A view on Financial Markets: Beware saying, "The market's wrong"

Monday, 26th September 2022 10:39 - by David Harbage

Financial markets have experienced a turbulent, bruising few days as central banks took action to counter uncomfortably high inflation, overnight interest rates were hiked in Norway, Sweden, Switzerland, the United Kingdom and the United States this week – which has increased the prospect of recession in Europe and North America.

Looking back on this year’s two previous commentaries “Batten down the hatches” in March and July’s “The darkest hour is just before the dawn”, the writer retains the same cautious perspective on the short term outlook and wonders if further comment can add much value. However, journalists would rightfully say that there has been a plethora of significant news events - both geo-political and economic – to impact financial assets and, in the modern age of ever-faster transmission and rise in distribution channels (notably web-based social ones, increasing the prospect of misinformation), the media’s has become increasingly characterised by ‘drama’ and ‘noise’.

- Batten down the hatches!

- A view on Financial Markets: "The darkest hour is just before the dawn"

Newcomers to stock market investment ask if the past couple of years’ roller coaster performance from company shares represents the norm and, while one can point to recent exceptional events like the Covid virus or Russia’s incursion into Ukraine, it is true to say that investors have always had significant risks to contend with. Different events do, of course, present risks of varying nature and magnitude, but the media’s volume seems to have risen – certainly to the point of drowning out any report of positive tailwinds. Private ‘Do-It-Yourself’ investors must always take a balanced view of such developments and apply longer term consideration of their circumstance and needs, ideally maintaining an emotionally detached perspective on the relative merits and risks attached to their investable universe of assets. At times of heightened drama, the emotive forces of greed or fear or can result in prices moving higher or lower than a more rational assessment of circumstances would suggest. However it would be naïve to say that financial markets have got it wrong, as there is always scope for prices to rise or fall further response to unexpected new developments.

So what has changed in the past three months, and how has that impacted the author’s view and suggestions made earlier this year to a potential investor? In the past week Russia’s lack of military success in the Ukraine prompted President Putin to call up another 300,000 soldiers and proffer talk of using nuclear weapons to ‘defend’ his country. Clearly, the Russian leader is unwilling to ‘lose face’ or seek peace – despite growing internal protest – and rails against the West’s economic sanctions, even as Europe has to search for new sources of increasingly expensive gas this winter. Meanwhile, wider global political tensions have risen as US President Biden promised to defend Taiwan from any predatory action from near neighbour China.

Against such geo-political headwinds, the global macro-economic landscape has deteriorated: the historical strength of the greenback in times of international concern (the US dollar has appreciated by more than 20% against the euro, sterling and yen in 2022 to date) has contributed to supply-constrained inflation accelerating in most corners of the world. With economists’ forecasts of consumer price indices struggling to keep up with announced CPI (currently 8.3% in the US, 9.1% in the Eurozone and 9.8% in the UK), central banks have moved, albeit with varying degrees of alacrity, to respond. The Federal Reserve Bank has been most hawkish, increasing US rates last week by 0.75% to 3-3.25%, the European Central Bank also raised its main refinancing operation (MRO) rate by 75 basis points to 1.25% earlier in September and, on Thursday last, the Bank of England moved Bank rate 0.5% higher to 2.25%.

The size of these hikes has taken financial markets by surprise, and the bond (fixed income investments, reflecting longer term interest rates) market – which has often be a more reliable portend of the economic outlook than equity valuations – shook off its early August complacency to reflect a more negative outlook. This featured an inverted yield curve, which is said to occur when longer term interest rates (reflected in bond yields) are higher than shorter term ones. Currently a 5 year US Treasury note (a government backed bond) yields 4% if held to redemption, whereas the 10 year equivalent pays 3.7%. A rise in medium and longer term interest rates makes borrowing less appealing to businesses and similarly to individuals considering a home loan. This, of course, applies to new lending – with much existing debt, in the corporate or personal residential sectors, fixed at lower rates – but the cost of servicing overdrafts, credit card debt and standard variable rate mortgages will inevitably rise to reflect the higher costs of overnight money rates.

In the UK on Friday, new Chancellor Kwarteng’s package of fiscal announcements further spooked financial markets. They took the view that the burgeoning public debt (the misnomer ‘mini budget’ added £200bn) represented an unacceptably high burden - becoming more expensive to service, via higher yielding (long dated fixed or inflation-linked) government bond issuance. The prospect of reduced confidence in the UK’s economic performance (the Bank of England indicated that Britain was experiencing recession, at least by reference to the technical definition of two consequent quarters of negative growth) and its public finances caused sterling to fall further. This was exacerbated by calls for a 1% emergency hike in Bank rate to stabilise the currency ahead of the Bank of England’s Monetary Policy Committee’s next meeting on 3 November.

