Log inInvestment Markets Update – 22nd December 2021 from Jilly Mann
Investment Markets Update – 22nd December 2021
Following another year well punctuated by Covid, it is only fitting to bring 2021 to a close with yet another Covid chronicle. Despite the newsflow, Covid isn’t the only issue affecting markets at the moment and so in this edition, we shall also cover the following topics:
- Omicron – markets need certainty
- European equity exposure
- Asset backed stockpicking
- Inflation, interest rates and distracted Central Banks
- Environment, Social and Governance (ESG) investing
Omicron – markets need certainty
As I write, the Omicron variant continues to spread throughout the UK and, leaving asides the limited measures announced by the chancellor to support pubs, restaurants and leisure facilities, we remain unclear on the decision by Central Government as to what additional measures they may or may not put in place to cope with this. Without being a scientist, one cannot assess the data fully, however, the vaccine rollout has again been an enormous feat, and the UK leads the way in terms of global protection against this variant. This should then minimise the impact which the variant has on wider society, however investment markets and the economy more generally need certainty to function effectively.
It is a phrase we often used to employ when discussing Brexit or the fallout from the Global Financial Crisis of 2008/09, but it remains true under the pandemic. Markets will generally rally or find their natural price once they understand how things are likely to play out. The challenge for markets and the economy at the moment, is that we don’t know if further lockdowns are coming, but we do know that the uncertainty of how things may play out is enough to impact the day to day functioning of many businesses.
It shouldn’t be as easy as it is presently to book a last-minute Christmas meal or to find a parking space if you need to buy that last minute gift and undoubtedly the message to limit one’s exposure to the virus is eminently sensible, but this time the message is having a different impact on business.
From the start of this pandemic in March 2020, Central Government has provided financial support to business to thwart the danger of mass redundancies and bankruptcies. This support no longer exists and whilst many businesses have moved online and built up cash buffers from the support payments accrued, some businesses simply don’t have that option. The present uncertainty means that cash buffers don’t last long and without either a clear message that further lockdowns aren’t coming or a reintroduction of the financial support program, certain sectors remain in limbo at a time when they had hoped to recoup some of their losses.
The uncertainty also means that the stocks which were deemed Covid winners or losers aren’t repeating their performance, because they just don’t know if we are indeed taking a step back or pressing ahead with a reliance on our vaccine program.
The following charts demonstrate this point quite neatly. We have charted Carnival Plc (the black line), the cruise ship operator, who falls in the Covid loser category and Ocado Group Plc (the red line), who falls in the Covid winner category, since mid January 2020 when Covid started to take hold globally.
As can be seen, at the point the pandemic took hold, Carnival shares plummeted, whilst Ocado shares soared. It is rare in normal market conditions to see such a divergence in stock performance, but what it demonstrates is a market response to clarity of policy. Lockdowns were concrete and mobility was effectively paused. The net result seeing travel as a sector to avoid, whilst online shopping mushroomed.
The logic would suggest that when a new variant takes hold, markets would react similarly to the above. What has been encouraging with each new wave or variant we have seen, is that markets do slip when the news first emerges, but each time they fall a bit less and then recover a bit quicker.
Below are the same two stocks charted since November 2021, when Omicron became more prevalent.
There is no real divergence on this chart. Both Carnival and Ocado have trended downwards overall, albeit at different rates and within different peaks and troughs. If we had policy certainty, then I suspect the chart above may look quite different.
What this tells us is that markets today are more about stock picking than they have been for a number of years. Markets have moved on from the pandemic producing linear outcomes of winners and losers. Markets are also less concerned by the spread of the virus globally, putting more onus on the strength of the vaccination campaign and increasingly we will see winners and losers emerging from different sectors and different countries, with those nations which have vaccinated less, being more prone to sustained periods of uncertainty. This has guided our thinking in recent weeks with regard to the positioning of the portfolios in the early part of 2022.
European equity exposure
We seek less exposure to areas where the response to Covid outbreaks has to be so hardline. Europe is a good example where we actually feel that there is still a lot of untapped potential and recovery to come across a number of sectors which haven’t yet caught up anywhere close to their pre-pandemic levels. However, this latest variant is causing mayhem in France and Germany in particular. President Macron seems rarely shy of big policy announcements, particularly where the UK is concerned, but the new German Government are also in the midst of new policy guidance along similar lines. This is wreaking havoc with certain sectors of the economy and this will feed through into further supply chain issues and travel issues, with a lack of fit manpower to keep things moving. We are reducing our exposure to Europe as a result. On a valuation basis, it is a move we make with some regret, but we need to look at the portfolio from the perspective of there being more certain places to invest in the near term and we feel that Europe needs to develop an improved strategy to cope with ongoing Covid outbreaks.
