Log inMarket Update 11th July 2022 from Jilly Mann
Market Update – the flickering of light at the end of tunnel?
It has been a fairly unsettled period for stock markets in recent weeks. There has been no one particular piece of newsflow which has been the catalyst for this period, it has been more a continuation of the same themes challenging markets which we set out in our last update. As we move through this cycle, we are beginning to see some signs of the light at the end of the tunnel and whilst we will explain the reasons for optimism, this update aims to highlight key concerns, causes and potential consequences (both positive and negative).
- Global markets – are they all the same?
- UK – what happens next?
- Economics – is the old world returning?
- US – if not there then where?
- Falling inflation and the impact on commodity prices
- If inflation does stabilise, then where do we invest?
- What else could go wrong?
- To sum up, a crash, recession or bubble?
- Conclusion
Global markets – are they all the same?
In answer to this, no they aren’t all the same. Year to date, the FTSE All Share in the UK has held up better than overseas investment markets, mainly due to its emphasis on resources, utilities and financials, compared to the American S&P 500 which has a bias towards technology assets. The FTSE All Share is down 5.30%, the S&P 500 is down 18.87% and the Nasdaq 100 is down 27.06% year to date. In comparison the Telford Mann score 4 growth portfolio is down 8.70% year to date, but the trajectory for the Telford Mann portfolios has turned upwards in recent weeks compared to the FTSE All Share which is falling as resources markets have fallen. Currency strength has also been a factor in returns with the US Dollar continuing to strengthen against a weakening pound.
Our aim is always to make money for our investors, but sometimes events (such as the war in Ukraine, rising inflation and the threat of recession) conspire against us and it isn’t possible. In an environment of falling markets, minimising losses for our clients is even more important. Relatively speaking, we have managed to achieve this objective, albeit we would much prefer to be reporting through 2022 from a positive perspective. However, we do think that markets are now through the worst of the losses. Valuations in the UK, Europe and emerging markets are not far off what they were in 2012 (i.e. a sideways movement in valuation terms over a 10 year period) and the US market is near pre-Covid valuation levels. The Telford Mann portfolios have been positioned in a very defensive manner through 2022 thus far and this has avoided the worst of the falls in sectors which remain frothy even at much reduced valuation points and we believe this defensive positioning provides an excellent base to recover from, in spite of the continuing issues which pervade.
UK – what happens next?
Each time I have sat down to write this update, breaking news on UK politics has rather rewritten the script on a daily basis, so I write with some trepidation as to what may have changed by the time you read this.
At the start of last week, it felt increasingly like Boris Johnson and Rishi Sunak would hold a joint news conference next week providing a compromise between fiscal austerity and tax cuts. The ideological battle between the two was causing conjecture as to who would win out. Mr Sunak wanted to maintain a more austere approach, maintain taxation at present levels, offer a token gesture to the public, but very much stick to the plan and not provide further stimulus to ease the burden of inflation on households. Not yet at least.
Mr Johnson was seemingly much more in favour of some form of tax cuts to provide a fillip to households struggling to bear the burden of elevated inflation across energy and food prices predominantly.
A potential consequence of reducing taxes is to restore or to increase the spending power of consumers and thereby boost the economy. If spending power holds up, then the demand for goods and services continues unabated regardless of prices inflating and therefore the cost of living becomes even more expensive. In this scenario, inflation then does not reduce or come under control, it continues to rise to ever higher levels and expectations mount that the Government will continue to step in, in knee jerk fashion, each time people feel the pinch.
One of the few means then left available to bring inflation under control is to continue to raise interest rates. However, investment markets around the globe have already priced in their expectation of future interest rate rises by the Bank of England and the Federal Reserve in the USA. By and large, the expectation is that interest rates won’t rise as high or as quickly as previously indicated by Central Banks and if the markets are right and inflation starts to dip, then the economy starts to sort itself out without needing to implement far higher interest rate rises.
As it stands, we do not know what the UK Government intends to do, or indeed can now do, until a new Prime Minister is in situ with a mandate to Govern and pass policy. This could lead to a period of inertia, albeit relatively short, until the Autumn which is the planned handover of power to Boris Johnson’s successor.
