Log inMarket Update – “What’s hot today, isn’t likely to be hot tomorrow – don’t follow the herd” (Warren Buffett) from Jilly Mann
2023 has been a frustrating period thus far with many investors worried about the returns from portfolios. We made a decision earlier in the year to maintain a defensive approach to our portfolios and we bunkered down on that a couple of months ago when we further reduced our equity exposure. Our current positioning is deliberately different to the benchmark. We consider this to be a temporary position, but one which we remain confident hindsight will prove to have been sensible as we move into the second half of the year and beyond.
In this update, we shall cover the following:
- The US stock market and what is really happening
- The US Debt Ceiling, what it is and why it matters
- Prospects for interest rates and a “soft landing”
- The UK market and the global time lag on economic data
- UK Commercial Property provides some good news
- Conclusion
The easier route for us to have taken would be to chase what in our view are the final throes of a bull market, in an effort to hunt down positive returns. We didn’t feel this was right. We have very little confidence in the thesis behind an equity bull run having started already. Our base case remains that there is pain to come for equities, but that bonds, cash and property offer a far more resilient investment outlook for 2023. Thus far, that hasn’t yet played out, but I will attempt to explain why the apparent positive returns from certain equity markets through 2023 are slightly deceiving.
The US stock market and what is really happening
The chart below shows the performance of the leading US index, the S&P 500 (pink line), against Meta Platforms Inc (blue line, formerly Facebook), Apple Inc (green line), Microsoft Corp (black line) and the S&P 500 Financial Sector Index (orange line) from the start of 2023 to date.
2023 has been quite unusual in that looking purely at the headline index returns on given days, the perception may be that the US market as a whole is holding up relatively well and is up about 9% for the year. The question could justifiably be asked as to why then we have very little exposure to the US market.
The chart above demonstrates why we believe this rally is deceiving and unsustainable. Essentially, the S&P 500 has been dragged upwards by a handful of mega cap technology stocks, 3 of which are highlighted above. These represent a disproportionate amount of the overall S&P 500 Index. In contrast the S&P 500 Financial Sector index is down about 7% for the year. I could replace the Financial Sector index with other sectors to show similarly negative results. The point being, that the US market in total is not performing well. The outperformance of a handful of mega cap stocks has simply overshadowed that and created what we believe is a false impression over the health of the US stock market.
The next question is then why are those stocks outperforming? In 2022, Apple and Microsoft were both down around 29%. Meta was down over 64% for the calendar year. Those are significant falls and it feels like the market is trying to suggest that the stocks were oversold. Add in the fact that they do form such a large part of the S&P 500 index. Algorithmic (automated computer trading) investors trade on price targets and as these particular prices had fallen far, the algorithm is set to buy them at a certain price and this in turn has a domino effect for other buyers. This is regardless of the investment fundamentals of each stock or the overriding economic situation, trading blind in other words.
We have often spoken about Microsoft being more of a long-term infrastructure holding than a typical technology stock. We still believe that Microsoft will be a good company to own in the future, but right now, we think there are far bigger factors affecting the broader economy than specific stock merits and ultimately those factors will win against this deceptive rally.
The US Debt Ceiling, what it is and why it matters
Something that we have been monitoring for a while has been the impending US debt ceiling decision day. The US debt ceiling is effectively the US reaching the upper limit of debt which they are permitted to run under current legislation. In order to build up Government debt in excess of that amount, new legislation needs to be passed and a new upper limit set.
This isn’t anything new and it rears its head every few years. I recall this happening in 2011, in the wake of the Global Financial Crisis of 2008/09 and it caused consternation in markets.
In July 2011, the US came within 72 hours of missing the deadline to increase the debt ceiling and in turn defaulting on their debt. The 2023 deadline for a decision is the 1st June. As it stands neither side of the Democrats or Republicans can even agree on the deadline date as set out by Treasury Secretary Janet Yellen and so we are some way off the parties agreeing the detail of any agreement.
The chart above shows the US Treasury 10 Year Spot Yield in black, the iShares USD Treasury Bond 7-10 year in green, the S&P 500 in blue and the FTSE All World index in brown over a period from the 3rd January 2011 to the 3rd October 2011.
It is clear from the chart that as 2011 played out, equity markets fell significantly. The S&P 500 was down 13.72% over this period, with the FTSE All World index down 18.07%. This wasn’t just a US problem. Global stock markets were affected.