Asset backed stockpicking
We are looking to increase our exposure to some of the more dependable areas of the portfolios. Artemis Global Income for example has performed quite strongly this year and echoes our thoughts on the stockpicking markets we now find ourselves in. The fund has shifted its focus toward more asset backed holdings. In part this will help to inflation-proof the strategy with inflation rising across most areas of the globe, but this is also in response to an increasing focus on price and valuation.
Below is a chart which Jacob de Tusch-Lec, the Artemis Global Income manager, produced when we met him recently and it addresses the issue of whether we are due a broad market correction:
The chart itself doesn’t give the definitive answer, but I think it does indicate some trends. Firstly, the market we currently find ourselves in is defined as the “US ‘growth’ bubble” on this chart and this has been running since 2006 to date. A period of 15 years and counting. Comparing that to other bubbles charted shows that the next longest bubble was deemed to be the “Basic resources bubble” of 2000 – 2011. The length of the present market compared to previous bubbles also means that the trajectory of the upward line is less steep and therefore less violent so far in its making than previous events.
The reason I show this is not to scaremonger, but to give some context to the perpetual view that markets must be in a bubble, that the bubble must be about to burst and we must therefore be heading for a significant downward correction. I don’t think the evidence suggests those outcomes must happen. I think what is more likely is that we may see some parts of the market correct and those corrections may be quite extreme, but I suspect that we may see other parts of the market continue to track upwards for some time yet.
The assets that are more attractive in this environment are those whereby there is something tangible remaining if there is increased market volatility. The definition of asset backed and an attractive valuation is not as clear cut as it once was. Technology stocks are often cited as the area of the market which has to fail at some point, but even within the technology sector, many companies will continue to thrive because they now represent assets we have to own. Microsoft is a good example. It isn’t a cheap stock at a multiple of 35 times its earnings, but so many businesses depend on Microsoft that it actually has become more of an asset backed stock. Amazon is another technology example which has diversified to the extent that it is no longer enough to bucket it alongside technology per se.
In contrast Uber Technologies is an example of a stock built around an app. If the app fails or someone else builds a better version of the same thing, what tangible asset does Uber retain. If inflation continues to rise, how do businesses such as Uber deal with passing on price rises to consumers directly, whereas perhaps bigger businesses with increased assets can absorb inflation easier and for a longer period before impacting the end user.
With this theory in mind, we are reducing our overall US allocation by reducing our exposure to some of these technology names which have done very well for us, but which we feel are less well suited to a shake out in stocks where winners may be the more boring, but ultimately more dependable parts of the stock market which Artemis Global Income and Schroder US Mid Cap represent.
Inflation, interest rates and distracted Central Banks
Moving onto inflation and interest rates, we have seen the Bank of England “hike” interest rates to 0.25% from 0.1%. The word hike amuses me because it wasn’t so long ago that interest rates were at 6 or 7% and higher, yet in a low growth, low inflation world, a movement of 0.15% is considered to be a hike.
The US seem more likely to press ahead with their own interest rate rises next year. This should sit well with our Schroder US Mid Cap holding, as they have been predicting these rises for a while now. In light of recent inflation and interest rate reports, we have also increased our weighting to UK equities, reintroducing the JO Hambro UK Equity Income fund alongside our other holdings. The UK exposure we have is based around solid businesses that will survive without central bank support and which may benefit from the resurgence in Merger & Acquisition activity within the UK economy.
Where inflation moves from here has been the destabilising factor for markets of late, certainly more so than the Omicron variant. Whether inflation is transitory or otherwise has become something of a moot point. Inflation is rising rapidly across most of the developed world. There are some countries who have tried to take a grip on inflation such as Turkey, but as I write President Erdogan of Turkey is having to step in to rescue the Turkish currency and so there is seemingly no right or wrong approach to managing interest rates and inflation at this time. As we have said previously, certain parts of the economy will see transitory inflation, where one year on from the pandemic taking effect, the extreme measures taken start to fall out of the numbers. Other parts of the market shall be less transitory, such as wage inflation. Wages rarely fall once a rise has been applied.