One thing we repeat time and again is that investment markets don’t like uncertainty, however, in this instance, market reaction thus far to the political upheaval has been largely nonplussed. The FTSE has risen in the past few days, albeit after a couple of fairly negative day’s trading. I wouldn’t be bold enough to say that markets are shaking off the change in Prime Minister, but currently there is no indication that a General Election will be called early. A General Election could affect markets far more than a shift in power between leaders of the same political party, with the lack of any candidates across the political spectrum who would currently be regarded as odds on favourites to be elected and the prospect of an uneasy compromise of a coalition.
Whilst the present political situation in the UK is unedifying, we must distinguish its impact on investment markets which don’t seem concerned at the moment about who takes over. What will affect the rate of inflation in the UK and how it is managed, is the ability or otherwise to implement policy during the handover.
If nothing can happen, then the Bank of England will stick to their script and make incremental changes to try and stem the rise of inflation. However, if policy is passed then the Bank of England will need to look much more closely at the mechanisms available to them to cool off inflation and stymie demand for goods.
Neither option will be painless for the UK consumer, but this is at least a sign that traditional economics are coming back into play after over a decade of being negated by the seemingly relentless quest to pump money into the economy after the Global Financial Crisis in 2008 at the first sign of trouble.
Economics – is the old world returning?
To continue this theme, it is worth considering that there are very few people working in the financial services industry worldwide who have worked through a period of elevated inflation. We last experienced similar inflation levels in the 1970s and 80s, but the world was a very different place then. Unions still held sway, quantitative easing hadn’t been conceived and worldwide trade networks were wildly different to the ones which exist today. Therefore, one cannot draw direct parallels between the past and today with a view to implementing the same fix. The recovery from the Covid Pandemic and the global stimulus implemented as result, has left a world needing to return to more traditional economic theory to find the answer.
Economics have been distorted entirely since 2008. In 2012, the President of the European Central Bank, Mario Draghi, delivered his “whatever it takes” speech assuring markets that irrespective of the perilous position various European economies found themselves in, the ECB would take whatever means necessary to ensure that no economy failed. This aptly sums up the ‘money printing’ approach adopted by much of the wider world, albeit some Central Banks turned off the printing press quicker and implemented austerity measures sooner.
The Covid Pandemic has placed repeated strains on economies. If we take Europe as an example, Italy who teetered on the edge in 2012, find themselves back at risk of their economy collapsing. Europe more widely, no longer has a solid Germany to rely upon when considering next steps. Germany finds itself in a post Angela Merkel world and saddled with dubious energy deals with Russia still foremost in their minds.
Since the invasion of Russia into Ukraine, the European Union has at times appeared as united as it ever has done, whilst as simultaneously divided as it has been for quite some time as the balance between individual state interests politically and economically simmer, scarcely beneath the surface.
In the midst of all the European uncertainty, we retain a small weighting to Europe. This is perhaps unfair based purely on the strength of individual companies within the region, but the unquantifiable threat posed by Russia, uncertainty over replacement energy sources and rampant inflation in delicate countries such as Italy, mean that we have greater concerns over the region than we do for other parts of the globe.
US – if not there then where?
Since the start of 2022, the US stock market has experienced its worst losses for over 30 years. The chart below highlights the comparative performance of two funds, which are both listed within the North American IMA sector, but which have produced hugely divergent returns from the 1st of January to the 30th June 2022; the Fidelity American Special Situations (blue line) and the Baillie Gifford American (red line) funds. Both invest in American companies but the difference in returns between the two is 53%.
This chart demonstrates that we are in a market whereby choosing the right sectors and markets to be exposed to makes a significant difference. With the backdrop of quantitative easing since 2008, we have experienced years of very little difference in returns between market leading stocks and stocks with less pedigree. In summary, everything could go up and everything could go down together. The only choice was really which sectors may go up the most and so the traditional investment thesis was thrown out of the window.
2022 has seen a reversion to a more measured approach to investment. A measured approach hasn’t always been rewarded in recent years but continuing this theme of a reversion to more traditional economics, investors are starting to be rewarded for a more logical approach to investment.
The Fidelity American Special Situations fund hasn’t been in our portfolios throughout the whole of 2022, but it has held up well during the period we have owned it compared to the Baillie Gifford American fund, as an example. We sold our remaining weighting to the Baillie Gifford fund in late 2021 and since that time the more technology focused names which comprise Baillie Gifford American have been punished by the stock market. Not all of these stocks are poor companies, but sentiment has shifted from stocks which are more ideological to stocks which have real substance and a repetitive business model.
