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A view on financial markets – Are we still travelling or have we arrived?

Friday, 24th September 2021 15:22 - by David Harbage

Investor sentiment seems to be changing as equity markets’ ‘risk on’ momentum appears to be slowing – notably on concerns that the authorities begin to pare back their financial support, as economies emerge from lockdown.

In the last month or so, investors’ assessment of economic data and forward-looking survey indicators have cast a shadow – driven by fears that the Covid pandemic continues to be an impediment to normality – notably via weaker trends emerging from China.

One particular concern surrounds the current rate of inflation, which has exceeded expectations and intuitively could lead to higher interest rates; will it prove to be transitory or becomes in-bedded, and therefore an on-going threat to the valuation of real assets.

Several leading equity market indices achieved new highs in the summer, driven by record levels of institutional and retail investor cash flows, but the last few weeks has seen investors’ appetite for risk ease.

Fears surround the level of indebtedness in the Chinese property sector and, closer to home, supply shortage-driven higher prices. Fund manager surveys have indicated reducing appetite for equity, while consensus forecasts for the next twelve months retain an overweight exposure to stocks.

Higher inflation persuading for higher interest rates, sooner, is the market’s prime current concern. In the UK, August’s 3.2% annual rise in consumer prices represented domestic inflation’s highest level since 2012 and the jump from July's CPI of 2% marked the sharpest month-on-month increase since 1997.

The price of food and fuel were two of the major drivers, prompting official calls for savers to acknowledge the deterioration in their purchasing power and to encourage spending. HM Government’s recent suspension of the average earnings element (estimated to be 8% per annum) of the so-called ‘triple lock’ to increase state pensions was justified by opining that the cost of domestic labour was extraordinarily, but also temporarily, high.

A plethora of supply shortages – ranging from foodstuffs to building materials, gas to electronic components – in part exacerbated domestically by Brexit, has also contributed to higher prices.

As a consequence of such inflation and in consideration of central banks likely tapering of their asset-purchasing support for bonds (keeping yields low), market strategists are reconsidering their forecasts for monetary policy.

While a consensus of economists in July had expected no change in key overnight rates before 2023, many commentators now expect a hike much sooner – if only to flag to financial markets the wish to move towards ‘normalisation’ of rates.

Of the major developed world central banks, the ECB may be the last to move: an unpublished report of their modelling for the Euro rate suggests the first rate rise on the continent in the final quarter of 2022. With economic growth and animal spirits currently appearing stronger in the UK, prospects for dearer money here are greater – as is also the case for the United States, despite a fourth wave of Covid infection which is impacting many populous states.

Our current expectation is for UK Bank rate to rise from its current 0.1% to 0.25% in May 2022 and to rise by another 25 basis points in December 2022 to reach 0.5%. Such moves would put prospective borrowers – corporate and personal – on notice of a clear change in direction from the current policy of easing, and the public sector should be able to manage its debt (features gilt repayment and issuance) at that level.

It is to be hoped that inflationary forces would then be easing (as factories move back towards full capacity and the distribution chain is in better shape) and pressure to hike again abates.

Although not seen for a long time in Britain or in most of the developed world, a self-feeding, wage-driven, rising and sustained inflation has some benefits (notably in reducing debt, if assets are rising) but, on balance, it would be an unwelcome visitor to the economic landscape.

From a company stock and bond perspective, higher inflation and rates would adversely impact the value of such investments – both from consideration of the relative immediate real return and a calculation of the present worth of future income.

The latter would particularly be unhelpful in valuing high growth businesses, such as those in futuristic ‘jam tomorrow’ industries where revenues are being reinvested rather than being distributed to shareholders.

We would reiterate the City’s saying that “financial markets prefer to travel, rather than arrive” – as evidenced by the equity rally which began as soon as a vaccine for Covid was found (in November last year), and has continued to draw support from central banks’ massive creation of money.

If it is now considered, based on high levels of vaccination, that we have ‘arrived’ the focus of investors’ attention will turn to the next phase in the economic, cum market, cycle and begin to travel in a more cautious direction until clearer evidence (notably of less Covid-induced economic disruption and supply-led dislocation) emerges.

It is not difficult to predict a pessimistic short term prognosis, based on the damaging consequence of higher interest rates which, adversely impacting public finances, would prompt a larger fiscal deficit and potentially persuading for a return to austerity measures (lower public spend, higher taxation).