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The overall new ‘Pro-growth, via lower tax & regulation’ strategy –flagged by Ms Liz Truss in the party leadership debates – would have received a warmer welcome at a time when economic growth was more obvious (for example when the Conservative party gained a large majority in December 2019’s general election). However much ‘water has passed under the bridge’ since then and the current squeeze on domestic living standards could make this package of financial measures (which featured the abolition of the 45% additional rate of tax which applies on incomes in excess of £150,000, and removing the maximum 2x salary cap on bankers’ bonuses) a risky political move. Investors will have to hope that “fortune follows the brave” but, notwithstanding the exceptional short term support given to consumers and business to counter higher energy costs, this winter looks like being a particularly difficult one.

As mentioned in previous blogs, history shows that stock market investments perform best at the bottom of an economic cycle – when interest rates are cut to stimulate activity and investors look forward to an improvement in company profits – but few commentators believe that the nadir is in sight, with the political landscape (likened to a return in the ‘Cold War’) remaining problematic and difficult to predict. Turning to equity (both of companies listed on recognised stock markets and in the private arena) valuations, most commentators suggest that a lot of bad news and pessimistic outcomes are already discounted (are reflected ‘in the price’); as such, some investors might be tempted to ‘test, if not re-enter, the water’. Currently such a strategy would only be held by a minority of market participants, (based on the estimated weight of monies that has exited European, UK and US stock markets over the summer months), but whether such institutions or individuals prove to be astute, early or just plain wrong will primarily depend on any military escalation or easing in tensions.

While the immediate, fast-moving economic picture is gloomy, one can envisage a more stable scenario (of lower interest rates and slower prices increases, albeit offset by a rise in unemployment) emerging in 2024. Pronouncements from the corporate sector on current trading and their prognosis for 2023 have been surprisingly resilient and, while financial analysts have resisted the temptation to apply a broad-brush mark down of the next two years’ forecast earnings, market strategists have fought shy from calling a turn in investor confidence and asset valuations. Wall Street’s research houses have perhaps been more realistic – reflecting the Fed’s aggressive rate hiking strategy, which has prompted remarkable strength in the US dollar (reaching $1.08 versus sterling and equality with the Euro). Money appears set to become yet more expensive, as economists now anticipate an overnight Bank rate of 3.5% in the UK by the end of the year, and the peak in this tightening cycle is for base rate to reach 4.5% in the late summer of 2023.

Pressed for a view of suggested action for individuals taking the appropriate longer term (essentially considered to be the foreseeable future, but typically a minimum of five years) view, we would reiterate previously expressed views or general principles of long term savings. Although negligible returns are paid on deposit accounts (which have barely risen in response to the hikes in Bank rate), it makes sense to retain cash reserves for unexpected needs, or have a plan to drip-feed monies into the market (perhaps via monthly savings plans). More boldly, investors might deliberately hold cash to take advantage of opportunities to purchase undervalued assets – mindful that fearful or enforced selling (on the part of traders or investors with shorter time horizons or pressing liabilities) might have taken prices lower than that which might be perceived as fair value.

History shows that real assets - be they land, minerals in the ground, property or successful businesses - are the intuitive beneficiaries of higher prices and, even as interest rates are rising, cash’s appeal in real terms (after taking account of inflation) can become even more negative (that is if inflation is running ahead of any rise in deposit rates). By contrast with bank or building societies’ unappealing offering (as savings accounts continue to lag Bank rate), the potential for growth in dividends or rental income suggests that investment in corporate stocks or real estate is likely to remain attractive

Upon seeing any glimmer of resolution in the current dark geo-political situation, the smart investor might choose to utilise accumulated cash to add equity or property investments which appear to be underappreciated by the market. In particular, weak investor sentiment has meant that the share prices of a number of investment trusts have fallen further than one might expect (a) because the underlying asset prices has retreated and (b) the share price has fallen further than the wider market, which has reduced the premium rating or increased the difference (known as the discount) between the trust’s share price and the underlying value of its assets. The institutional or astute private investor will be aware of the normal or average discount over say a one or two year period and, when the discount has significantly widened from this historical ‘rating’, will endeavour to finesse existing positions by adding at opportune moments.

Over the past three months or so, almost all risk assets have delivered disappointing returns despite often encouraging corporate trading results and upbeat management statements. Smaller and medium sized firms, which often offer the prospect of higher future growth than the largest businesses, have been particularly neglected by global institutions – many of whom possess negative views on the British economy. By contrast, the FTSE 100 index’s multinationals retained their recent relative appeal, aided by the translation effect of overseas profits (boosted when considered in sterling terms) and an intuitive belief that larger companies can survive an economic downturn better than smaller listed or private family-run firms. However, such potential ‘silver lining from recessionary clouds’ – perhaps from an increase in market share as ‘Momma-Poppa’ businesses fail – extends beyond the UK’s largest hundred listed concerns (the constituents of the FTSE 100 index) to medium and smaller sized quoted companies, which could also be industry leaders.

