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Wednesday, 15th November 2023 10:34 - by David Harbage
Two months ago, we wrote “Growth has stalled, and posed the question “but is that bad for markets?” Since then we have witnessed terrible atrocities in Israel and loss of life in Gaza which has reinvigorated a perennial geo-political risk within the Middle East. Insofar as the impact on financial markets is concerned, beyond a spike in both the price of oil and gold, worst-case fears of military contagion (notably from Iran) have not as yet materialised. It is to be hoped that peace prevails.
This blog has been prompted by today’s announcement that US inflation is slowing more quickly than economists’ expectations: annual CPI fell to 3.2% in October (down from 3.7% in the previous month and lower than consensus forecast of 3.4%). Encouraged by this data, the writer now expects that we have seen the peak in US inflation and in interest rates; although a fall in the latter won’t arrive until 2024.
A domestic inflation report is due tomorrow, which is set to show a sharp easing in the pace of higher prices – as a hike in the cost of energy last autumn dropped out of the comparison. Yesterday’s announcement of 7.7% UK wage growth in the third quarter of the year is good reason not to be complacent about the path of domestic inflation, but nevertheless the balance of probabilities (driven by negligible growth in current and immediately forecast economic activity) would seem to have moved decisively towards a belief that interest rates in the UK have also probably peaked.
This update is being provided as a brief comment on current news flow and as a reminder that financial markets are driven by an expectation of the foreseeable future (say 18-24 months). Therefore today’s inflation data seems particularly significant and could mark a change in direction for the yields on (and capital values of) bonds and real assets like property and company shares. Unashamedly, an update of the previous blog is reiterated, if only for ease of reference, noting in particular the economic & equity ‘clock’ illustration.
The remainder of this commentary represents 15 September report:
Most financial commentators would agree that growth in the economies of many of the world’s major developed countries has stalled as inflation has proven to be more persistent, which in turn has prompted central banks to raise interest rates further in an effort to dampen consumer spending and economic activity. Financial assets are typically priced off the perceived risk-free rate of medium term government bond yields and, until evidence that overnight money rates have peaked – preferably by seeing a new trend of falling rates, rather than just a single step – money markets’ confidence remains fragile.
The longer that inflation and interest rates remain relatively high, the greater damage being inflicted upon public finances (much of whose debt is being serviced at the rate of inflation) and in turn the overall economy. Earlier in September, Andrew Bailey the governor of the Bank of England encouraged a view that Bank rate may have peaked at 5.25%, as he intimated that interest rates would probably not have to be raised again, based on current slowing growth in the UK economy. However, this week brought Office for National Statistics (ONS) evidence of stronger than expected, 8.5% growth in wages – notably in the public sector – which countered small movements elsewhere: notably a decline in food price inflation (to 12.2%) and job vacancies (to under a million), alongside a rise in unemployment (from 4.2% to 4.3%). The intuitive belief that a domestic slowdown has occurred over the summer was reinforced by the ONS’ advice that while Britain’s economy had been performing better than it had forecast in 2023 to date, it shrank by 0.5% in July.
Geo-political concerns have probably ‘taken a backseat’ in investors’ minds of late, coming to terms with the probability of a more protracted conflict in the Ukraine (which depresses more productive public spend), even as environmental issues capture media headlines. The prospect of higher taxation to fund budget deficits in the US and Europe is an unpalatable one (especially ahead of imminent elections), given the headwind this will have on labour’s appetite to work and corporations’ plans to invest, leading to pedestrian economic growth.
While not subscribing to embedded stagflation - high inflation allied to declining economic growth, probably featuring rising unemployment (noting rapid jump in those considered as unable to work) – as a real prospect, the current immediate prognosis for the global and local economy justifies reconsideration of how the long term investor can position their assets. The author has almost fifty years’ experience of studying economic developments and financial market behaviour and, having seen UK retail price index (RPI) inflation in excess of 27% and UK Base (or Bank, as it is more correctly termed) rate at 17%, is not fazed by the magnitude or pace of the recent pick-up in inflation data or interest rates.
In previous blogs we have focused more on economic data, but in this update are commenting on the merit of each of the assets which we would expect to see in a portfolio constructed with the long term (say ten years) in mind:
1. Cash would not make up a significant portion of a long term asset portfolio – typically ranging between 10% and 20% - in an expectation that clients will possess separate monies to meet their immediate needs and also retain sufficient cash to match their risk comfort profile and generate income. Most of us intuitively appreciate that bank, building society or national savings accounts offer negative real (after taking account of inflation) returns – both historically, as well as today it is losing its purchasing power – and, within a real asset portfolio, cash is primarily held as an opportunistic investment: to add to real assets when prices appear especially low. Based on feedback from personal investors it would seem that many are awaiting evidence that economic events and financial assets have truly reached a valuation nadir in the current cycle before committing more funds – but many are eyeing up low-cost trackers of a particular segment of an equity market (perhaps a global equity ETF, a more UK-centric FTSE100 or FTSE250 ETF) or an investment trust whose assets appear anomalously underpriced.
