Log inMarket Update – Why, and for what, are we waiting? 9th March 2023 from Jilly Mann
Thus far, 2023 has not yet delivered the returns that investors have been hoping for. That said, when I think back to 2022, we anticipated that the first half of 2023 may feel rather uncomfortable at times, leading to a hoped-for revival in the second half of the year.
One needs to be careful with the phrase revival. If the parallels we have drawn previously between stock markets during the Global Financial Crisis of 2008/2009 and the post pandemic world of 2022/2023 ring true, then revival won’t apply to all sectors and all markets. Far from it. Revival will apply to certain sectors and certain markets at different times and will require a progressive shift through the gears as the recovery plays out.
The easiest approach we could take at the moment from an investor perspective would be to chase returns. I say easiest, because investors rightly want to see their portfolios grow and fairly question why we aren’t invested in markets which seem to be rising. This approach though isn’t the easiest one to take from an investment strategy perspective. Sometimes, the strategies which our investors want us to take and those which we choose to take won’t align. I appreciate that can be frustrating and there are also no guarantees that our chosen strategies will succeed, but hopefully this update provides some explanation as to what has happened to markets thus far in 2023 and also explains what we are waiting for in the coming weeks.
- The FTSE 100 rally and the impact of the US Dollar
- The uncertainty surrounding interest rates and inflation data
- The lag of the property market
- Cash, China, Europe and Commodities
- Our outlook and positioning
The FTSE 100 rally and the impact of the US Dollar
Firstly, I will address the elephant in the room, the performance of the FTSE 100 and its current minimal role in our portfolios. One cannot argue with the statistics. From the start of January 2023 to the end of February 2023, the FTSE 100 rose over 6%. The FTSE 250, which does feature in our portfolios, is up nearly 6% and the S&P 500 (the predominant US index) was up over 3.5%, but on a downward trajectory.
The FTSE 100 has appreciated recently, despite the weakening US Dollar. Due to the composition of the FTSE 100, which largely consists of huge companies whose earnings are generated overseas and which are measured in US Dollars, normally when the dollar rises, the FTSE100 does too and vice versa. Miners and oil companies are good examples of this.
This chart shows the relationship between the British Pound and the US Dollar since the recent low point for the US Dollar in May 2021. Initially, the US Dollar only strengthened marginally against the British Pound, stabilising for long periods. 2022 was a different story. The US Dollar rapidly appreciated against the British Pound as inflation concerns took hold and as the impact of the Covid recovery was factored in. The rate of appreciation was staggering, over 20% in nine months, which in developed market currency terms is far from usual. The appreciation bottomed out in late September 2022, and we saw the British Pound claw back some ground on the US Dollar, only for 2023 to signal a period of uncertainty.
Uncertainty is the key word. At the moment, there is little certainty in markets. The appreciation of the US Dollar has been far more aggressive than we anticipated and reached higher peaks, but for global markets, a continuing appreciation in the US Dollar is not a positive sign. Therefore, we have taken the view that we do not see it continuing interminably. We are not suggesting it will fall against the British Pound as fast as it rallied, but any stabilisation between the relationship of the two currencies will impact the performance of the FTSE 100. The FTSE 100 outperformed for longer than we thought it may do and so some returns were foregone, but on a strategy basis, we didn’t feel it right to chase returns from the FTSE 100, when we expected those returns to largely diminish as soon as the US Dollar stabilised. Historically, at the points where the US Dollar has depreciated, we have seen that stymie growth in the FTSE 100.
From our perspective, we looked at the FTSE 250 and saw potential returns that were far less dependent on any single currency trade and an index that had far more scope for upside than the FTSE 100. The FTSE 250 index represents the UK’s mid-size and smaller companies sector. Since the start of the Covid pandemic in March 2020, the FTSE 250 was lagging FTSE 100 returns by over 12%. We remain concerned about prospects for the UK economy and the forthcoming Budget will give a good indication as to how much Rishi Sunak’s cabinet are prepared to restore growth whilst wrestling with economic stability, but we consider the FTSE 250 to offer stronger growth opportunities than the FTSE 100 whose growth hasn’t been led by the performance of its constituent companies, but by external factors.
The uncertainty surrounding interest rates and inflation data
I come back to uncertainty, because markets felt more certain at the start of 2023, however, as 2023 has played out, uncertainty is now prevalent again.
What has changed are expectations for further interest rate rises and the speed at which inflation can be brought under control. We have been underweight equities and overweight fixed interest (bonds) for a few months now. This is a significant position to take and is not one we have taken lightly, especially as we watched certain equity markets rise. However, I have written before about bear market rallies (i.e. a sharp, short-term rebound in share prices amid a longer-term bear market decline) and not wishing to be caught out by these. Our belief is that the bounce we have seen in markets since the start of 2023 is a bear market rally. As talk of further interest rate rises has taken hold in the last fortnight, this has cemented our view.
The rationale for bonds over equities is that the bond market will lead the markets out of a recession. When that happens and we have seen mini breakout attempts by the bond market through late 2022 and early 2023, it will be swift and significant.
Until a couple of weeks ago, markets were confident that the US in particular would abate on future interest rate rises and would start to cut interest rates in late 2023. There was a wave of opinion almost forcing central banks to believe that inflation was under control and that what was needed to stimulate growth and avoid a prolonged recession was interest rate cuts.
