Arctic Monkeys, then Guns N’ Roses, then Sir Elton
Having been a supporter of the team from the red side of Manchester since my early teen’s and having lived in the south-east of England for the majority of my life, I find nothing ironic in saying I’m a big fan of Glastonbury, despite never actually going (so as not to completely offend my fellow Reds, I did eventually visit Old Trafford about 35 years later!).
On that basis, I’ll look forward to my trip to the Eavis’ farm, sometime halfway through my retirement. Until then, I’ll remain a keen watcher in control of the volume button. Like the economic outlook, this year’s headliners were somewhat of a mixed bag. Economically, we’re in the ‘Arctic Monkeys’ phase; an underwhelming phase that most people aren’t enjoying, inflation is problematic but probably past its peak (Guns N’ Roses), and a long-way short of a triumphant, joyous celebration (Sir Elton). There will be better times ahead, but for now it remains ‘tough sledging’.
Inflation – The Relentless March
Talking of nightmares, we continue to need to talk about inflation. As a reminder, the first inflationary wave, that in goods prices, was driven by COVID lockdowns restricting supply change, whilst consumers were still clamouring for “stuff”. In the UK, this peaked last October to be replaced by a secondary wave, as war in Ukraine caused both energy and food costs to spike. This will begin to roll out of the annual numbers in the coming months (oil and natural gas prices are now well below the level they were at the onset on the invasion). The third, shallower, wave has been the rising level of services inflation, think pubs, restaurants, and hotels and running alongside that the rising costs of labour.
There is no question that inflation remains central bank enemy number 1. That central banks were too loose in keeping interest rates at their COVID ultra-low levels is now a given and the reason why they continue to talk in hawkish tones about rate rises to come. In the US and Europe at least, they will be breathing a sigh of relief that the inflation genie is heading back to the lamp. Weaknesses remain in the banking system but for now this is a secondary concern and commercial banks tightening their lending standards, in order to strengthen themselves, works alongside the central bank objective of sucking demand through increased cost of loans.
So, central banks remain on their relentless march – pushing up interest rates in the battle against the persistence of consumer price inflation. Recent survey data goes from weak (service sector) to very weak (manufacturing sector) suggesting a slowing economic backdrop.
Among the big economies, the UK is becoming an inflation outlier. Consumer price inflation (year over year) has been falling in the US for the past 11 months and now stands at 4% and is set to fall further. Chair Powell continues to talk about rate hikes despite a weakened banking sector and the full weight of rate rises to date still needing to feed through (their full impact is yet to feed through to economies). In Europe, the ECB is very clear that there are further rate rises to come, even whilst its own staff forecast headline inflation to fall to 3% next year and 2% the next.
The Bank of England has more work to do and will be looking for the idiosyncrasies of how energy costs are calculated in the UK to begin to bring inflation down quicker. The energy price guarantee has just ended and the large number of households on standard energy tariffs will see declines in conjunction with how Ofgem calculates the energy price cap. From 1st July, the energy price cap falls by 17% to £2074 and is predicted to fall slightly further in its October calculation (announced this August). This will help drag down UK inflation, but in chunky quarterly lags, just like it did in April where energy price falls accounted for a drop of -1.4%. More patience required.
A job-filled recession
Our recent experience of recessions has been particularly nasty. The financial crisis precipitated the near collapse of our financial system and quarter after quarter of real economic decline, with unemployment spiking amidst a protracted recovery. By contrast, the COVID-19 recession was relatively short-lived, but was incredibly deep as workers were told to stay at home and unemployment was forestalled through stimulus packages and furlough schemes. Both were deeply scarring.
The existing threat of recession is clearly unwelcome, but all recessions are not created equally. Unemployment remains low and a job-filled recession is likely to be a less fearful beast than those recent recessions that stemmed from the financial crisis and the pandemic. Household savings remain healthy but are unequally spread, governments have large-scale stimulus packages in place as part of their industrial policy and to support the transition to a clean energy future. When central banks become comfortable that inflation has eased enough, and ultimately interest rates begin to fall, then the most significant headwind to markets over the last 18 months will turn.
The Relented March
The march by Wagner Group forces, from the battlefields of Ukraine towards Moscow sparked governments and newsrooms into life and then disappeared as quickly as Wagner did to Belarus.
The impact of the war in Ukraine was felt most significantly by markets at the outset of the invasion but has become an accepted ‘negative’ since. The war impacted gas markets significantly, most clearly in the restrictions in supply for Russian gas, but also because European demand for new sources of gas supplies meant countries became relatively price insensitive buyers. The warm winter has left Europe in a good position with gas storage levels over 75%, well above the 5-year average of 60% for the time of year and so energy supply is less likely to be a cause of further market instability.
Markets have absorbed and moved (or are moving) through a series of potential crises already this year – inflation and interest rates obviously, but US bank failures, debt ceilings (see next paragraph) and the continued war all hang over sentiment.