Consumer confidence would fall as personal spendable incomes are squeezed by higher mortgage costs, and corporate investment would come under pressure leading to a contraction in investment in new capacity (impacting employment et al).

However, while public finances are particularly stretched, post governments’ financial support over the past year; market commentators and central bankers have encouraged a belief that a benign longer term outcome is possible via a flatter economic cycle.

More positively, one can point to a domestic personal sector which has reduced its debt over the past two years, and that the cost of servicing corporate indebtedness is very low, as larger businesses having carried out major financial engineering to lock into very low rates.

The experience of the past eighteen months illustrates the importance of retaining an appropriate ‘head over heart’ perspective on the various assets available for long term investment. An emotion-driven decision to exit risk assets, such as equity or property – in favour of holding cash - in early 2020, as economic lockdowns were introduced was understandable, but probably flawed.

Sitting on the side lines, in an asset which provides negligible returns, awaiting the best opportunity to re-enter the market is not a comfortable place to be. More sensible to remind oneself of long term objectives, progressing diversification (owning different asset types that can perform in an uncorrelated, but positive inflation-matching way) and placing an increasing emphasis on defensive, essential or undervalued assets..

As a manager of monies for the long-term (say ten years, plus), one would want to own assets which offer the potential of keeping pace with rising liabilities (the cost of living in layman’s terms). Based on passive, low-cost replication of a major index, the ishares UK inflation index linked gilt Exchange Traded Fund (ETF) provides exposure to sterling-denominated British Government stocks whose income and capital redemption worth is linked to domestic inflation (retail price index and, from 2030, the consumer price index plus housing costs CPIH).

In similar vein the ishares Global inflation government bonds ETF (SGIL) owns and tracks equivalent issues overseas. These investments have appeal for their ability to preserve capital rather than enhance its worth. To achieve inflation-beating returns, one would have to look to other real assets which offer the prospect of growth – ideally in their income, as well as capital value – but which probably involve greater turbulence in short term worth, which some savers will find uncomfortable or unacceptable.

In assessing company share (often known as equity) investment one could choose low cost asset replicators, such as the ishare core FTSE 100 ETF (ISF) which tracks the performance of the largest one hundred listed companies on the London stock exchange – and currently offers an income of 3.75%.

Alternatively, one could delegate individual selections to fund managers who you believe can outperform a particular benchmark or are capable of producing an incremental return not offered by an index tracker.

While most fund managers are unable to consistently beat indices over longer term periods, some of the best historic returns have been achieved by investment trust managers.

When appraising such pooled or collective investments, consideration should be taken of the performance of both the underlying portfolio of assets and a trust’s share price – ideally seeking to buy shares when their discount to NAV is greater (or premium is less) than their recent past.

Typically, trusts investing in particular assets or segments of the equity market will be priced in accordance with that theme’s current popularity – but ideally one should try to identify neglected investments and, therefore, opportunities to add incremental value.

In current uncertain times the writer would focus on seeking Value in individual investment trust selections – examining fund manager strategy or style of investment management (favouring asset backed, profitable businesses with low or no financial gearing) as well as favouring trusts whose share prices’ are priced on a significant discount to underlying asset worth - believing that both can enhance returns over coming years.

Pressed to proffer a view, the writer is unexcited by the prospects for fixed income investment over the next twelve months, but the following kinds of asset have appeal:

UK smaller and medium sized companies – in expectation of an upward re-rating of domestic businesses, further corporate activity and in appreciation of their increasing ownership of revenue-generating digital assets, the following merit closer inspection: Aberdeen Smaller Companies Income, Aberforth Smaller Companies, Downing Strategic Micro-Cap, North Atlantic Smaller Companies and, amongst those focused on medium sized (typically within the FTSE 250 universe) firms, Herald (HRI), Mercantile (MRC) and Schroder UK Mid Cap (SCP) investment trusts.

UK equity – looking beyond smaller companies, the multi-cap, thematic investor Independent investment trust may appeal and for those looking for a focus on large, high quality growth businesses Finsbury Growth & Income (FGT) merits investigation.

