Log inMarket Update – 14th August 2023 from Jon Telford and Jilly Mann
Market Update – Part 1 – from Jon Telford 14th August 2023
“Those who fail to learn from history are condemned to repeat it”– George Santayana
Following the news that the Bank of England (BOE) has decided to hike interest rates by another 0.25%, the UK base rate is now up to 5.25%, which is the highest rate we have seen in 15 years. The 0.25% increase did not come as a surprise to markets, but that should not take away from the fact that this rate increase is the 14th consecutive increase we have seen in the past 18 months.
In my opinion, Andrew Bailey and the BOE have made, and continue to make, terrible decisions which have caused upheaval in markets and will likely cause significant damage to the UK economy.
The chart below shows how steep the rise in interest rates has been and how it contrasts with the very low rates we have seen for the previous 15 years.
Some of our clients will know from our discussions with them about markets, that I liken the BOE’s use of interest rates to control inflation as akin to trying to turn a Super Tanker in the ocean around using an oar. It takes a very long time to take effect and there is a real danger of oversteering.
Economists believe that it takes 18 months for an interest rate rise to fully take effect on inflation. This means we are only now starting to feel the effects of the 0.25% rise we saw in February 2022, when rates were raised to 0.5%. With rates now at 5.25% there is much more delayed reaction to come.
The way that inflation is measured (an historical 12-month rolling average) means that the BOE is far too focussed on what has happened in the past, instead of what is ahead. It’s like trying to drive a car whilst only looking in the rearview mirror.
Some of our older clients may point out that interest rates at the current level are nothing compared to the much higher rates we saw in the 1980s, which went on to hit an all-time high of 15% in October 1989.
However, this time it’s different. The problem is that our society has become very dependent upon low interest rates. We have a shortage of housing as the UK only builds around 250,000 new homes per year, but with net immigration around 500,000 there are more people looking for somewhere to live than we have homes for. This increasing demand for housing and low interest rates have fuelled a boom in house prices, as the rising demand has been met by affordable mortgages. The chart below shows how prices have soared whilst the Bank of England base rate was 0.5% or lower.
However, with the recent rapid rise in rates over the last 18 months, mortgages are much more expensive than they were. For example, the average mortgage size in the UK is £200,000 and 18 months ago the monthly repayments on a typical fixed rate mortgage would have been £900 per month. Today that same mortgage, at current rates, will cost the mortgage holder £1,500 per month. That’s an extra £600 per month that mortgage payer has to find and that’s on top of higher gas and electricity bills and food prices up 20% from where they were a year ago.
As the Economist, and writer for UnHerd, Philip Pilkington, recently observed, Andrew Bailey is being aggressive with his interest rate increases because he believes he has no choice. In June, the consumer price index registered a 7.9% change year-on-year. While this had fallen from 8.7% in May, the UK inflation rate remains far above its peers. Inflation in the Eurozone in the same month was 5.5%, whilst in the United States it was only 3%.
These are not abstract numbers. The cost-of-living crisis is the elephant in the room that the government does not want to recognise because it does not really know how to address it. Earlier this month it was reported that the number of British households missing essential bill payments had risen back to levels previously seen last winter. The government has been promising that energy bills would ease for some time, but we have yet to see it — and when they do ease, it will not be by much.
Since the outbreak of the war in Ukraine in February last year and the disruption to energy supplies due to sanctions and countersanctions, the economy has rocketed to being the most important issue for voters. Today 60% of people list it in their top three concerns with the next biggest concern, health, at 41% and immigration a close third at 35%. The day the war broke out in February of last year Labour had a 4 point lead over the Tories in the polls — today that lead is 23 points.
Yet if the government thinks that the Bank of England is going to save them, it has another think coming. It is an open secret that, to get inflation under control, the Bank will likely have to keep hiking rates until the economy slips into recession. While the incumbent government’s poll numbers can’t really get much worse, a recession is likely to be just as unpopular as inflation.
Where will that recession come from? Most likely the construction sector. Earlier this month Nationwide reported that house prices had fallen by 3.8%, the sharpest fall in 14 years. This is already feeding through into construction sector output, which has been falling since February of this year and as of May was just over 1.3% lower than its peak. At some point, this fall in construction output will feed through to construction employment and this will likely be what drags the economy into recession.
The Ukraine war and the resulting sanctions and countersanctions have wreaked havoc on the European economies. None have been worse hit than Britain, which was in a fragile position both from the point-of-view of its energy policy and its overreliance on imports and foreign capital flows. The Bank of England is now in the unenviable position of trying to put things back on an even keel, but to do so it will likely need to create a recession. Looking at the data, that recession is already perceivable on the horizon.
