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A view on Financial Markets – it’s a Barometer, not a Thermometer

Monday, 17th July 2023 09:59 - by David Harbage

Looking at the first half of 2023, it was a period in which economic data disappointed and fell short of consensus market forecasts. In particular, domestic inflation and UK interest rates turned out to be significantly higher than had been anticipated on 1 January – with consumer price index (CPI) inflation slow to fall at 8.7% in the year to May, Bank rate reaching 5% on 22 June, and 5 & 10 year UK government bond (gilt) yields of 4.7% and 4.5% respectively.

The FTSE 100 – an index of the one hundred largest companies listed on the UK stock market - which began 2023 at 7,465 and touched 8,023 in mid-February, slipped to 7,328 a month later before rallying back up to 7,933 in late April. Since then the higher inflation cum interest rate headwind has dominated, pushing the FTSE 100 down to 7,229 on 10 July. In a week of media headlines surrounding industrial action within the public (doctors & teachers) and private (rail) sectors, economic data remains decidedly weak, with housing expense (mortgage and rent) capturing the headlines – from energy and food bills – in the ‘cost of living’ crisis.

With tougher economic times in prospect, as inflation becomes more embedded and yet higher borrowing costs probable, investors in company shares and other real assets (such as property) will be asking themselves if, and when, sentiment can turn for the better. In the belief that the painful ‘medicine’ of higher interest rates will eventually choke off inflation – as the demand side of the economy is curtailed – the experienced observer will already be anticipating an improvement in the news flow, as the peak in medium term money (illustrated by 5-10 year bond yields) comes into sight.

A pivotal piece of data may have emerged earlier this week in the form of annual CPI in the United States for the month of June increasing by just 3% - down from the forty year high of 9.1% a year ago – as energy prices retreated 16.7%, encouraging hopes that the Federal Reserve Bank would not have to hike rates again. While domestic inflation has proven more difficult to tame, the global picture provides a glimmer of hope which could be a catalyst to the stock market starting to regain the ground it has recently lost. It should be remembered that financial assets are priced not to reflect today’s news – like a thermometer taking the immediate temperature – but rather the longer term expectation: barometer-like.

Such a focus on the medium term – or the horizon (equates to a view of what can be seen the furthest away, perhaps 20 miles to the human eye or two years in terms of possessing confidence in anticipated developments) – is helpful. For example, the economic cycle (of lower or higher activity) repeats itself through history and can be a useful guide to how the next couple of years pan out. Seeking to avoid boom-bust scenarios, politicians and central banks use various tools to smooth and lengthen the cycle – notably raising interest rates to dampen activity or lower the cost of money when seeking stimulate growth.

Not unlike manipulating a rudder on a boat, such smoothing action should be taken early in anticipation – rather than belatedly, to avoid a calamity – and certainly British authorities appear to have underestimated the threat of wage and other core drivers of local inflation. The UK will pay a price for this via higher indebtedness, in both the public and private sectors, which in turn will inhibit economic activity (discouraging taxation cuts, corporate investment, and consumer confidence). Irrespective of whether a technical recession occurs (evidenced by two subsequent quarter periods of negative growth), a more painful downturn will occur – especially for those with heavy debt commitments.

However, although inflation statistics and developments to date this year have disappointed or underwhelmed, the international community has begun to appreciate that the risk of excessive inflation is being tackled and that a repeat of the deep recession of 2009/09 - when the UK’s gross domestic product (GDP) fell by 7.2% - can be avoided. Sterling has strengthened (from US$1.07 in September last year, when Chancellor Hunt was forecasting recession, to 1.31 today) which, while appreciating that higher interest is necessarily being paid, also recognises that the UK can avoid a severe downturn.

There is no doubt that the naysayers have held sway insofar as the perception of the opportunity to invest in Britain is concerned – especially since the Brexit vote seven years ago. However, while UK plc’s economic performance since Covid may have fallen short; the same cannot be said of its stock exchange listed businesses. Overall, corporate earnings have met or beaten analysts’ forecasts – perhaps not surprising when considering that 82% of the FTSE 100 index constituents’ revenue arises overseas. The next largest 250 companies listed on the London stock exchange (delineated within the FTSE 250 index) procure 57% of their turnover from outside these shores.