Private equity and Flexible assets – these managers, primarily of unquoted businesses, often feature a bias to the technologies of the future, be it in healthcare or the internet-facilitated age. They are able to manage businesses out of the public glare and often these trusts are priced on significant discounts to their underlying worth. Oakley Capital (OCI) is a fine example of a manager taking direct ownership of private companies, and the following more diversified trusts are also worth investigating: Caledonia (CLDN), Harbourvest Global Private Equity (HVPE), ICG Enterprise (ICGT), Pantheon (PIN) (which announced a pleasing increase in its asset value today) and Standard Life European Private Equity investment trusts.

Global equity – the prospective investor has a range of specialisms or geographies to choose from. These include a focus on medium sized companies Smithson (SSON) and TR European Growth (TRG), exposure to the world’s biggest gold miners i shares Gold Producers ETF, major technology focused industries Scottish Mortgage (SMT). However, probably favourite for closer scrutiny – with global equity indices close to their highs – would be the following generalists, as their shares lag their asset worth: AVI Global (AGT), Brunner (BUT), Pershing Square Holdings (PSH) and Scottish investment (SCIN) trusts.

Specialist assets – offering diversification beyond equity, the following investments might have appeal: property trusts with a bias towards industrial units or warehouses Standard Life Property Income (SLI), UK Commercial Property (UKCM), TR Property (TRY) and Tritax Eurobox (EBOX), precious metal i shares Physical Gold ETC, beneficiary of global infrastructure spend Ecofin Global Utilities & Infrastructure (EGL) and clean energy, water & waste focused Impax Environmental Markets (IEM) investment trusts.

In planning finances, one should never ‘put all of your eggs in one basket’ and all investors must ensure that they have liquid funds - to meet planned, as well as unanticipated, needs – before considering stock market or other forms of investment.

In addition to a ‘rainy day’ fund, retaining some of one’s longer term wealth in Cash could prove beneficial as a source of funds to take advantage of new investment opportunities as they present themselves.

Gold can also be seen as a quasi-cash asset, notwithstanding its dull performance this year - reflecting a period when investor sentiment favoured riskier forms of investment.

Digital crypto-currencies have captured a lot of media attention over the past year and have probably restrained investor appetite for the traditional ‘safe haven’ alternative asset of precious metals.

Looking forward, a potential combination of high inflation, low bond yields (interest rates) and a weak US dollar could provide a supportive backdrop for the price of gold.

The re-opening of the domestic economy has provided a helpful tailwind to Property, as tenants’ ability to pay rent has recovered and asset prices have recovered in almost all segments - except secondary retail locations.

Online shopping is here to stay and is set to take a greater share of the non-food retail market in particular – which continues to encourage ownership of industrial, warehouse, business and retail park property.

Residential property prices – driven by structural factors (notably excess demand over supply) - have benefitted from HMG schemes to help first time buyers and, most recently, the reduction in stamp duty. With the end of the latter in particular, domestic house prices are likely to cool in the short-term.

Looking forward, inflation data is set to remain high in the final quarter of 2021 – with annual domestic consumer prices set to rise from August’s 3.2% to reach.as high as 4.5%, before easier comparative numbers reduce the headline number in 2022.

Gas and other fuel prices have garnered recent media headlines and the prime risk is that, in the current tightened labour market, wage demands could follow to feed today’s supply shortage-based inflation into becoming a longer-term issue.

Within developed economies like the UK, the consumer is overwhelmingly the prime driver of economic activity and the higher, relatively uncontrollable gas, electricity and motoring costs reduce disposable income - which might otherwise have boosted the wider economy – contributes very little to growth.

Global growth remains fragile and, as a consequence, interest rates are unlikely to move sharply ahead in a hurry, anywhere of importance soon (given the interaction of the world’s major economies and a wish to retain stability in the relative worth of currencies).

Investors have to place their monies in one sort of asset or another and currently we retain confidence in those which offer the opportunity of producing a growing income to keep pace with the diminishing purchasing power offered by fiat currencies in the current inflationary climate.

Bottom line, the intuitive conclusion that we have arrived and share prices are set to pause for breath – after travelling well over the past year (for instance the FTSE 100 index has risen from 5,500 to 7,000) – is a logical one.

Short-term inflationary and stalling GDP concerns are certainly very real, and trading activity may yet exacerbate retail profit taking in the next couple of months, but financial markets have the habit of surprising (on both the up and down side) and, behaving as a predictive barometer (rather than a thermometer), may yet begin to travel again via a seasonal rally in December.

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.

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