inflation and labour market numbers. The persistent underlying strength of core inflation suggests the UK is fundamentally diverging from Europe and the US. The recent interest rate rises have had a negligible impact on demand or the housing market (so far), but the economy is teetering on recession whilst unemployment remains lower than expected at this stage of the economic cycle and strong wage inflation (and industrial action) persists. Market expectations are for interest rates to be ‘higher for longer’ in the UK than elsewhere.

The IC approved the Capital Market Assumptions for Q3 2023 which signalled significantly large increases for fixed income volatility (around 10 bps), relative to previous quarters.

Expected returns for fixed income were increased given the recent rise in bond yields. There were also increases for equity return expectations (but to a lesser extent), with the exception of the UK, where they have been lowered.

Read full, Q3 2023 analysis from the Dynamic Planner Investment Committee.