What is most interesting though is that the bulk of the falls came after the July 2011 debt ceiling agreement had been reached. The agreement itself provided a short-term relief to markets, but what followed was a period of uncertainty as the implications of both raising the debt levels and running it so close to the wire played out. Back then, the ratings agency, S&P, came out in August 2011 with a decision to cut the US Sovereign Credit Rating. This was monumental at the time, because the US Dollar remained the pre-eminent global currency and the ramifications for question marks over its security sent out shockwaves.
The graph above also shows that the US Treasury 10 year spot yield fell by 47.77% during this period in 2011. Whilst the yield fell, returns from owning Treasury assets rose by 14.04%, as evidenced on the graph by the iShares USD Treasury Bond 7-10 year. As bond yields fall, price returns rise.
If we look at the comparison of the US Treasury 10 year spot yield and the iShares USD Treasury Bond 7-10 year for 2023, a similar pattern plays out. As the spot yield has risen, the price returns of the iShares assets have fallen.
Yields have held up for longer than we anticipated through this year, but we feel that we are imminently close to a turning point. As we approach decision day for the US debt ceiling, we have already started to see equity markets drop, the 10 year Treasury Spot Yield start to turn downwards and bond prices start to turn upwards. The debt ceiling is not the only reason as to why we are positioned in such a defensive manner, but it is going to grab headlines in the foreseeable future.
The 2011 decision ran close to the wire, but much of that was in the wake of the Global Financial Crisis of 2008/09 when negotiations were a battle between fiscal caution and economic stimulus. In 2011 there was backdrop of zero interest rates and nominal inflation. In 2023, US interest rates stand at 5.25% with inflation at around 5%, much lower than in the UK where we are still in touching distance of double-digit inflation numbers.
The decision to increase the debt ceiling and to which number is one that requires careful management, when debt repayment levels are at elevated rates. Something that wasn’t such a concern in 2011.
The US is also gearing up for an election battle and this time there is far less certainty over who the candidates may be and what their policies are. The shadow of Donald Trump hangs heavy over the Republican party and so finding common ground even within each party is going to be extremely difficult to achieve.
We expect an agreement to be reached, but we also expect this situation to drag on for longer and become more bitter than 2011. What we don’t know is what implications this may have and how the Federal Reserve may be dragged into the debate with regard to being pushed to cut interest rates sooner than they perhaps may have done otherwise. This uncertainty is not likely to be good for equity markets, but we think this will be beneficial for our defensive positioning where we are heavily exposed to the bond markets which could do well from a protracted debate that results in bond yields falling.
To be clear, we don’t think that the US will default on their debt and so we think that US Treasury securities are safe to own. What happened in 2011 was that the US instead closed down various Government departments as a result of the ongoing saga. For example, social security departments closed and this impacted US residents, but they protected Treasury assets at all costs. Whilst 2023 has seen much talk about the US Dollar no longer being the global powerhouse currency that it once was, in reality, the US Dollar remains the underpin for so much of the globe that it will survive this latest challenge and will continue to be omnipresent.
Prospects for interest rates and a “soft landing”
Our overall thesis for owning so little in the way of equity at present is that irrespective of the US debt ceiling issues, we believe that a recession is imminent and that we aren’t going to see the “soft landing” from this inflationary environment that markets have been trying so hard to achieve through 2023.
The Federal Reserve have raised interest rates once more than perhaps we thought they might and this has impacted the returns we have seen from bond markets in recent weeks, but we cannot see further rises continuing in earnest. If anything, we would be more surprised if we didn’t see the Federal Reserve start to cut interest rates as we head through the second half of 2023. Interest rates won’t fall to zero any time soon as inflation will remain stubbornly high, but we don’t think it is unrealistic to see them fall to around 3% over the next 12-24 months.
Once the Federal Reserve confirm a pause in interest rate rises, then the pressure will turn to economic signals for them to cut rates. At the moment, we remain in a tussle situation between markets trying to force a happy ending to this cycle and the Federal Reserve attempting to hold firm and reintroduce some traditional economic constraints to society. The US debt ceiling may be the turning point for that tussle.
As we head into what we believe is the contraction phase of the economic cycle, traditionally fixed interest and cash have been the outperformers with equities trailing. Whilst interest rates remain high, we continue to hold an overweight to money market funds. If we can generate a return of around 4% from these assets then we are in strong position to benefit in the short term, but then also buy back into a recovery phase of the cycle as opportunities arise and as interest rates reduce.
