Batten down the hatches!

Friday, 18th March 2022 15:22 - by David Harbage

Russia’s military incursion into the Ukraine and the economic consequences (notably the spike up in energy prices) has not just replaced the Covid infection as the focus of global media and investor concern. It’s a different world, seemingly a return to the pre-1990 ‘Cold War’ and, in financial markets, a ‘risk-off’ perspective has prevailed as fears of an escalation in hostilities resulted in significant markdowns in the price of equity investments. The markets’ perennial concern surrounding the health of the global economy, as central banks raise interest rates to combat higher-than-forecast inflation, also dampened sentiment with several leading economists predicting recession for much of Europe by the year-end.

‘War and pestilence’ has often been cited as the biggest existential threats to health and wealth. For inexperienced investors – especially those new to equity – the past couple of years have no doubt been testing and uncomfortable, as one cannot predict the prognosis of disease or developments in military conflict with any degree of certainty. Commentators might view the authorities’ media-driven economic ‘lockdown’ response to the coronavirus as being overly cautious and unnecessarily destructive to business, but the prospect of war in Europe – with a worse case involvement of nuclear or chemical weapons - represents a much more deadly development.

And this comes against a backdrop of meaningful inflation returning to the world’s largest economies for the first time in thirty years (US annual inflation has not exceeded 5% since 1991), posing the biggest challenge for central bankers since the financial crisis of 2008. Managing stagflation (combination of stagnation and inflation) – a period of time when inflation is rising as economic growth is slowing – presents a dilemma as the conventional ‘medicine’ (of raising interest rates) to curb inflation will typically exacerbate an economic downturn. It feels as if the world is shaking and that such tectonic plate movement extends from climate to health, politics to the economic landscape. Irrespective of the outcome of the conflict in Ukraine, the next couple of years appear set to be testing for financial markets and investors should review their finances and ‘baton down the hatches’ in anticipation of a stormy year ahead.

How should individual savers with a long-term horizon respond to the current geo-political tremors? In previous blogs, the writer has commented that experienced stock market investors have become accustomed to uncertainty and typically possess confidence in the ‘animal spirits’ of entrepreneurs and consumers to facilitate a bounce-back from difficult circumstances. We retain a belief that sentiment towards owning real (inflation beating) risk assets will improve from the current cautious perspective – while acknowledging that in the very short-term, markets are likely to experience heightened volatility, as fears of a military escalation or a pick-up in Covid infection are possible. However it would be prudent to reassess and take defensive action if necessary, based on one’s comfort zone and expectations to protect one’s capital worth in response to the changing investment landscape.

This week’s quarter point interest rate hikes in the US (the first since 2018) and at home, along with the likelihood of another 1% over the next twelve months, can almost certainly be accommodated by the financial markets. It is possible that a slowdown in economic activity caused by a squeeze on personal consumption (as higher energy prices impact), might yet persuade the Bank of England to look through the current high inflation data and adopt a more dovish strategy. However, headline UK inflation of between 8% and 10% over the summer is certainly a very real concern, as higher prices could become embedded. In particular, the labour market is tight - domestic unemployment is historically low at 3.9%, while 1.3m vacancies represents a record high – and, even without industrial action, skill shortages could prompt a pick-up in wages, which lagged inflation last year by 1.5%.

Thursday’s 25 basis point rise in the Bank rate from 0.5% to 0.75% will also inhibit personal spending, as that hike flows through into higher costs of servicing both personal (mortgage, credit card et al) debt and businesses’ lending. A further squeeze is due from next month’s 1.25% increase in National Insurance rates payable by employees, the self-employed and employers. Although Britain’s big corporates are typically carrying relatively low levels of variable rate debt on their balance sheets at present, the 6.6% increase in the National Living wage next month will represent a significant additional expense for many large employers.

It is worth remembering that businesses and owners of property can be the natural beneficiaries of higher inflation (as attached debt falls), while the attraction of cash in real terms (that is after taking account of inflation) is likely to remain negative – notwithstanding that absolute interest rates are rising and as such may appear more appealing. While yesteryear’s double-digit percentage level of borrowing costs and inflation are most unlikely to be seen again, savers’ real returns on cash deposits – and therefore, in reality, spending power - appear set to remain in negative territory.

By contrast with Bank, Building Society or National Savings’ unappealing rates, the potential for growth in dividends suggests that company shares (often termed equity) are likely to remain relatively attractive as a source of both immediate income (albeit lagging current inflation) and a rising stream of such income. Speculators and traders in stock markets might have a different perspective, but most institutional and retail investors with an appropriate long term perspective will prioritise the income stream and view turbulence in capital values as a secondary consideration.