That the FTSE 250 is not a reflection of the domestic economy has perhaps escaped the appreciation of some global asset allocators – given their neglect of medium sized businesses which typically have an individual worth of between £1 and 4bn. After having comfortably outperformed the FTSE 100 in the first two decades of the new millennium, the mid cap index retreated from being north of 24,290 in August 2021 to reach 16,520 in October last year. In 2023, the FTSE 250’s path has closely resembled its larger peer – rising to 20,610 in January before settling back to 18,575 today – some 24% lower than its August ’21 peak (as compared to the FTSE 100 which is just 7% off the all-time high it reached in February 2023).

For those who are taking the appropriate longer term view (think in terms of a decade plus) and have the stomach for further unpalatable economic news over the shorter term, the current dearth of good news but overwhelming weight of negative sentiment towards the UK as an investment destination could prove to be an irresistible opportunity. This blog has previously highlighted the low valuation of UK listed companies compared to similar firms listed on overseas stock exchanges (for example, based on current profitability, they are priced at half that of the US) and the apparent value in the higher growth FTSE 250 compared to the FTSE 100 (Price to book, or asset, value of 1.3 times versus 1.6x for the larger businesses). In an entirely free market, US businesses could afford to pay a near 100% premium to current equity prices to acquire these UK firms on immediately earnings-enhancing terms.

Such mathematics persuade the author that exceptional value resides amongst the UK’s medium and smaller sized companies and that the pessimism towards Britain has grossly exceeded the likely medium term outcome for the listed firms – which often feature global niche leaders within this segment of the London stock exchange. The prudent investor will reduce the risk of individual corporate failure (an inescapable inevitability) by investing in a large number (say 100+) of individual companies – either via an index tracker such as Vanguard FTSE 250 exchange traded fund (ETF) (VMID)  or an actively managed fund, where the manager makes selections from the available universe.

In the author’s previous blog, ‘The Value Portfolio’, the following actively managed UK equity investing trusts were flagged as worthy of consideration (please note: not recommendations): Aberforth Smaller Companies (ASL), Artemis Alpha (ATS), Baillie Gifford UK Growth (BGUK), Henderson Opportunities (HOT), Lowland (LWI), along with FTSE 250 focused trusts: Mercantile (MRC) and Schroder UK Mid Cap (SCP).

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This blog can be summarised by saying that financial markets’ remain focused on inflation, central banks’ response and the economic consequences. Geo-political concerns continue to cast a shadow on risk assets, as investors come to terms with a more protracted conflict in the Ukraine (even as the defenders launch a counter-offensive). More encouragingly, the prospect of a global banking crisis – prompted by several relatively small bank failures in the US and, closer to home, by the demise of Credit Suisse – has receded.

Public finances came under the microscope in the second quarter of the year, most notably in the United States via the perennial debate surrounding the appropriateness and level of the debt ceiling (the curb, determined in law by the House of Representatives and the Senate on government borrowing). US debt has almost tripled since 2009 and rising geo-political tensions (will equate to higher defence spend) allied to sub-trend economic growth will exacerbate national debt of $31.4 trillion on 1 January 2023 by a further $1.4tr in the current calendar year. America’s government debt is likely to reach 133% of the country’s GDP (gross domestic product) by the end of 2023.

By contrast, UK government debt is in relative terms a little lower - equating to 100% of GDP - whereas most economists would view a 40% ratio (akin to Australia’s current balance sheet), as being a healthier or more acceptable level of indebtedness over the course of a normal business cycle. In figures released in late June, Britain’s debt exceeded the size of its economy for the first time since 1961 – even as Bank rate was hiked 50 basis points to 5%. HMG borrowed £20bn in May to plug the gap between tax receipts and public expenditure (double May 2022’s deficit, as inflation boosted state benefits and pensions, and public sector pay increased).