2. Inflation-linked Government bonds – both UK and global, via low cost, relevant index tracking exchange traded funds (ETFs) – offer some hedge against inflation, as their interest (in the form of income coupons) and capital worth (via redemption value) is linked to local or international rates of inflation. In addition to the latter, these bonds are valued by reference to conventional (non-inflation linked) government bonds – whose typical fixed income attractions have diminished over the past couple of years of rising rates. Mindful of the latter (and that interest rates could only move in one direction, i.e. up from their 2020 low), many of us have maintained a relatively low allocation to such assets – while also acknowledging that one does not wish to invest all of one’s money in higher risk company and property assets.
3. Corporate bonds – both UK and global, again via appropriate index tracking exchange traded funds (ETFs) – provide greater certainty than many assets, as typically they pay a fixed rate of interest through the life of the bond (usually paid once a year or semi-annually) and offer a fixed redemption date. However, unlike the previously mentioned gilts (which are backed by governments), the income and capital returns are dependent on the quality or creditworthiness of the company or authority issuing the bond. As a consequence and to compensate for that risk, corporate bonds have to offer a little more income than an equivalent duration conventional government stock; they also tend to be more volatile – reflecting economic health (anticipating a rise or reduction in corporate defaults). As with the inflation-linked gilts, the writer would have been wary of committing to a large position in such assets over the past five years, but now believe that bonds – both inflation-linked and corporate conventionals - are beginning to offer better value.
4. Commercial property – both UK and European – represent tangible assets which produce relatively reliable income (as most tenants continue to meet their rental obligations, even if struggling to pay other expenses, in order to carry out their business) and growth in that income as property is developed and rents rise. Such income is usually competitive – by comparison with other sources, such as bonds or company shares – but the rise seen in medium term interest rates over the past two years has meant that surveyors have marked down the capital worth of offices, shops and almost all other forms of non-residential property. Commercial property businesses will normally carry a reasonable level of debt which – unless fixed at low rates with long duration – may also have become more expensive to service as the cost of borrowing has risen. A consensus of professional investors would appear to have a significant bias towards ‘big box’ warehouses and industrial property with, by contrast, an aversion to high street retail. In addition a focus on valuation persuades for trusts whose shares are priced at a significant discount to their underlying properties’ worth. Finally, in addition to owning actively managed direct property, one might also choose to take an interest in stock exchange listed companies (more than 40 UK stock market quoted real estate companies such as Segro, Land Securities and Big Yellow) via an ETF of the sector.
5. Company shares – both UK and global, stock exchange listed as well as unquoted – will also normally own ‘bricks & mortar’ assets and possess the merit of providing investors with the opportunity to keep pace with inflation, as well-managed firms increase their revenue, profits and dividend pay-outs. Over the longer term such rises in earnings and income should result in the value of company shares (often termed equity) appreciating – if past history is any guide. The writer would favour investing via actively managed, well diversified investment trusts (rather than individual company shares, with a view to minimising ‘alpha’ stock specific risk), possess a bias towards smaller and medium sized companies (which intuitively promise higher growth over the course of a full business cycle) and have a preference for fund managers with a leaning towards buying undervalued ‘growth at a reasonable price’ (GARP) businesses. In addition to that particular search for Value, readers might also wish to seek trusts which are priced at an attractive discount to the underlying market worth of their portfolio of company shares – both in absolute terms, but also as compared to their normal discount to net asset value (NAV). The same criteria of diversification, value focus and relative price versus asset worth can be applied to private equity investments. While less transparent, management in this sector can often operate more efficiently (with less interference from stakeholders) and their track record of growing companies is often better than their more public peers. In addition to closed-ended trusts, one could also use ETFs to capture a particular segment – by size, industry sector or geography - of equity; including a wish to take advantage of exceptional circumstances when the overall market becomes undervalued, perhaps as a consequence of a fear-driven fall which cannot be attributed to fundamentals.
It can be helpful to look at the economic cycle and the stock market cycle in the form of a clock. Financial assets like bonds and equity are, of course, forward-looking and endeavour to ‘price in’ (today) what they anticipate will be occurring in the foreseeable (say 18-24 months) future. Therefore perhaps one can visualise an economic ‘clock’ – with 12 representing the peak of economic activity or health (as measured by gross domestic product – GDP), and 6 being the nadir. At 3 the economy is slowing and at 9, GDP is pick-up. Based on historic evidence of previous economic cycles (considering the UK back to 1945 in particular), it is interesting to see where the best performance of the FTSE All Share index emerged – in terms of the state of the economy. Perhaps counter-intuitively, when GDP was strongest, stock market returns were weakest and company shares were strongest when the economy reached a low point (sometimes, but not always, featuring recession).