A fund which we are adding to portfolios, the J O Hambro Global Opportunities fund sums this thesis up quite well when you look at their underlying holdings. They seek out inflation proofed stocks, that is companies that are considered essential and can still sell their goods and services even while consumers are cutting their costs. In 2022, being inflation proofed doesn’t mean you have to be a mega cap bank or a utility company, it can be any stock within any sector if it has a strong market share, a competitive advantage and a pedigree for treating investors well. For example, the J O Hambro fund holds a relatively unknown US building society (M&T Bank), because it has done the same things well for year upon year. It has an ethos of looking after its customers in a way which UK building societies used to do before so many of them demutualised. Such holdings offer diversification within our portfolios, whilst providing a defensive underpin which we continue to believe remains essential for the uncertain months ahead.
The US remains a major weighting within our equity allocation and despite the fact that inflation in the US is also at extremely elevated levels, predictions for interest rates in the US are lower than the mooted Federal Reserve target rises for the remainder of 2022 and 2023.
Falling inflation and the impact on commodity prices
The economist Alan Detmeister of UBS, formerly the head of price forecasting at the US Federal Reserve, was one of the few economists who predicted the rise in inflation levels to their present rate last year and he is now predicting that inflation levels have peaked and are on the decline. His view is that inflation will be below 2% again in the first half of 2023 from a present level of 7-8%. His views have been quite out of tune with the broader market, but he has been proven correct in the past and his theory makes sense.
If we look at the prices of two commodities which were directly impacted by the war in Ukraine over the last year, after peaking in late May/early June, the clear trend is downwards and quite markedly so.
The scale of the chart is slightly distorted, but natural gas prices have almost halved from the highs they reached (red line) and wheat (blue line) has fallen by around two thirds from its high.
Inflation is measured year on year as a rolling average. What this means is that for inflation trends to continue on their upward trajectory at the current rate, the price of oil as an example would need to double from the current $100 level to over $200 per barrel. It is highly unlikely that such a price threshold would either happen, or be allowed to happen, given the impact it would have on consumers and supply chains. Therefore, inevitably year on year inflation levels will come down at these 12 month revision points, as the previous spikes drop out of the data.
We have seen this before in the wake of the Global Financial Crisis in 2008, but at that time it was predominantly energy price inflation rather than broad brush inflation which was peaking. The same revision downwards happened after that 12 month point and inflation then fell. The theory of vastly reduced inflation in 2023 therefore holds weight with regard to commodities.
The supply/demand equation could keep inflation higher irrespective of energy prices. If demand maintains or increases, then supply side pressures could force prices higher as greater demand than availability, equals higher prices being justified for those goods. The reality is that even if demand were to maintain, there aren’t supply side issues across all industries. Yes, there remains an issue in certain industries such as automotives and the time lags on electric car orders, but many retailers are sitting on excess stock having stockpiled post Covid. In the US some clothing manufacturers are even offering refunds on goods without requesting the items be returned, because they simply have too much stock to cope with. Their issue is clearing through the stock so that they can then restock at more normal levels with items that are currently in demand.
Companies have also used Covid as an opportunity to regroup. Survival of the Fittest was a phrase often used to see which companies would still be standing at the end of 2008/09 and whilst 2022 represents a quite different set of circumstances, our portfolios are now weighted towards companies who are regarded as essential rather than as luxuries and who can absorb elevated inflation, rather than need to pass it all on to the end consumer.
The Artemis Global Income fund is a good example of this approach. In the previous low inflation environment, we saw the rise of the discretionary spending darlings, those stocks who offered the latest technology or app and whom we could afford to spend excess cash on without worrying too much about necessity. Convenience over affordability. However, in 2022 with higher inflation levels, we have seen a shift towards companies who are deemed essential rather than flashy. Tesco is a good example. Online shopping may be the genie that never goes back in the bottle, but Tesco have pricing power, they can absorb more costs than alternative retailers and thus avoid passing all of the price rises on, they retain customer loyalty (not having a club card actively penalises you price-wise) and they are winning back consumers who need to check the basket cost before hitting order far more than they have in recent years. These stocks aren’t particularly exciting in a way that funky technology is, but they are defensive ways of investing through an inflationary period.