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This comes at a time when debt is becoming more expensive to service for governments (as inflation rises and coupons increase on redemption rollover of debt) as well as the consumer (notably in the form of mortgages and credit cards). While there is evidence that rate hikes - the traditional instrument for controlling inflation – is having the desired effect in the US (interest rate paused in June, at 5% to 5.25%, after US inflation eased); regrettably, the same cannot be said in the UK. Domestically, the consumer price index (CPI inflation) has fallen from a recent high of 11.1% last October to 8.7% in April – and unexpectedly remained at 8.7% in May, which prompted the Bank of England’s more aggressive hike on 22 June.

By contrast with public and personal finances, the balance sheets of stock exchange listed businesses in the UK appear relatively healthy – having been re-engineered in recent years, locking into low fixed rates over longer terms. Published company results have evidenced low interest charge expense and firms with pricing power have managed to pass on higher input costs and maintain their profit margins.

The investment landscape looks more level – based on the income yield on offer from various asset types - than it has for 15 years: investors can choose to own:

UK 2 year gilts (government-backed bonds) yielding 5.1%, the 5 year equivalent gilt pays 4.7% if held to redemption, the 10 year gilt 4.5% and the 30 year gilt 4.4%.

US treasury equivalents 2 year 4.8%, 5 year 4.0%, 10 year 3.8% and 30 year 3.8%.

German bund comparators 2 year 3.2%, 5 year 2.6%, 10 year 2.5% and 30 year 2.5%.

UK investment grade quality corporate bonds 2.8%.

Global lesser quality corporate bonds 4.0%.

UK commercial property ranges between 4.0% and 7.0%.

UK larger companies (FTSE 100 index) 4.0%.

UK medium size companies (FTSE 250 index) 3.0%.

A combination of the forecasts made in June from the International Monetary Fund (IMF) and the Organisation for Economic Co-operation and Development (OECD) suggests sluggish economic activity (measured in GDP growth or decline) in developed markets this year: US +1.6%, Canada +1.4%, Japan +1.3%, Italy +0.9%, France +0.7%, UK +0.2% and Germany +0.0%. In almost every case, a small improvement is anticipated in 2024.

Taking a global perspective, the peak in interest rates has been pushed forward by six months as wage pressures continue to fuel inflation, even as high previous year comparators fall away. While some developed economies may have already reached the rate summit (notably the US, whose economy is slowing rapidly), and most will reach it in the second half of the year, the UK may be outlier and its peak (of perhaps 6.5%) may not be comfortably assumed (from the ‘rear view mirror’) until the first quarter of 2024. Allied to upward pressure on the price of life’s other essentials, core UK inflation is set to be significantly above its 2% target and the ‘cost of living squeeze’ will no doubt remain a critical factor come the next general election (due before January 2025).

Inflation and interest rates will almost certainly be moving in a southerly direction by then, but the parlous state of the UK’s public balance sheet would indicate little scope for tax ‘giveaways’. By contrast the global economy is likely to be exhibiting greater ‘animal spirit’ and history suggests that both fixed income, property and equity (business or company share) investments can make progress in an environment of falling interest rates and lower costs of capital.

Looking beyond economic data, the biggest boost to investor confidence would be an end to the conflict in the Ukraine - ideally accompanied by an easing in China-Taiwan political tensions. Clearly the geo-political landscape is particularly difficult to call, but the writer retains a positive perspective on a revival in global co-operation - which extends beyond trade – with influence from export-dependent China facilitating a better outcome than currently appears likely.

While most stock markets began the first quarter of 2023 in optimistic mode, mixed economic data restrained April’s enthusiasm – especially in the UK. Given the macro ‘top down’ economic news and political shenanigans, it has been somewhat surprising that investors have retained an appetite for risk. Countering this, ‘bottom up’ trading reports from listed businesses, private equity concerns and commercial property companies have been encouraging. Typically news of strong profitability, higher dividend distributions and asset appreciation has been ignored by the market, resulting in the gap between an investment trust’s portfolio worth and its share price has widened.