The current economic environment seems eerily similar to that which we faced during the financial crisis of 2008/2009. Steadily rising interest rates led to a slump in the US housing market resulting in the failure of Bear Stearns Bank in March 2008. The powers that be told us that this was an isolated incident and that everything was fine, whilst they continued to ratchet interest rates. Six months later in September 2008, Lehman Brothers Bank collapsed, but again we were told that everything was fine. It wasn’t until March 2009, that the BOE and other Central Banks finally realised that the world was on the brink of a deep and damaging recession. Even though the warning signs were there with the collapse of Bear Stearns 12 months earlier and Lehman Brothers Bank after that, their reactions were too slow and too late.
Many economic commentators around the world are pointing out that we are again seeing similar warnings signs following the collapse of Silicon Valley Bank (SVB) in March 2023, followed by Signature Bank and First Republic. These were not small banks, SVB was $212bn, Signature was $110bn and First Republic $213bn.
The BOE will likely continue along its chosen path for some time to come unfortunately. We may see further rate hikes in the coming months and unfortunately for our economy, the longer this wrong strategy continues, the worse the consequences will be and the deeper the recessions will be.
I am conscious that this is an extremely pessimistic and gloomy forecast. Importantly however there are some very powerful reasons for optimism.
I started this piece by referencing history and my belief that the BOE seems intent on repeating the mistakes of 2008. However, when they finally realised the consequences of their actions in March 2009, they cut interest rates dramatically and this proved to be the turning point for markets. Long term clients will remember that although 2008 was the worst year on record, with portfolios down by around 15%, 2009 was the best year on record, bouncing back by 30%.
The reason that portfolios bounced back so strongly in 2009 was because of our portfolio holdings. In March 2009 when the recession started and the BOE cut rates to 0.5%, stocks and shares performed badly, whilst Fixed Interest investments such as Government Bonds and Corporate Bonds did very well indeed. In March 2009 our client portfolios were around 60% to 80% invested in Fixed Interest and so we saw strong growth in our client portfolios. Although we saw poor returns in 2008, similar to those in 2022, the subsequent recovery was very powerful. Importantly, our current positioning of client portfolios mirrors that of 2009, i.e. around 80% in Fixed Interest and Cash.
In summary, the performance of markets during last 18 months has been poor and disheartening. However, I don’t believe that the negative trend will last for much longer. The actions of the BOE will eventually break something in our economy and they will be forced to change direction rapidly. I do like a good analogy and one of our clients recently suggested in a review meeting that what is happening at the moment with Andrew Bailey and the BOE hiking interest rates and the corresponding economic reaction, is a bit like trying to pull a brick out of a wall with an elastic band. You pull and pull, but nothing happens until all of a sudden, the brick shoots out and smacks you in the face.
It’s not a question of will Andrew Bailey and the Bank of England change direction, it’s a question of when. Hopefully that turning point won’t be too much longer.
Market Update – Part 2 – from Jilly Mann 14th August 2023
Following on from Jon’s assessment of the Bank of England’s role in the current economic cycle, I agree that it has been a difficult period for portfolios.
The continued raising of interest rates for a prolonged period of time has surprised us. Primarily because we don’t think such rates are sustainable and the signs are now starting to multiply that things could become quite messy, quite quickly. When that happens, I think interest rates will tumble back to around 2.5% far quicker than they rose. As that happens, bonds are going to rally strongly, but equities will fall for a time until they too stabilise and stage a recovery. The gains to be made from bonds in my view will far outweigh any positive returns from equities. I also think that whilst we are in this cat and mouse position, as we wait for Central Banks to push the button on rate cuts, the potential losses on equities far outweigh the downside on bonds. To benefit from this expected turn in markets, one needs to be invested in bonds. Waiting for the signal will mean missing out on a significant portion of the potential uplift.
The graph below shows the FTSE 250 in yellow, the iShares Overseas Government Bond Index in red, the Bank of England Base Rate in purple and the iShares UK Gilts All Stocks Index in blue. This data is run over the last 10 years. What the graph demonstrates is that during periods where the FTSE 250 has fallen, i.e. in early 2016, in late 2018 and in Spring 2020, Gilts and Overseas Government Bonds have rallied. Late 2018 is perhaps the clearest, if not biggest, example. As the FTSE 250 fell around 30%, Overseas Government Bonds rallied by around 10%.
I understand why our defensive positioning may be difficult to understand as portfolios drift downwards, whilst some equities rise. If we are defensively positioned, why is that happening? Simply put, it is because the rally in equities is at an historically narrow level. What we mean by this, is that a handful of stocks and sectors are driving equity markets overall upwards, the vast majority of equities are struggling and dragging indices down. It is generally only in times of a sudden equity market slump that this sort of behaviour takes hold. The technology bubble of the early 2000s is a good example, but Central Banks have averted proper recessions for so long now that it is uncomfortable to experience this or be reminded of how this plays out. The reason that the turn in markets hasn’t yet happened, is in part a legacy of the economic mechanics (such as Quantitative Easing) used to artificially stave off recessions and any impact on households over the last 20 years.