Within prudently managed savings for retirement, an investor should seek to maintain a broad spread of investment – featuring various types of asset and, to minimise losses from any individual security, via a well-diversified portfolio – and be prepared to ‘weather inevitable storms‘ which could temporarily adversely impact particular investments. Essentially, in the absence of having a professionally managed portfolio, the DIY investor is likely to be best served by a ‘Buy & Hold’ strategy for their stock market assets - rather than trying to ‘hop in and out of the market’, rushing to avoid any new threat or capture every new developing theme both of which may prove to be transitory. The adage “Time in the market is more critical than timing the market” best sums up the need to be a patient owner rather than a trader of company shares.

In 2022 to date, most equity investments delivered negative returns despite underlying corporate trading results and management guidance being positive. However, it is not surprising to see the prices of company investments being marked down in the face of the new, largely unanticipated threat to peaceful co-existence. Three days after penning “I’m taking early retirement – how should I invest £100,000?” for this site on 21 February, Russia surprised and disappointed the world by launching its military offensive on Ukraine. This blog is in part being written in answer to the question, of whether I would now make any changes following the subsequent geo-political developments.

The answer is that I would make no changes but, (after placing £40,000 into Premium Savings Bonds as a cash reserve), would adopt the suggested longer list of investments which, for ease of reference, are shown here:

UK company shares 30% - via Henderson Opportunities (HOT), Independent (IIT), JP Morgan Mid Cap (JMF), Aberforth Smaller Companies (ASL) and North Atlantic Smaller Companies (NAS).

Global company shares 20% - via Herald (HRI), Manchester & London (MNL) and Pershing Square Holdings (PSH).

Private company shares 25% - via Harbourvest Global Private Equity (HVPE), Chrysalis (CHRY) and Riverstone Energy (RSE)

Real estate 25% - Schroder Real Estate (SREI), Civitas Social Housing (CSH) and Standard Life Property Income (SLI).

All of the above are investment trusts and, as some of our readers may be unfamiliar with this type of investment vehicle, perhaps brief mention of four instances of how they differ from open-ended funds (historically termed unit trusts) would be helpful:

First, most managers of investment trusts, having an optimistic medium term view of their prospects, will possess a certain level of financial gearing. This means that they will borrow monies, at very low interest rates, to be able to own more of their chosen asset – in search of higher returns. This may depress their net asset worth when markets retreat but, taking the medium or longer term expectation and trend of higher prices, historically such gearing has proven to be beneficial. When asset prices fall or rise, the share prices of investment trusts (which are registered companies) tend to fall or rise further; the difference between the net asset value (NAV) and the share price of a trust will also be inclined to widen or diminish – which will be driven by selling or buying, as investors respond to news flow, sentiment and a recognition of how much gearing might exacerbate or enhance performance.

Secondly, positive long-term investors will often be attracted to investment trust companies, as they are can be priced at a significant discount to their net asset worth (NAV) – rather than open-ended funds which, by contrast, are perfectly priced to their asset valuation. In addition to the core returns generated by the underlying assets, capital appreciation can result from a trust’s share price (which is on a discount to NAV) moving closer to its underlying worth or indeed moving to a premium (share price moving above NAV). Investment trust share prices are traded on the London stock exchange and investor appetite will depend on the success of NAV performance (compared to benchmark indices or peers) and sentiment towards the particular asset class.

Thirdly, the fund manager of an investment trust does not have to sell his or her portfolio’s constituents – whereas an open-ended fund can become an unwilling, but enforced, seller of the underlying assets (perhaps as investors become fearful of financial markets and place redemption orders).

Finally, while open-ended funds distribute all the income they receive (which prompted a drop in income payments to unit holders in 2020-21, as companies were persuaded to cut dividends in the face of Covid), investment trusts tend to retain some income in reserve which has enabled many to smooth and consistently increase their dividend pay-outs. In 2021, nineteen investment trusts could boast that their income had risen every year since the turn of the millennium – including seven funds which had increased their dividends without fail for fifty years.

Back to financial markets, the immediate prospects for risk assets will depend on a resolution of the Russia-Ukraine conflict, and the probable aftermath both in political and economic terms. As regards the latter, one thing seems certain: the Western world will seek to become less dependent on other nations for essential product (be it Russia for oil & gas, or thinking of Covid & health, China for manufactured goods). No doubt, European nations will spend more on armaments, as they bolster their defences. In the short term this is set to mean higher government expenditure, which will also stoke inflationary forces. Taking the appropriate longer term perspective, we are confident that leading companies can ‘weather this storm’, pass on higher input prices and generate higher revenue, earnings and dividends for their owners.