If inflation does stabilise, then where do we invest?
Fixed Income investments are typically government bonds (sometimes known as Gilts or Treasuries) and corporate bonds (issued by big companies). As the name suggests they pay a fixed rate of income and when inflation and interest rates are falling, they tend to do very well. However, when inflation and interest rates are rising (i.e. as per the last 6 months) the reverse is true and they fall in value.
We do believe that interest rate rises will start to ease off and indeed reverse through the latter part of 2022 and early 2023, at least in the US. The UK is a little more uncertain given the political backdrop discussed earlier. We can’t be sure exactly when the US Federal Reserve will change their rhetoric towards markets and give the nod that they no longer need to carry out the interest rate rises previously factored into markets, because inflation is indeed starting to fall. We think there are a couple of opportunities in August and potentially November when the Federal Reserve could give this guidance to markets, but until then we don’t feel that Fixed Income has much further to fall.
2022 has been unprecedented in recent memory for the way that all areas of the fixed interest market have fallen. It hasn’t mattered if a bond is rated as a junk bond (i.e. the lowest credit rating) or is a US Treasury (the highest credit rating), both have fallen by around 15% since the 1st of January. Every type of bond or Government Bond in between has suffered similarly. Given that US Treasuries are considered to be a safe haven asset, that is quite a startling drop.
We don’t think such falls will continue, but as with equities, we need to be selective about which areas of the fixed interest market we build exposure to. We are increasing our exposure to overseas Government debt, including US Treasuries, higher rated corporate bonds and emerging market debt. The latter may seem surprising as emerging market debt is often deemed to be a punchier allocation than developed market debt, but there are good reasons to be encouraged by the region. Unlike developed markets, emerging markets have had to raise interest rates far sooner and far more aggressively in order to reign in inflation and maintain some economic equilibrium. This works twofold in the sense that the yields available from these markets maintain their value against the prevailing rate of inflation. Compare this to UK Gilt Yields at a rate of say 2%. With inflation rumoured to reach 11%, investing into UK Gilts devalues your investment by 9%. However, looking at an example in the emerging world, Mexican Government debt pays a yield of 11% compared to inflation of 8%, thereby providing a real return of 3% above inflation.
Although we are increasing our exposure to fixed interest, we are maintaining our increased cash weighting for the time being. If inflation does start to fall and if Central Bankers do row back from the purported interest rises, it will still take time for inflation to fall out of the system and for the systemic issues in the energy market to be resolved, but we could easily foresee a portfolio position whereby we maybe double our fixed interest weighting from its present level in lieu of a reduced equity exposure through the latter part of 2022.
With fixed interest funds offering yields of 4-5% and the prospect of a real recovery from their overly depressed valuations, increasing our fixed interest allocation for a healthy return at reduced risk is something that we are factoring into our strategy. Add in the positive returns we continue to see from our Property allocation within the portfolios and you can see that we are relatively excited about the prospects for these defensive strategies.
What else could go wrong?
Russia may decide that Ukraine has been a great success and turn already voiced threats against Finland and Sweden into military action on the ground. We are presently in the unfortunate, yet predictable, period of the Russian invasion whereby the shock and horror of war in Europe has lost its impact for anyone not directly affected by it.
The atrocities haven’t ceased. There has been no absolute replacement of Russian energy and it feels like as long as the conflict remains confined to Ukraine, the rest of the world will go about it’s daily business. If Putin achieves his goals then maybe he will settle at this, but one senses that his ego requires more attention than quiet dominance and so we cannot discount Russia doing something further to shake Europe out of its new status quo.
China could decide to invade Taiwan. China is steadily losing ground in its quest to be the World’s leading economy and it’s refusal to criticise President Putin or stop sniping about Taiwan or Hong Kong, continues to build a nervous picture around their intentions. If China invades Taiwan, global stock markets will react extremely poorly, far worse than Putin invading Ukraine.
These undercurrents of a modern day Cold War are now feeding through into a revolution with regard to global trading partners. The US Dollar remains incredibly strong and concerns abound about when it starts to weaken, but reasons for the US Dollar to weaken are hard to support with global politics such as they are.