The chart below shows six key elements which are either in, or affect, our portfolios: Bank of England Base Rates in purple, FTSE 250 in yellow, iShares UK Gilt All Stocks Index in green, Janus Henderson Strategic Bond fund in red, JPM Natural Resources fund in blue and the S&P 500 index in grey.
The data in the chart above tracks back to 2007, in the run up to the Global Financial Crisis and each set of data shows discrete calendar year performance for that element. Whilst we don’t think the forthcoming recession will be as all encompassing as the Global Financial Crisis, we do expect markets to perform similarly, albeit not quite so extreme. 2007 saw Bank of England Base rates rise, broad equity markets flat, gilts holding up and natural resources soaring ahead, thus performing that recession proofing role which they are often used for.
2008 saw the banking crisis take a grip. Equities of all types sold off, as can be seen by sharp downward movements in the FTSE 250, with the JPM Natural Resources fund returning all of it’s previous years gains to investors and the S&P 500 also down. Gilts were up over 10 % in that environment.
2009 is what we expect to happen again as Central Banks in 2023/24 start to cut interest rates rapidly. Central Banks in 2009 slashed interest rates and whilst Gilts were no longer performing, Strategic Bonds were flying, returning over 30% during the calendar year. The S&P 500 recovered some ground during the back of 2009 and the FTSE 250 see-sawed upwards from its 2008 lows, as natural resources flew into the distance. At that time, we had rotated out of Gilts and overseas Government Debt and into corporate bonds and selected equity markets.
What followed were some more normalised years, with bonds lagging as equities by and large produced some consistent, if unspectacular returns. The backdrop for those returns though were nigh on zero interest rates. The economy and consumer were protected as Central Banks wrestled with how to withdraw the artificial liquidity (Quantitative Easing) that they had pumped into markets in 2008/09 to save the economy.
2022’s data signalled the start of recessionary and inflationary concerns and clearly we are only part way through 2023, so that data isn’t yet shown.
What is easy to forget is quite how volatile these same elements have been over the last 16 months since the Bank of England embarked on this latest round of interest rate rises.
The data in the above chart shows the discrete performance of each element on a monthly basis rather than across a calendar year.
Natural resources in blue continues to boomerang around from highs of nearly 8% up to lows of 13% down the next month. It is easy on any given day to cite the S&P 500 as the asset we should have held more of, but it hasn’t been a one way street to success. How comfortable are investors feeling about the S&P 500 in June 2022 when it is down around 5%, or in September 2022 when it is down nearly 6% or indeed in December 2022 when it is down nearly 7%. The FTSE 250 tells a similar story albeit with greater highs and lows.
What is key to remember is the timescales we are looking at. Less than every three months from April 2022 to December 2022, the S&P 500 was hitting some fairly significant lows. It isn’t true to say that equities have been the safest place to be invested of late.
As interest rates have risen, bonds have produced some consistently negative returns, but the extremities on the graph are closing and as we approach the endgame for further interest rises, we expect to see the green and then red bars on the graph above peak upwards, whilst the grey, yellow and blue lines shift downwards.
We are not ignoring equities and we maintain some limited exposure to them, but hopefully both of these bar charts demonstrate what is actually happening in markets beneath the bonnet. Having confidence in what we are owning and why is key. There has to be a rationale. Investing to chase a return is not what we are here to do. When the time is right, we will be swiftly rotating through gilts, overseas Government Bonds, corporate bonds and high yield bonds. At the same time, we will be increasing selective equity allocation. I expect it to be a swift rotation, I expect to see portfolio changes quite frequently as we capture the upside in each asset class. To those wondering why we own our Blackrock bond funds (Overseas Government Bonds, ESG Overseas Corporate Bonds and UK Gilts), these charts hopefully help to explain why. Those funds represent sleeping asset classes, which will turn upwards the fastest on a Central Bank policy shift. Once that shift has happened, I wouldn’t expect to see us owning them in any great proportion thereafter, but for now, there is a rationale.
To close with some further colour on these fund selections, the graph below charts the Bank of England base rate in purple, the iShares Overseas Government Bond Index in red, the FTSE 250 index in yellow and the iShares UK Gilts All Stocks Index in blue over the last 2 years.
I think this chart highlights the scale of the potential upside. As interest rates started to rise, Gilts and Overseas Government Bonds dropped in value, well over 30% in the case of Gilts, at the same time as the FTSE 250 has trodden water struggling to regain its own losses.
Interest rates will fall far quicker than they rose. Yields on bonds have risen as interest rates have risen and bond yields are now at levels which in some cases are more than 3 times their historic average on a 10 year basis. Government bonds, Gilts and European Corporate Bonds demonstrate the most extreme examples of inflated bond yields and it is into these assets we are looking to bias our bond allocation. This further supports our belief that, as interest rates tumble, so will bond yields. Given the unprecedented highs which bond yields have reached, alongside the tremendous fall in the capital value of bonds, we see a potential double whammy for positive bond returns in the remainder of 2023 and throughout 2024.