The most recent inflation data hasn’t continued the downward path of late 2022. Some of the easy wins in terms of inflation falls have been and gone. There will be more to come as inflation data typically works on a rolling 12 month period and so peaks or troughs in any abnormal inflation data of 12 months ago always have a greater impact when the equivalent data is produced for the current year. That said, there are greater concerns that “sticky” inflation is not falling as fast and in some cases has even gone up.
The balancing act for central banks remains avoiding a deep recession, whilst coaxing inflation down and not incurring cripplingly high interest rates. The balance which markets believed was being achieved and which was pushing equity markets higher, has dissipated in recent days.
There is hope of a soft landing, which might mean a minor recession and one which in effect has already seen us experience the worst of inflation and interest rate rises. A hard landing would see central banks continuing to push interest rates higher in an attempt to force inflation to fall, by preventing consumers from buying goods which they cannot afford and inevitably increasing redundancies from employers struggling to survive the economic climate. Borrowing at elevated interest rates to fuel continued consumer spending would also be deterred in that scenario. Central banks do not seek that scenario, but we are in no doubt that to achieve a soft landing or indeed no landing at all, is going to take some time to achieve and will not be averted by the will of the equity market.
The expectation is now that the Federal Reserve will raise interest rates further throughout 2023 and won’t look to stop raising rates until 2024. That is quite a shift from the expectation that late 2023 would see some interest rate cuts. One may question why this matters if certain stock markets have continued to rise through this uncertainty. It matters, because we need to position for what we consider to be the most likely scenario and our base case has been for some time that inflation won’t be brought anywhere close to central bank target rates in the near term. It is going to take a long time to do that. The best we can hope for is that central banks gradually bring down inflation over time to a manageable level, whilst maintaining interest rates at a level that doesn’t become wholly unmanageable.
The lag of the property market
I titled this update, “Why, and for what, are we waiting?”. When I think what else we are waiting for as either a catalyst for improved returns or indeed news flow which hasn’t yet hit the airwaves, well part of the answer is a marked slowdown in the property market. Counterintuitively, as interest rates have risen, fixed rates on mortgages have come down and the property market in the UK hasn’t yet shown signs of a real recession or slowdown. The US is quite different and has already started to see quite a negative shift in the property market and one which is likely to get much worse before it gets better, particularly based on the way lending is conducted in the US.
The UK has proven resilient thus far, but the property market lags the rest of the economic indicators in a recession and we expect things to get worse before they get better. We are already seeing buy to let landlords struggling with rising interest rates and tenants increasingly unable to pay their rent. Interest only mortgages are likely to become more difficult to service and this is without factoring in additional tax constraints on landlords. We hope to be wrong on this, but we fear we may be right.
Cash, China, Europe and Commodities
The good news of rising interest rates is for savers, who can finally see some reward from banks and building societies for keeping their savings with them. Jon Telford has provided details of our new service for savers in his covering note for this update, but we have been able to benefit from higher interest rates in our portfolios by way of money market funds and this is something we shall do more of in the coming weeks.
There remain other concerns at play at the moment. China’s intentions with Russia over the war in Ukraine and increasing concern over Chinese controls on foreign money in Hong Kong for example. Whilst the impact of either of these matters worsening could have far reaching global implications, for now, they have to be a secondary concern for us. We had also increased our weighting to Europe during 2023 as we have seen some resilience from European companies that have thus far withstood the pandemic, the war in Ukraine and rising interest rates. We are mindful of the potential impact of inflation in Europe should it not be controlled and this too contributes to our strategy planning.
Our portfolios continue to be defensive in nature. The overweight to bonds is one indication of that, but we have also rotated out of assets that have done very well as inflation spiked, but which offer less positive prospects through this phase of the economic cycle. Commodities and infrastructure are good examples of this. We continue to look at the role Gold could play in our portfolios and depending upon what happens next, we may need to revert back to some of these assets through 2023, but for now we think we have seen the best of the returns from these asset classes.
Our outlook and positioning
Our outlook at present is to further reduce our equity exposure and increase our cash and bond exposure in the coming weeks. We may run the risk of missing out on further bear market rallies in equity markets, but we remain of the view that the risks associated with equities outweigh the potential upside. The upside we have seen in broader equity markets during 2023 has felt frenetic. Days of 4% rises followed by 3% falls are not symbolic of a stable outlook and so whilst they may appear attractive on certain days, the pattern does not look sustainable.
It has been unfortunate that the rally in bonds has also stalled in the last couple of weeks and that some gains have been given up, but we are confident that this is a temporary position. Some bond funds had rallied hard in late 2022/early 2023 and there was no reason to believe that they had achieved all of the potential upside. The bond market has already started to form a view on future central bank policy and inflation expectations and we fully expect the bond market to rally swiftly and to great effect in the coming months.
I cannot say exactly when this will be or what the returns will be, but I have far greater confidence in bonds than equities based on the economic data to hand. I also think it is fair to conclude that the bond markets retreat in the last couple of weeks is highly likely to be followed by the equity market. This doesn’t feel like an environment where the bond market alone is going to suffer. We also believe that major shifts in currencies won’t continue through 2023.
This strategy doesn’t feel comfortable when we see equity markets rally and currencies continue to behave in extreme manners. Investors are right to question our positioning, but hopefully this update provides some clarity as to why we are invested where we are and more importantly, why we aren’t trying to chase returns, however easy that may seem for quick wins. In my experience, quick wins can just as easily translate to even faster losses when so much uncertainty holds sway. May 2023 be the year of the tortoise and not the hare.