Within Asia itself, specifically the ASEAN region (Association of Southeast Asian Nations), there is a decisive shift away from reliance on China as a trading partner, to greatly increased trading reliance on other Asian nations and the wider world. The US would clearly be a key partner within this as well. In short, suspicion around China’s intentions, is forcing other nations away from China as a trading partner, which in turn is unravelling much of the work they have done in recent years to shore up their position as the necessary trading partner for Asia and the West, whether or not it was always welcomed.
In this environment, the US, the UK and Japan reassert themselves as the established trading partners of choice, much to the chagrin of global dictators.
For the UK and Europe, the Irish issue within the Brexit agreement will need to be a key priority for whoever takes power. There is a genuine concern within Government, that the overriding of the Brexit agreement in lieu of Ireland could lead to the break up of the Good Friday agreement and revert Ireland to the nationalist troubles of the past. That is in nobody’s interest and so whilst relative to the international fallout on markets that could arise if China takes aim at Taiwan, closer to home, the Brexit protocol surrounding Ireland is an issue that needs resolving on a domestic footing.
To sum up, a crash, recession or bubble?
We don’t think we are in market crash territory. Markets tend to track downwards over a period when heading for recession and we have seen that across the major stock markets year to date. A crash is a much shorter, sharper hit such as we saw when Covid rocked the world in March 2020 or when banks across the globe ceased trading in 2008. Economic conditions are nowhere near that point and that perfect storm of factors that can cause a crash is absent in 2022.
We have entered technical recession territory according to economic statistics and we could end up with a protracted recession if inflation and interest rates spiral out of control. At the moment, Central Banks just about have a grip on what is happening, and one just has to accept that the Federal Reserve were perhaps late to the party when raising interest rates and will be late to the party when changing course if inflation falls. The markets work ahead of the economy though and so even if we saw protracted technical recessions, we could see markets heading upwards because they have already priced in these eventualities. Therefore, a recession does not mean further falls in stock markets are inevitable.
We do think that history will prove that there was at least one bubble that burst over the last few months and that relates to ESG investing (Environmental, Social and Governance). Typically, ethically minded investors have greater exposure to ESG assets and the desire to invest for the greater good has not been rewarded this year.
ESG investments are typically tilted towards younger companies with a focus on technology and new ideas, less pedigree and less balance sheet strength to rely on real assets in hard times. We have shifted our ethical portfolios towards the most defensive, inflation-proofed assets we have available to us, but such investments are few and far between in the ESG space.
The chart above shows the Gravis Clean Energy fund in yellow versus the Liontrust Sustainable Global Growth fund in grey. We have owned plenty of Liontrust Sustainable funds in the past, but this chart shows a snapshot of 2022 for Ethically biased funds. The Gravis fund is in all of our portfolios (mainstream & ethical) and it is defensive, with a dividend yield and a stable portfolio of predictable stocks. The Liontrust fund is well managed and the best in class for more growth, technology focused ethical stocks, however this chart shows that even the best weren’t protected from the ESG bubble. This speaks volumes as to the performance of other, lesser investments in ESG, which were much harder hit.
It may be hard to see the positive in the ESG story at the moment, but we do think this could prove to be a seminal moment for ESG investing. Those companies who really didn’t warrant investment will cease to exist and those companies who were built on a combination of intellectual property with good financial management will be the winners and should make for a much healthier investment market in the future.
Conclusion
We started the update by highlighting the performance of various stock markets across the world and how things had been fairly bleak so far this year. We aren’t yet in a position to say that markets have reached the bottom and so we should just buy back all of those names which are down 60% year to date. The recovery from here will be more complex than simply buying something cheap and expecting it to soar back as quickly as it fell.
This economic cycle will conclude quicker than previous economic cycles and so we need to be prepared to move through the asset classes equally quickly. However, we think that a defensive strategy focused on dividend yields, companies with a competitive advantage and pricing power, mispriced fixed interest and inflation-proofing continues to be the way to both avoid the worse of the falls and benefit from an upturn in performance. The coming months will continue to be challenging for companies who will find growth hard to come by, the easy money has gone and so now is the time to blend the right assets with those core characteristics and set expectations for a solid, not funky, remainder of 2022.