When reviewing the portfolios, we have again looked for businesses with strong balance sheets. Those businesses that will survive wage inflation and be attractive for new recruits in an ever more difficult recruitment market. We are also looking to reintroduce the BMO Property Growth & Income fund into our strategies. The fund should offer us increased exposure to rental inflation which generally lags property price inflation across the UK and Europe. In Europe, the rental market remains much more favoured than home ownership and with rents locked in for a period, buoyed by rising wages to support the rental payments, we feel it is a sensible asset to bring back in.
In terms of future interest rate rises, we think the US will likely proceed as planned with their predicted rate rises in 2022, especially if Joe Biden can finally push his $2 trillion economic agenda package over the line, but we aren’t so sure that the UK will follow through on the planned rate rises next year. The Bank of England are giving out mixed messages. The market seems to have factored in the rises anyway, which from a pricing perspective is helpful, but we are dealing with a period of time where traditional Central Bank guidance has become muddled with politics. The chart below was another one presented by Jacob de Tusch-Lec, but I think is symbolic, because it demonstrates the number of speeches given by Developed World Central Banks which reference inequality.
If Central Banks are taking an increasingly less independent view of the economics, preferring to pander to woke political messages, then there is no wonder they are providing muddled policy statements. Again, markets like certainty and they react negatively to a seemingly yes/no approach to inflation management and interest rate statements.
Perhaps the irony is that Donald Trump was pilloried in some quarters for his America First slogan, but the fallout from Covid 19 has seen more countries than ever put their own needs first. China is a good example of a nation trying to build a fairer class system internally at the expense of international relations, big business and trade. It can be argued that the UK have adopted a similar approach with Brexit, albeit with much work to do on social equality. Looking across Europe, Japan and Australia at their responses to the pandemic and it is always to preserve individual interests first. This isn’t wrong in itself, but it represents a changing dynamic in international markets and is something that we are adapting to within our portfolios.
Environment, Social and Governance (ESG) investing
Finally, I wanted to touch on our approach to Environment, Social and Governance (ESG) investing. This is slightly different to the traditional delineation between ethical investing or otherwise, whereby decisions are often made based on personal preferences or a desire to not invest in particular sectors, as well of course as wanting to invest to support businesses trying to slow the impact of climate change for example.
ESG is something which every business in the land will have to increasingly consider in their day to day existence, but for us it is something which we factor in to our selection of investment funds. It is tricky area to research, because some fund houses are very clear on their strategy and have built a strong reputation for imbedding ESG in their approach. Sadly, many fund houses are playing catch up and it is quite easy to see through their greenwashing strategy.
We are continuing to build a process by which we challenge each and every fund manager on their integration of ESG. As with ethical investing, it will rarely be clear cut. Some countries and sectors need time to change and so perhaps won’t score very highly at outset and so an element of pragmatism and engagement will be necessary when we look at this theme. Some sectors may be surprising. In the race to halt climate change, some of the big winners are likely to be some of the more traditionally damned investment sectors, take mining for example. The Glencore Chief Executive said earlier this year that copper supplies needed to increase by one million tonnes a year until 2050 to meet an expected demand of 60 million tonnes in order to replace fossil fuels with renewable energy. To explain why this is, consider that a car with a traditional internal combustion engine contains roughly 23 kg of copper whereas a full electric vehicle requires 83 kg. Nickel mining is in a similar supply/demand position. As I said, Glencore and other miners wouldn’t be top of most ethical investors’ buy lists, but they cannot be ignored.
I am listening to plenty of vacuous ESG presentations at the moment and so I won’t go into too much detail, but needless to say it is an area we are spending a lot of time researching and my colleague Charlie Hancock has just attained his CFA ESG qualification to hopefully give our investors some confidence that we are committed to this area.
To sum up, we still see areas of opportunity within investment markets. We are neither doom-mongers nor raging bulls about the prospects for 2022. There should be opportunities for sensible stock picking to achieve some strong returns, but we don’t expect to see this repeated across all sectors or regions. We are at a point in the emergence from the pandemic where we think the wheat will separate from the chaff and we need to be mindful of our primary purpose which is to try to generate solid, consistent returns for our investors. That may mean that at periods in 2022, we don’t participate in a mega-rally in certain sectors we think may be built on sand, but hopefully this update goes some way to explaining our concerns and sets out our aspirations for the coming months.