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

Monday, 18th July 2022 10:04 - by David Harbage

Our previous blog four months ago “Batten down the hatches” now seems aptly titled as Russia’s military incursion into the Ukraine and the economic consequences (notably accelerating inflation and central banks’ rate hiking response) of a squeeze on living standards to the detriment of global growth, has been the focus of worldwide attention. Investors’ ‘risk-off’ perspective has continued, from the first half of 2022 into the second, with fears of double-digit inflation, regular rises in borrowing costs leading to recessionary conditions dominating sentiment and prompting further significant markdowns in the price of both bonds and risk assets.

It will not be easy for investors to recover from the geo-political shock of 24 February (when Russia invaded Ukraine), with major global dislocation in energy and food supplies exacerbating the Covid lockdown-induced disruption to supply chains. The domestic political shenanigans and drama – with a new Prime Minister to be appointed in September – represents something of a sideshow in relative terms for financial assets, beyond saying that anyone besides the previous incumbent represents a step forward in terms of the Conservative party winning the next election. Historically, stock market investments have performed 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’) appearing particularly opaque.

While fund managers have expressed optimism in regard to the financial health of their stock selections, market strategists have been decidedly shy about calling a turn in investor confidence. A major portion of the US equity market – in the form of the big technology industries which dominate the Nasdaq index - has already experienced a bear market (typically defined as having occurred when a 20% fall in share prices occur). Wall Street’s forecasters are predicting a steady upward procession in the cost of holding debt and, while domestic interest rates may be ratcheted up less aggressively in the UK – with a consensual view of Bank rate reaching 2.5% by the summer of 2023 - the slower growth, more traditional business activities of the FTSE 100 (featuring high income paying constituents) have had relative appeal.

The US dollar has benefitted from an expectation of higher rates, arriving sooner – by contrast with the Eurozone in particular – prompting a sharp jump in Cable, which has moved from $1.36 on 1 February to $1.18 in the past three months. While such a move in foreign exchange will flatter the revenue and earnings of UK equity businesses (dollar receipts and accounting applies to a high proportion of the FTSE 100), it will also increase domestic inflation as import costs rise and most commodities are priced in dollars. Much of the greenback strength can be attributed to the Federal Reserve Bank’s more aggressive implementation of rate hikes – with another 75 basis point or even a full 1% expected at its next meeting on 26-27 July, following June’s Consumer Price index reading of 9.1% - by comparison with the European Central Bank or the Bank of England. While this may choke off some elements of the inflationary pressures, such a hike (with an expectation of further rises in coming months) could also risk taking the US economy and many other parts of the world into recession. Hawks would argue for a short sharper shock to bring inflation - and, with it, the rate tightening cycle – to a peak sooner, thereby reducing the risk of a more imbedded, wage claim-induce inflation, and resulting in an upward turn in investor sentiment. It may be darkest before the dawn.

At home, the prospect of a marked slowdown in economic activity later this year, caused by a squeeze on personal consumption (notably as higher household energy and transport fuel prices impact), might persuade our central bank to look through the current high inflation data and adopt a more dovish strategy. However, the outlook for headline inflation breaching 10% later this year is certainly a real concern – against the highly unusual backdrop of there being more unfilled vacancies than unemployed in the UK at present – with such labour shortages prompting a marked pick-up in wage demands.

As mentioned in our previous article, ‘war and pestilence’ has often been cited as the biggest existential threats to health and wealth. For inexperienced investors – especially those new to company shares – the past couple of years have no doubt been testing and uncomfortable, as the prognosis of disease or developments in military conflict cannot be predicted with any certainty. While the economic ‘lockdown’ response to the coronavirus might have been unnecessarily destructive to business, the prospect of war in Europe – with a worse case involvement of nuclear or chemical weapons – certainly represents a more serious concern. Coming as it does against a backdrop of high inflation impacting the world’s largest economies for the first time in thirty years and the re-emergence of rising costs of borrowing. Equities’ retreat in the first half of 2022 is not a simple re-evaluation of their worth, after more than a decade long bull market; rather it reflects a new paradigm of fundamental, although not insurmountable, problems and uncertainties.

