Log inMarket Update 15th December 2023 – Swimming With Our Trunks On – from Jilly Mann
Firstly, thank you to everyone who attended our recent Open Day. It was a pleasure to meet so many of you and to hear your thoughts on investment markets and the economy.
Given that the US Federal Reserve held their closing meeting for 2023 on Wednesday and that the Bank of England followed suit on Thursday this week, I thought it timely to summarise developments from these announcements as we approach the end of 2023.
I also wanted to provide some insight into our equity exposure and the sort of opportunities which we think will outperform the crowd as we head into 2024.
- US interest rate announcement
- Bank of England interest rate announcement
- Tesla v Aixtron
- Prospects for 2024
US interest rate announcement
In our last market update, we explained our belief that the US will look to cut interest rates early in the Spring of 2024, well before forecasts are suggesting that they will do so. This week, Jerome Powell, Chair of the US Federal Reserve chose to keep interest rates in the US on hold for the time being. However, the announcement was significantly different to previous ones. Mr Powell went on to say that the Federal Reserve were now actively considering when to cut rates in 2024 and were factoring in three potential rate cuts of 0.25% apiece before the end of 2024.
To pull this apart a bit, the key message has changed. From the Federal Reserve’s staunch view even in November 2023 that they were nowhere near ready to consider cutting rates, here we are in December 2023, with the Federal Reserve now considering when to cut rates.
Their own dot plot chart has shifted markedly. The dot plot chart is an illustrative measure to record where all of the members of the Federal Reserve Committee think interest rates in the US will be in the future. Compared to the last meeting, the dot plot chart again shows a significant shift in thinking from the Federal Reserve from one month to the next. What have they seen in the data to cause such a pivot in their position?
Whilst this latest announcement is starting to bear out our views on early rate cuts in 2024, we don’t agree with the relatively modest cuts which the Federal Reserve are publicly factoring in. To accept their view would be to believe that interest rates in the US will remain at around 4.625% at the close of 2024. Our view is that rates will be cut much more sharply and swiftly and that we may well end up with interest rates much closer to 3% by the end of next year.
Mr Powell was also keen to strike a balance in his delivery. To fend off a potential market overreaction to the thought of future interest rate cuts, he was at pains to point out that he felt that they would be in a position to do this, because the US was heading for a soft landing, i.e. that the US would avoid recessionary conditions. In essence, the message was the economy is in much better shape than people think and we can achieve this golden target of falling inflation, falling interest rates and no recession. Time will tell whether he is proven right, but our view is that this is unlikely to be achieved.
If rates reduce only to 4.625% by December 2024, the wall of credit (faced by businesses and consumers) which needs refinancing in the next couple of years will remain unaffordable. Rates need to come down further than that in the near term to avoid mass defaults or a credit squeeze. To evidence why this is such a worry, new house prices in the US haven’t fallen as much in the last 60 years as they have done in the last 12 months.
Inflation is coming down, but economically the signs remain ominous for unemployment, job creation and bankruptcy filings in the US. UK data is not much different. Based on a survey by the UK’s Office of National Statistics, November 2023 saw a steepening in the rise of industries who are cutting jobs on a monthly basis.
This level hasn’t been so high since either the Global Financial Crisis of 2008/09 or the Covid pandemic. This pattern is also repeated when looking at the total number of employees on UK payrolls excluding healthcare and education, which is slumping at a rapid rate.
As ever with economic data, Central Banks and Governments can deliver a headline to massage perspectives, pumping up headlines with public sector jobs being a good example, but it is what lies beneath which tells the true story for vast swathes of the population.
Why should we believe the Federal Reserve’s latest outlook for interest rates, when they have consistently dismissed the idea of rate cuts in the near term? We continue to think that we will see a much swifter and sharper reduction in rates in 2024, with the bulk of the cuts and therefore, feelgood factor, hitting the US consumer before the Presidential election campaigning commences with gusto.
Bank of England interest rate announcement
The Bank of England have also held interest rates this week, although they have maintained their view that rates will remain higher for longer, with no inclination to cut anytime soon. Again, we don’t believe this will be the case. Now that the US have opened the door to rate cuts, we expect Central Banks globally to shift their stance towards rate cutting in quick succession.
The economic data for the UK is not particularly positive, nor is it in Europe and so whilst nobody wants to allow inflation to rally out of control again by cutting too soon, the lag effect of high interest rates is only just starting to come through and will continue to emerge even once cuts are made. The lag works similarly up and down. Only now are we seeing the impact of the interest rate hiking cycle on economic data and it will take time for interest rate cuts to also take effect on the wider economy.
The idea of interest rate cuts is a positive for our portfolios whilst we are heavily weighted toward fixed income investments. We have seen the benefits of this over the last 6 weeks with a score 4 growth strategy being up over 5% as US 10 year Treasury and UK 10 year Gilt yields have fallen sharply. The chart below shows the UK 10 year Gilt yield falling by over 13% during this time.
There is much further for both the 10 year Treasury and the 10 year Gilt yield to fall, we anticipate them settling around 3% in the medium term. Currently the 10 year Treasury yield is just under 4% and the UK 10 year Gilt is under 3.8%. To put this into perspective, 4 months ago both of these Fixed Interest investments were yielding closer to 5%. These recent falls have come as a result of market speculation that Central Banks would not only hold rates, but may look to introduce the concept of rate cuts. The point being that had we waited for confirmation from Central Banks that they would consider rate cuts in 2024, we would have missed out on significant returns from the Fixed Income sector.
