The September quarter brought different experiences for share and bond investors. Strong company earnings helped equity markets withstand higher interest rates, while those same rates weighed on fixed income returns. In this more volatile and selective market, we were pleased to see an improvement in fund performance, with the majority of our funds outperforming their benchmarks in the third quarter.
Market drivers in the third quarter
The headline 1.9% gain in the MSCI World Index for the third quarter masked turbulence beneath the surface. Investors had to absorb sharply rising interest rates, escalating conflict in the Middle East, and a slump in the AI trade during the quarter. US Treasury yields also reached 20-year highs on rising government debt concerns and persistent inflation, weighing on interest-rate-sensitive sectors such as housing-related cyclicals, utilities and REITs.
Global equity markets were supported by strong performances from large cap US tech companies including Meta (+29), Microsoft (+38) and Nvidia (+14%), while US small cap stocks and markets in Europe, the UK, Australia and Emerging Markets declined during the quarter. Strong US corporate profit growth also helped offset what may have otherwise been problematic interest rate and inflation increases.
Selected AI-related stocks fell sharply in July, when the SOX semiconductor index slumped 21%. Investors are increasingly distinguishing between companies where heavy AI investment is driving accelerating revenue growth, such as Microsoft and Meta, and those where the returns remain less visible.
Our selective approach to the AI trend and focus on business quality and the sustainability of earnings helped our fund performance over the quarter.
Borrowing became more expensive
For bond markets, the pressure was more direct – with rising interest rates pushing bond prices lower in the quarter. Persistent inflation and elevated government debt burdens have led investors to demand higher yields. By the end of September, the yield on 30-year US government bonds had reached its highest level since 2002. Energy prices added to the problem, with Middle East tensions again pushing oil above US$100 a barrel and central banks faced renewed pressure to contain inflation. Rate increases can restrain spending, but they cannot resolve disruptions to energy supplies. That leaves a difficult balance between containing prices and avoiding unnecessary damage to growth.
Substantial investment in AI infrastructure has also had consequences for interest rates. While spending on data centres has supported business activity and equity markets, it has also resulted in a surge in debt issuance to fund that construction. This elevated demand for debt capital is also contributing to a more expensive financing environment.
Attention now turns to whether companies can sustain growth as higher borrowing costs work through the economy. Investors will also be looking for further evidence that spending on AI is translating into stronger revenues and profits.
For fixed income, higher yields offer a better starting point for future returns. Over much of the last two decades, fixed income investments offered unattractive yields. That is starting to change and should provide improved results for investors with more conservative risk settings.
An encouraging improvement in fund performance
The investment team has been busy repositioning our portfolios in recent quarters, and it is encouraging to see an initial improvement in performance. Over the third quarter, the majority of our KiwiSaver and managed funds finished ahead of their benchmarks.
After a challenging 12 months, our Australian Growth Fund (+3.9%) and International Growth Fund (+3.3%), both outperformed their market benchmarks during the quarter. Our KiwiSaver Growth Fund (+1.4%) and KiwiSaver Balanced Fund (+0.5%) also outperformed their benchmarks.
It is still early, and a single quarter is too short to judge performance but it is pleasing to see progress. Our focus remains on building on that improvement through careful investment selection to deliver sustained results for clients.
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