As investors with an appropriate long term horizon, what should be our current view? In the previous blog we encouraged defensive action to protect capital worth, notably taking more expensive (by reference to asset worth in particular) risk assets ‘off the table’ in response to the developing investment landscape. Notwithstanding an expectation that prudent savers will not want to put ‘all their eggs in one basket’, there will almost certainly be opportunities to take a stake in successful businesses and other real assets (those capable of keeping up with inflation) at attractive prices - prompted by fearful enforced selling on the part of traders or investors with shorter term horizons.

It is worth reiterating that property and businesses are the natural beneficiaries of higher inflation as, while returns on savings accounts might be rising, cash’s attraction in real terms (after taking account of inflation) can become even more negative. By contrast with bank deposit or building societies’ unappealing offering (as interest paid on savings accounts invariably lag Bank base rate), the potential for growth in dividends suggests that company shares are likely to retain their relative attraction as a source of immediate and future income. The imminent corporate reporting season, disclosing profits for the first half of 2022, announcing dividend pay-outs and providing investors with guidance for the next half year or so, will be critical to confidence and the market’s direction of short term travel.

While speculators and traders may have a different perspective, most institutional and retail stock market investors with longer term objectives will be mindful of income returns and view turbulence in share prices as an inevitable, secondary consideration. The private investor who decides that equity investment is suitable, (based on personal circumstances and financial objectives), should also maintain a portfolio of various kinds of asset, seeking to minimise losses from any individual security, via a diversified portfolio – and make selections based on the longer term. This necessitates ‘weathering stormy conditions‘ that will temporarily cause good quality investments to be mispriced, retaining a belief in the critical reason for taking a stake in successful businesses: to benefit from higher earnings, dividend income and asset worth.

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 would be sensible to exercise caution in the short term. Further to the suggested asset mix and investment selections proffered in this blog’s previous “Batten down the hatches” and “I’m taking early retirement – how should I invest £100,000?” articles, the author would maintain the exposure to Premium Savings bonds of £40,000 as a cash reserve (please note that in June ‘Ernie’ increased its prize money pay-out from 1% to the equivalent to 1.4% tax free per annum).

More cautious investors may choose to increase this cash reserve to say the £50,000 maximum – perhaps in the hope of being able to reinvest at a lower level, but more likely to provide greater comfort – perhaps funded by reducing company share investment. The writer has taken the opportunity to update specimen selections by adding another asset-backed property trust, as well as replacing two specialist private company-focused investments with two more diversified trusts. The full list of favoured asset allocation and individual investment (but not personally recommended – readers must carry out their own research) trust selections for long term investment is shown below, for ease of reference:

UK listed company shares 25% of total worth - via Henderson Opportunities (HOT) (on a 23% discount to net asset value, as at 30 June 2022), Aberforth Smaller Companies (ASL) (on a 16% discount to NAV), North Atlantic Smaller Companies (NAS) (on a 32% discount) and Schroder UK Mid Cap (SCP) (on a 14% discount),Global company shares 20% - via Herald (HRI) (on a 21% discount to underlying asset worth) and Pershing Square Holdings (PSH) (on a 29% discount to 21 June valuation),Private company shares 25% - via Harbourvest Global Private Equity (HVPE) (on a 44% discount to its 31 May 2022 valuation), ICG Enterprise (ICGT) (on a 39% discount to 30 April worth) and Pantheon International (PIN) (on a 45% discount to 30 April NAV), Real estate 30% - Schroder Real Estate (SREI) (on a 31% discount), Civitas Social Housing (CSH) (on a 29% discount), Aberdeen Property Income (API) (previously known as Standard Life Property Income trust (on a 28% discount) and UK Commercial Property (UKCM) (also on a 28% discount). All of these property trusts are based on their last published quarterly 31 March valuations.

While it is impossible to call the bottom of a market or indeed for a particular investment, there does appear to be some appetite for risk assets (which typically look out 18 months or so in anticipating future prospects and can offer some protection from inflation), if only in the form of averaging down or buy on weakness purchases. The writer’s natural optimism has been tested since the 24 February events, but an expectation that wider geo-political fears will subside (the Ukraine-Russia conflict appears more contained, if protracted), alongside reports of a few astute bullish economists’ calling a reduction in US inflation to 3% in the second half of 2023, provides hope that financial markets could bounce back sooner than current news would suggest possible. While the news flow will remain deeply negative for the remainder of this year, perhaps the ‘dawn’ arrives just before if not when it is ‘darkest’.

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.