We anticipate that the bulk of the return which is left to be achieved from Gilts and Treasury stock will come before many of the proposed interest rate cuts take effect. At that point, we will then be looking to rotate out of Gilts and Treasury stock, having collected the best of the returns, and moving into higher yielding corporate bonds, emerging market bonds and selective equities.
As it stands today, the risk of owning higher yielding bond and emerging market bonds is that the headline yield is hugely attractive, but the underlying capital value will likely behave more in line with equity markets than Gilt or Treasury type assets if it becomes clear that a recession is imminent. Their time will come, but we don’t think it is yet.
Tesla v Aixtron
We commented on the Magnificent 7 US stocks in our last update and our reluctance to be over-exposed to these 7 technology names at seemingly unjustifiable valuations. Cutting interest rates swifter than expected will upset broad equity markets, especially those stocks whose valuations have become overblown by a favourable economic backdrop. If the soft landing proves to be a pipedream and the US economy does enter recessionary territory which the lagging data in our view will start to support, then business confidence will be knocked, which in turn will spook investors.
With an index such as the S&P 500 so heavily weighted to the fortunes of 7 stocks, the impact of such a loss of confidence could be especially painful. Keep in mind that most trades in the S&P 500 are driven by computer generated algorithms buying and selling the index en masse, rather than stock selectors who are making an educated decision on the size and timing of individual stock positions.
As our position in US mid cap stocks demonstrates, we aren’t against all equity allocation, we are just looking for the right equity allocation for these market conditions. To give an example, another fund we invest into is the Regnan Global Equity Impact Solutions fund, a small/mid cap focused fund.
A holding within that fund is a company called Aixtron. Aixtron is a German business which produces the equipment to develop alternative semiconductors. Whilst I’m not a scientist, the benefit of these new generation semiconductors is that they produce more power efficient transistors, which deliver superior performance in terms of energy saving, less heat, lighter weight and lower system cost. Why this matters to us is that rather than buying Tesla, we want to buy Aixtron and businesses like them.
Tesla are one of the Magnificent 7, they are a huge business that everyone has heard of, they were the flagbearer for electric vehicles and have entered the mainstream through their soaring valuation and position as one of the largest 7 US stocks. The stock is also highly valued with a share price that now moves due to its sheer weighting in the index rather than due to stock specific decisions.
Aixtron allows us to access renewable technology at a fraction of the price and before most of the world knows about it. Yet it is a play on a Tesla theme. In order to power renewable energy, massive battery storage centres need to be built. These storage centres are hugely costly to run and typically they use traditional semiconductors. If they can install new generation semiconductors that are more efficient and which generate less heat, that will save the storage centres significant amounts of money, and they will be using Aixtron technology to do that. Aixtron have market share, competitive advantage and have a proven track record in being able to deliver these semiconductor chips in a way which other firms have not yet been able to do.
When we talk about moving into a stock pickers market and away from a passively driven, buy the index market, this is an example of what we mean. We aren’t dismissing equity indices per se, but we are loathe to overpay for all equities or indeed follow the herd when we think there are better placed alternatives in a similar sector, but with broader reach. The difference is that Tesla is a household name which is covered by investment analysts across the globe, Aixtron is a small/mid cap business with a few local analysts covering it. We believe Aixtron will be a well-known name in the future and that it will provide core technology to support the inevitable growth in alternative energy, but for now owning this sort of stock gives us a potential return advantage over other investors.
As we move through this stage of the economic cycle, I expect to be increasing our allocation to these type of small and mid cap names globally. To counter Federal Reserve optimism over a soft landing, many global small and mid cap stocks have already discounted recessionary conditions and earnings growth rates. Many large cap stocks have not yet taken these steps. Small and mid cap names typically begin to outperform at the start of recessionary environments, in anticipation of looser financial conditions, such as falling interest rates. The Federal Reserve’s interest rate announcement this week could well prove the signal for those loosening financial conditions, which in turn will signal the start of a recovery in selected stocks.
Prospects for 2024
I expect that the next 12 months will bring about quite a number of changes within our portfolios as we maximise returns from Gilts, Treasury stock, the spectrum of fixed income and selected equities. Now is not the time to simply buy an index, now is one of the most exciting times in markets and economics that we have seen over the last couple of decades.
2023 has been uncomfortable and has required patience, but what has happened economically and in stock markets has been necessary in an attempt to bring back some semblance of economic normality. I was often asked on our Open Day if we are turning the corner in markets and I firmly believe that we are. This period has felt extended, but for too long Governments and Central Banks have done everything in their power to prevent any pain reaching the end consumer. That simply isn’t tenable. Our portfolios are on the road to recovery and are in a much stronger position than those who are simply following the herd. We are turning the corner.
To my mind 2024 shall be one of those times when we discover “who is swimming without their trunks on when the tide goes out”, to coin a Warren Buffett phrase and I fully expect our investors patience to be rewarded.
Thank you for your feedback and patience throughout 2023 and I wish you all a merry Christmas.