Economic cycles do not conform to a particular pattern – in either duration or steepness of fall and subsequent recovery – with the causes of a change in economic activity being various and often unpredictable. Although the length and magnitude of the cycle will vary, some factors remain constant: call it ‘animal spirits’ or ‘funk’ but the ‘bouncebackability’ of human nature in the face of disaster or setback is remarkable. Secondly, the patterns of professional investor behaviour within a cycle are fairly consistent – taking a median of previous periods of economic and market evidence.
Back to the economic ‘clock’ – and dividing it into quartiles (12 at peak, 6 at its nadir, as mentioned) - historically, the UK equity market performed best when the pace of GDP growth was positioned between the 5 and 8 on the clock – that is when the economy is close or within sight of the bottom and in the early stages of recovery. As growth in economic activity stabilises, so does the pace in equity market total (income, as adjusted by capital appreciation or depreciation) returns; with weakest stock market performance being seen when GDP growth can be seen to be slowing or falling, albeit from peak absolute levels. This equates to the quartile between 10 and 1 on the clock – when the media might feature positive news – and yet financial assets are beginning to anticipate tougher times on the economic horizon.
The reader might be asking the perennial question of where the stock market goes from here. Guidance from the ‘clock’ would require a view as to where the economy is currently positioned – in a downturn, most would agree, something reflected in dull stock market performance – but one cannot call number 6 or even number 5 on the clock with full certainty until improving GDP evidence emerges. Based on previous recoveries, that may be a V shape (a sharp bounce back), but the current global or domestic economic cycle is more likely to be a bath-shaped U (indicating a longer, flatter period) bumping along the bottom of the economic cycle.
What will be the catalyst to an improvement in economic activity or the market’s anticipation of a sustained pick-up in GDP? The removal of inhibitors to global free trade and an end to less productive government spending would demand an easing in geo-political tensions and war. Another hurdle to growth is taxation (be it from an incentive to work or spend perspective) while high inflation and interest rates undermines business confidence, which leads to a lack of investment, contributing in turn to poor productivity. As intimated earlier, when interest rates can be seen to be falling then investor sentiment could revive quickly. It is because markets have proven to move rapidly - on any whiff of a significant change in the economic landscape - that independent financial advisors (IFAs) recommend long term investors remain in the market - rather than try to second guess its inevitable ups and downs. Since the end of the Second World War, the UK stock market has fallen on an annual basis in 31 of the subsequent years (essentially 4 negative years alongside 6 positive ones out of every 10) but the overall picture has been one of clear advancement, with total returns dramatically boosted by dividend income.
Yesterday the European central bank (ECB) hiked interest rates by 0.25% to 4%, and its governing council’s new forecasts for inflation were lowered to 5.1% this year, 2.9% next and 2.2% in 2025, alongside a reduction in GDP growth for the euro zone economy: 0.7% this year, 1% next and 1.5% in 2025. Such projections – showing a similar pattern to our domestic economy – suggest that the peak in rates might have been seen. If, and it is a big if, recession can be avoided then investor sentiment could turn rapidly as sights move towards 2025. But before then 2024 has to be considered – a year which is shaping up to be a major political one.
Looking beyond economics, the most obvious catalyst to a revival in investor confidence would be an end to what appears to be a more protracted conflict in the Ukraine. While the geo-political landscape is difficult to call, we retain a positive perspective on global co-operation - which extends beyond trade – with influence from export-dependent China facilitating a better outcome than currently appears possible.
Most stock markets began each quarter of 2023 on a positive note but, as in March and June, September has struggled to hold onto early gains in the face of news flow resembling a ‘curate’s egg’. However market commentators, influencers and professional investors recognise that the headline media invariably seeks to dwell on negative developments, while the latest fund manager surveys do not reflect a bearish view. Interim trading updates for the first half of 2023 and guidance for the full year from leading businesses (both quoted and private, as well as commercial property companies) have been upbeat. Such pronouncements seem to have been overlooked by investors (especially of UK firms), with the gap between investment trust’s portfolios worth and share prices continuing at a near record magnitude.
Looking forward over the next twelve months there are, as always, big issues for investors to contend with – from suggestions that company profits could be squeezed by higher wage and other input costs through to falling consumer discretionary spend as the tax burden rises. Beyond the economic concerns, investors will be wondering how next year’s US Presidential election will pan out (and if the new incumbent will be any younger) and if a change in UK Prime Minister would result in any meaningful change in policy. 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 financial stress over the past three years - but still manage to generate higher revenues, buy back their own equity and pay 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.
Making no apology for repetition, this commentator retains confidence in successful businesses and real estate investment for the appropriate longer term as it is only this kind of asset which offers the potential to deliver rising income to investors. While anticipating difficult economic and uneasy geo-political conditions to prevail throughout this year, a change in direction on interest rates could provide confidence that the market cycle (which is always ahead of the economic data) is about to change for the better. Economic growth seems to have stalled in most developed economies, including our own, but that may not necessarily translate into poor performance for equity. Indeed history suggests that when the economy reaches its low point that company share prices might already be rallying in anticipation of better times ahead.
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.