Many readers will no doubt be saving monies for their retirement (or plan to pass on their wealth to the next generation) using tax-efficient SIPP and or ISA wrappers. They will adopt a logical ‘head over heart’, less emotional perspective of such share price markdowns – welcoming the opportunity to buy good assets at lower prices. The active personal investor will closely monitors the progress or otherwise of each of the investment, perhaps adding to those which appear particularly neglected by finessing purchases as well as top slicing individual investments which appear fully valued (by comparison with their benchmark index, the performance of peers and other exceptional considerations).

Interest rate sensitive assets like bonds and property (and to a lesser extent venture capital) have suffered most from the rising recognition that domestic inflation is proving more resilient - than is the case in many other developed economies – and that the peak in UK interest rates could yet be six months away. As a consequence, real estate has received a particular poor press (given that our media is fixated on house prices - having already called annual falls of between 1% and 3% a ‘slump’ – rising rents and the woes of buy-to-let investors) and commercial property has not been exempt. As an example, Britain’s biggest listed property company Segro (previously known as Slough Estates) is enjoying high occupancy and trading well , but its shares fell 15% in June, reflecting the rise in Bank rate and borrowing costs.

Last month there was considerable speculation that the online food retailer Ocado Group (OCDO) was being stalked by the US technology giant Amazon (which owns Amazon Fresh and Whole Foods Market); prompting a 40% rise in the former’s share price. Priced in sterling, much of British business appears undervalued, by reference to Wall Street’s metrics. However, as intimated earlier, it is beyond the UK’s largest one hundred businesses that best relative value would seem to reside. There have been 12 bids for listed UK companies in the first half of 2023 with a combined value of £13bn – all of which were smaller or medium sized, rather than large cap, companies. If the current level of mergers and take-overs in this segment of the market continues in the second half of the year, 2023 could exceed the record level set in 2021 for such activity. It is notable that private equity and venture capitalists (who are, based on impressive track records, regarded as being particularly astute) have been pronounced buyers – alongside other traditional predators who might be acquiring a competitor, an industry peer or a complimentary asset.

Acquirers are frequently paying 30%+ premium prices which suggest that Britain’s smaller companies are often significantly mispriced. This should not come as a surprise, given the declining level of research produced by sell-side broking institutions. Conversations with fund managers of small cap trusts and funds indicate that they are invariably having to carry out original investigation and monitoring of their portfolio’s constituents. As mentioned above, we continue to favour both listed and private closed-ended funds investing in non-FTSE 100 sized businesses in the belief that much of this asset class is undervalued. A positive, potential ‘double whammy’ presents itself by such trusts whose shares are priced at discounts - ranging between 10% and 45% - to their estimated asset worth.

Looking forward into the second half of 2023 and immediately beyond, there are certainly plenty of headwinds to concern investors whose focus may be on short term valuations. The old adage about the “market climbing a wall of worry” can be reiterated without apology and hopefully provides a boost to confidence, as we have seen businesses cope with pestilence, war and most recently financial stress over the past three years - but yet continue to generate higher revenues and distribute higher dividends. This has not just applied to listed firms, but private ones too – where progress in asset values and earnings have seemingly been overlooked.

Without wishing ‘to sound like a broken record’, this writer retain confidence in successful company businesses and real estate investments for the appropriate longer term as it is only this kind of asset which can offer the potential to produce a rising income stream over the longer term. While expecting difficult economic and uneasy geo-political conditions to prevail throughout this year, one can envisage prospects for 2024 appearing brighter. In anticipation of forward-looking investor sentiment adopting a more ‘risk-on’ approach, this encourages a view that the worst has been seen and real assets can appreciate from here. Evidence of a labour force taking sub-inflation wage increases would encourage a belief that the potential scourge of embedded inflation (experienced in the 1970s and 1980s) can be avoided, would be the catalyst to reignite investor sentiment.

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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