Besides the awful tragic events in the Ukraine, the other stand-out feature within financial markets in 2022 to date has been a significant rotation away from ‘jam tomorrow’ growth sectors and back towards the value offered by more traditional mature industries generating high rates of cash and paying big dividends. In mathematical terms, the rise in interest or discount rates means that the present day worth of future income streams is reduced and investors will pay more attention to companies offering more immediate (if slower growing) earnings. Large, high dividend-paying companies within the UK equity market, which feature a bias towards energy, mining and financials, fall into theis Value grouping and – along with the strength seen in commodity prices – explain the FTSE 100 index’s outperformance of the US, Japan and continental European markets to date in 2022. However, by contrast, domestic smaller companies tend to represent more of a growth proposition and their performance this year has more closely reflected the double-digit weakness of overseas equity market indices.

Since the geo-political ‘earthquake’ represented by Russia’s invasion of Ukraine, fund managers have redoubled their search for value in individual company shares or amongst collective investments – examining fund manager strategy (typically favouring profitable businesses with low or no debt) as well as choosing to own those whose share prices’ are priced on a significant discount to their underlying asset worth. The previously mentioned investment trust selections invest in differing kinds of asset and gain exposure to various geographies in different stages of economic development, but all appear discounts of more than 10% (and many on more than 20%) based on the latest net asset valuations.

As previously mentioned the invasion of Ukraine on 24 February came as a surprise to financial markets, notwithstanding the build-up of Russian troops in previous weeks. The hope that a ‘show of strength’ would be sufficient to intimidate the Ukraine has proven to be erroneous, and covert mention of using nuclear weapons has induced a new fear and a ramp-up in volatility to financial markets. The price of risk assets have been marked down - although not to the same extent as applied in March 2020 when Covid fears sparked a much bigger drawdown and collapse in retail investors’ confidence. Perhaps encouraged by the financial press “not to panic sell” and heartened by the subsequent rally and recovery in share prices in 2020 and 2021, it has also been evident that brave bargain seekers have tried to buy company shares on down days. Those more inclined to ‘batten down the hatches’ may have purchased gold as, by contrast with most company shares, the price of the ‘risk-off’ shiny metal has made significant progress, rising from $1,795 at the beginning of February – reaching a high of $2,070 on 8 March – and, at the time of writing, settling $1,933.

While the previously mentioned investment trust selections have been made on a long-term basis, one stands out as having particular shorter term significance: Riverstone Energy (RSE). Ostensibly, the shares appear to be undervalued by contrast with its underlying portfolio of oil, gas and increasingly renewable energy business, driven by a combination of higher commodity prices (which should be reflected in higher asset prices) and a tightening difference between the share price and the NAV (919p as at 31 December 2021, which pre-dates the oil & gas price hikes). That discount has moved from 40% to 31% to date in 2022 and could progress further following the company’s announcement of the repurchase of 14.99% of its own equity over coming weeks. The trust, whose assets are based in the US, Canada, Gulf of Mexico and Europe, is also committed to investing more in green, non-fossil fuel sources of energy which currently accounts for 20% of its assets. The extent to which Europe seeks to replace Russian gas & oil with cleaner energy sources – as opposed to coal – and just how (nuclear power generation or even fracking could feature), will be interesting to discover.

Bottom line, looking forward, events in the Ukraine represent a sea change for the world – and not for the better – with a return to pre-1990 ‘Cold War’ relationships between Russia and the West. China represents something of an enigmatic factor: being closer to Russia in political terms, but dependent on US & European demand for its manufacture product. A cessation of hostilities in the Ukraine, which it is to be hoped has not encouraged President Putin to expand his land grab ambitions, will not facilitate a return of 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 nations will seek to ensure that they are less dependent on others for essential manufactured goods.

Dislocation in customer relationships and a jump in the domestic price cap will mean higher energy prices, raising the prospect of more inflation, higher interest rates, slowing GDP, stagflation and the possibility of recession in Europe. In the UK, a jump in the domestic energy price cap is imminent and the retail price index (RPI) could see 10% annual growth by the summer - certainly inflation appears set to remain higher for longer, through the second half of the year and well into 2023. It is to be hoped that the Bank of England will be mindful that much of the inflation is driven by the supply-side and is aware of fragile consumer confidence - as business and personal net incomes become squeezed further by static taxation allowances and rising tax rates - when setting the overnight rate. Given the recent bias towards issuing government stock with inflation-linked coupons and redemption terms, the Treasury will also be fearful of the impact higher prices will have on the public purse.

On a brighter macro note, the prospect of further Covid infections leading to hospitalisation and economic lockdown would seem to be receding – at home, but not so in China, where vaccination of the elderly is surprisingly low. Higher containable levels of inflation can be positive (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 prices to the end customer). Against a backdrop of cash rates and investment grade bond yields lagging returns offered by real, but higher risk-reward, assets, we retain confidence in successful company share and property investments for the appropriate longer term. However, anticipating stormy economic conditions and higher levels of geo-political uncertainty for the remainder of 2022 at least, would suggest “battening down the hatches” by owning assets priced at a comforting discounts to their market worth and within a well-diversified portfolio.

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.