We would anticipate seeing further opportunities in different parts of the fixed interest market and equities as that cycle changes and we have a plan in place to capture such opportunities when the time comes. What we do anticipate is that any buy back into equity markets will be into different assets to those which we sold out of earlier in the year. As it stands, Europe looks to present more opportunities than the US and Japan also seems to be on the recovery path as well.
We have said many times that the markets lead the economy when it comes to economic cycles. Whilst we remain negative on equities and expect a recessionary environment in the near future, we are relatively positive about potential returns through the second half of 2023. That may seem contradictory as a recession feels like it should be bad news for everything, but it isn’t the case and typically when the economy appears to be at a low point, we have been able to generate significant outperformance within portfolios over the last 17 years.
The UK market and the global time lag on economic data
I haven’t spoken much about the UK in this update. Economically, what happens in the US will largely ordain what happens in the UK. The two economies aren’t identical and clearly the UK is impacted much more heavily by events in Europe, but if the US start to bring down interest rates, the pressure will be on the UK to follow suit. Inflation in the UK is starting to show signs of coming down, but it is behind the US in that regard, not least because of events in Ukraine. We expect inflation to remain elevated, perhaps more so than in the US, but the general direction we anticipate being similar.
The FTSE 100 is flat for the year to date, with the FTSE 250 down over the same time period. This performance is perhaps more reflective of where the S&P 500 should be overall, were it not for those few technology stocks. An entry point back into the UK market will present itself in the coming months, but it will be selective exposure rather than market wide.
Our fundamental belief is that globally the impact of consistent interest rate rises has yet to fully reveal itself. We are starting to see more data referring to rising unemployment levels, reducing household cash reserves and a potentially difficult period for mortgage renewals coming up, but as yet, the full impact to our mind has not yet been evidenced in the economic data. There is always a lag effect to data as it takes time for a rapid rise in interest rates and soaring inflation to come through in the numbers, but it is now happening and it is this data which will contribute towards central bank decisions over cutting interest rates to boost economic growth, whilst continuing to keep a grip on inflation.
UK Commercial Property provides some good news
To end on a positive, I want to mention UK commercial property. 2022 was a difficult year for the CT UK Property Feeder fund, as it was for all Property funds as their valuations were revised downwards. 2023 has started well for the fund. It is up over 3.5% and having just spoken to the manager, he is hopeful of at least doubling that return through the remainder of 2023.
To bring life to the argument that negative economic news can still bring positive investment opportunities, the fund sums up what we are looking for. In contrast to the news on the UK domestic rental market, the fund is still seeing commercial rental growth of between 5 and 7%. The fund is heavily weighted towards industrials and warehousing, but not the massive Amazon type sheds which proliferate the motorways, rather the sort of warehousing you may see on the estate around our office in Kettering. Presently, the vacancy rate in UK warehousing is at its lowest level for 10 years. Finally, a positive difference for the UK market over the US, is that UK lending to Commercial Real Estate is 6% of total bank lending. In the US, many small banks have exposure of at least 40% to Commercial Real Estate. This matters, because small US banks have faced severe difficulties through 2023 with bailouts rarely out of the news. Add in that lending in the US market has stagnated, there is virtually no refinancing market at present, interest rates are at a high point and loanees are unable to repay their debts, then when we talk about selective investment opportunities, this is what we mean.
The chart below demonstrates that not all markets are the same and not all sectors are the same. With a yield of 5% before factoring in any capital return on top, the CT UK Property Feeder fund is in the recovery phase already and we are looking for more opportunities in the sector to add to our property allocation. Compare the blue line of the CT UK Property Feeder fund to the red line of the UK Direct Property benchmark, which is down 0.7% over the same time period as the CT fund is up 3.58% and it is evident why selective fund picking matters for portfolios.
Conclusion
To sum up, whilst it may seem counterintuitive, sufficient negative economic data coming through consistently will be the moment we have been positioned for. We have tried to eliminate the noise and impact of equity markets in 2023 and neutralise as much as possible the economic situation within our portfolios. It is taking some time to play out, longer than we would hope, but we are confident that we are nearing that point when our positioning will be rewarded and more to the point, puts us in the box seat for rotating our strategies to benefit from selective investment opportunities, whilst avoiding the worst of the fallout in markets. Staying patient will be rewarded as the last 17 years have shown, this market rotation will offer a fleeting moment to maximise returns as a host of factors all suddenly combine to signal the turn and so being out of the market entirely is just not where investors should be in the coming weeks and months.