Looking forward, events in the Ukraine - which undoubtedly represent an adverse sea change for the world – are set to dominate: a return to the 1980s’ relationship between autocratic and democratic nations. China represents something of an enigmatic factor: being closer to Russia in political terms, but dependent on US & European demand for its manufactured product. A cessation of hostilities in the Ukraine (an experience which should discourage President Putin’s ambitions to restore the USSR concept), will not necessarily facilitate an immediate return to the pre-invasion ‘landscape’. In addition to increasing spend on defence budgets, the Eurozone will seek to reduce dependence on Russian oil & gas and, post the Covid experience of supply shortages, most developed nations will endeavour to become less dependent on others for essential product. Speaking of the pandemic, investors should not forget that China still operates a ‘zero tolerance’ policy towards the coronavirus which, reportedly, is currently impacting 70 of its cities and is set to reduce the world’s second largest economy to GDP growth of just 1% in 2022.

Closer to home, inflation remains the key concern. Dislocation in customer relationships and historic supply chains has produced higher prices (especially in energy), with a tight labour market raising the prospect of wage inflation, leading to higher interest rates, slowing GDP, (a combination often referred to as stagflation) and the probability of recession in Europe along with many other parts of the world over the next year. In the UK, the cost of living ‘squeeze’ - as inflation appears set to remain higher for longer – is expected to be felt throughout 2023.

It is to be hoped that central banks will be mindful that much of current inflation is driven by shortages (of both labour and other resource) and is aware of fragile confidence (as business and consumers struggle to keep up with price rises) but, most importantly, appreciate the historic lesson of ‘boom & bust’ that can result from under or overkill - when setting rates. Recognition that inflation has probably already peaked (acknowledging comparative data, as previous year’s numbers drop out), and economic activity is naturally slowing (if not already in negative growth territory) should encourage central banks to adopt a less aggressive, hawkish strategy. In addition, given the UK’s recent bias towards issuing government stock with income coupons and redemption values calculated on inflation data terms, the Treasury will also be fearful of the longer term impact this will have on the public purse’s ability to service its debt.

On a brighter macro note, the prospect of further Covid infection this winter leading to economic disruption – with 2021’s lockdown being generally agreed to be an over-reaction - would seem to be receding in most developed countries, although China (where vaccination of the elderly remains surprisingly low) might be an important outlier. Higher controllable levels of inflation can be a positive factor (notably in reducing debt, relative to asset prices) and successful businesses can maintain profitability if their services or products feature sufficient pricing power (as to be able to pass on higher input costs to their end customer).

Reiterating a belief in successful company businesses and property investments for the appropriate longer term but, anticipating tougher economic conditions and geo-political uncertainty (at home and abroad) over coming months, it remains sensible to exercise caution in the short term. Certainly it is dangerous to ignore falling financial markets and to minimise their predictive efficiency or accuracy by saying “the market is wrong”.

Finally, further to the suggested asset mix and investment selections proffered in this blog’s previous articles “Batten down the hatches” and “taking early retirement – how should I invest £100,000?” the author updates his views. In the first instance, maintaining £40,000-£50,000 in Premium Savings bonds as a cash reserve, before providing an indication of asset allocation for the remaining monies along with a few favoured investment trusts. Please note, that the investments mentioned below are not personal recommendations – readers must carry out their own research:

Placing 25% of remaining worth in UK listed company shares – for example via Henderson Opportunities (HOT) (on a 16% discount to its underlying net asset value - NAV), Aberforth Smaller Companies (ASL) (on a 17% discount to NAV) and Schroder UK Mid Cap (SCP) (on an 18% discount), each having valued its assets on 22 September.

20% into Global company shares - such as Herald (HRI) (on a 20% discount to its 22 September worth) and Pershing Square Holdings (PSH) (on a 34% discount to a 20 September valuation), 25% into Private company shares - via Harbourvest Global Private Equity (HVPE) (on a 44% discount to its 31 August 2022 valuation), ICG Enterprise (ICGT) (on a 39% discount to 30 April worth) and Pantheon International (PIN) (on a 45% discount to 31 July NAV), 30% into Real estate - Schroder Real Estate (SREI) (on a 43% discount to NAV), Civitas Social Housing (CSH) (on a 37% discount) and Aberdeen Property Income (API) (on a 46% discount). These valuations are based on 30 June 2022, the latest quarterly dates.

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.