‘Crises’ are overcome, but each ‘crisis’ saps the strength of market enthusiasm. A weak economic outlook, slowing inflation, high interest rates, a slow trudging war, and a slowing China are all accepted. There is a ‘but’, which is that we’re less capable of absorbing the impact of further negative shocks and geopolitical risks remain, most obviously centred around Ukraine and possibly a de-stabilising Russia.
US Debt Ceiling – Why have a drama when you can have a crisis?
“Don’t have nightmares, do sleep well”, were the reassuring words Nick Ross would close out the long-running BBC crime-reconstruction programme, Crimewatch, episode after episode. Running for over 30 years, the TV cameras rolled as the public was invited to help solve some notorious crimes with a mix of reconstruction, grainy CCTV and some dubious E-Fit’s. The phrase sought to calm an otherwise terrified nation and prevent viewers being sent to their beds, wide-eyed with heartbeats racing, to face the sleepless night ahead.
“We averted an economic crisis, an economic collapse”, Joe Biden asseverated to the TV cameras broadcasting from the Oval Office that yet another US debt ceiling ‘will they, won’t they’ soap opera had passed. Less reassuring perhaps, but equally welcome as the US President signalled the passing of the Bill to agree to restrain some spending over the next decade and throwing the hot potato of the debt ceiling into another presidential cycle. The great fear of course was a re-run of the summer of 2011, when the issue of raising the debt ceiling was taken to the wire, resulting in a significant and steep fall in equity markets and the US facing the ignominy of having its credit rating downgraded.
This time, no downgrade, and perhaps a look into the future as centrist politicians held sway to ensure a relatively smooth passage through Congress…
Growth and Inflation Numbers:
Thanks, as ever, to our friends at Schroders for the latest consensus forecasts, which are:
I must confess I was never the greatest fan, but you don’t need to go much further than the ‘Queen of Rock and Roll’ to find a greater triumph over adversity, nor for a stronger comeback story in the annals of music history. It has been many years since cash has had its own paragraph in this revered (my word, no-one else’s) publication. ‘TINA’, or ‘there is no alternative’ was the result of desultory levels of interest achievable on cash and was made for the easiest decision for asset allocators over the last five years. Zero interest in an asset that gave zero interest. Simples.
Whilst interest on a typical current account seems to be languishing (banks seem very happy to pay derisory levels of interest, whilst pushing up the interest rate on mortgages), the same can’t be said for fixed rate cash accounts. With many cash savings accounts offering rates in excess of 5%, even some pushing towards 6%, interest rates can be found at levels not seen since before the financial crisis. With inflation still ticking along at 8.7%, real returns, even from the highest paying accounts are still negative, but with inflation forecast to fall through the year, that may be temporary.
History suggests that cash held for the long-term presents a real-terms risk to maintaining its value, but at the same time maximising the rate of interest on those rainy-day savings would make a great deal of sense.
In fixed income markets, 2023 is proving harder work than anticipated. UK Government bond yields have risen (which means prices fall) but have typically fallen elsewhere. Credit spreads have been relatively stable. We continue to use several strategic bond funds, some of which have been slowly increasing interest rate sensitivity in portfolios, in anticipation of falling interest rates. This is a move we concur with and across a number of portfolios we have reduced exposure to short-dated fixed income. This does not mean that we see little value in the short-dated end of the fixed income market either and we continue to hold funds in this area. Yields do remain attractive at the shorter end too but by adding to longer-dated assets you can capture the yield for a longer period, whilst accepting more sensitivity to the movement in interest rates. The yield available from fixed income, whether it be government or corporate bonds should serve as a positive, long-term backdrop for the asset class.
The mood in equity markets remains wary of recession, but one in which investors have been happy to accept the positive returns year to date. The weakness of the UK market and the strength of sterling are negating much of these positive returns, for example, the Japanese TOPIX is up 22% in local currency terms, but the weakness of the yen means for sterling investors, the return is just over 5%. Areas such as US equities have seen valuations move from ‘expensive’ to ‘average’ since last year, but there remain pockets of very high valuations. Others, particularly the UK and Japan are looking cheap versus history, but both require a catalyst to unlock that value. We should anticipate pressure on corporate earnings and profits will grow as consumer spending pressures build, but as a broad comment, valuations are at a level that makes prospective long-term returns from equities look more positive than they have been for some time.
Conclusion – More Patience Required
The year remains hard work as the pressure from rising interest rates continues to build and reverberate. Challenges, such as the US debt ceiling are being overcome, but interest rates remain the biggest hurdle and little progress is likely to be made until the tide of interest rate rises turns.
It is easy to get wrapped up in negativity and we are not blind to these economically tough times. There are, however, plenty of areas in both fixed income and equity markets that should deliver long-term positive returns in future years. We ended our last quarterly arguing that time and patience are likely to be an investors best friend. Portfolios are surviving, not thriving, in these headwinds, but sometimes treading water in turbulent seas is necessary. As Sir Elton sang at Glastonbury “I’m Still Standing”.
From all of us in the investment team, Emma, Will, Becky, Kim, Hayley and me, we thank you for continuing to place your trust with us in managing your portfolio.