Don’t look back into the Sun
Alas, the summer season passes us by for another year. The leaves are starting to turn brown; the summer holidays seem more and more distant, the evenings gather darker and Strictly is back on the TV.
After a lightweight summer with too much rain in the UK and too much sun everywhere else, the mood music in markets remains downbeat. The pace of interest rate rises may well now slow, but this period of adjustment in going from an era of low interest rates stemming from the financial crisis and then the ultra-low interest rates seen in the pandemic, is both painful and ongoing. Economic growth looks very hard to come by and there are plenty of potential pitfalls, chief amongst them policy error by central banks. The years ahead will be a time where interest rates settle at a higher level than we’ve been used to for 15 years. Over the last 18 months, there has been more than just central bank policy for asset markets to digest – reverberations from pandemic disruptions, an energy crisis and war in Ukraine. There have been headwinds aplenty, but looking backwards only offers solutions to yesterday’s problems. Valuation is a slippery concept, spawning a stream of financial sayings – yes, cheap stocks can get cheaper and catching a falling knife is going to hurt, but being a perma-bear keeps you stuck on the sidelines. We are positioning portfolios for an environment that recognises that some value has been created through all this tumult and where pockets of value emerge accept that buying and holding for the longer-term, allows the benefit of being able to look through some nearer-term challenges.
Slow, Slow, Quick, Quick, Slow
To say I’m an underwhelming dancer is, in itself, somewhat of an understatement. Accustomed as I am to be sitting on the sidelines at all major friend and family gatherings, I can reliably be the one person safely assumed to have left their dancing shoes at home. Perhaps it was the French air, more likely the effect of some recently consumed French bubbles, but whichever was stronger helped carry me to the dancefloor at a friend’s recent wedding. The legs moved but it wasn’t particularly elegant.
Having steadfastly struggled to raise rates in the post-Global Financial Crisis era, central banks rushed straight from the sidelines into a quickstep of interest rate rises at the fastest pace for decades in reaction to a post-pandemic surge in inflation. The message coming from central banks is they are now going to spend quite some time catching their breath before a slow waltz of cuts come through.
The Bank of England has been more successful in keeping its forward guidance alive as a policy tool than others. Recent messages coming out from MPC members have very much been to paint a picture of very-near peaks in interest rates, but now a protracted period of elevated rates. At the last meeting in September, the MPC left policy rates unchanged, which probably suggests we’ve hit peak rates in the UK. Central banks are saying they are ‘following the data’ (have we heard that before somewhere?), but after such a turbulent period of time, what if the data is wrong? We have already seen big revisions to UK GDP data, which has turned Conservative politicians from navel gazers when asked about the UK’s economic rebound from COVID, to back-slapping cheerleaders. If central banks are focused on conducting policy by looking in the rear-view mirror, the risk of missing the chance to take the first exit off this path of squeezing consumers, may well be missed.
In sickness and in health
Given the importance of the consumer to developed economies, assessing the financial health of consumers helps to paint a picture of the health of the overall economy. There are some concerns. US consumers have spent down pandemic savings far more aggressively than their UK peers and student loan repayments are restarting for over 40m Americans. Rising financing costs are beginning to work on constraining spending power and activity too. UK household savings ratios remain higher than immediately before the pandemic, but in the same way as rising energy bills sucked those accumulated pandemic savings away from any consumer spending boom, rising mortgage costs will slowly begin to impact the spending power in a rising number of households.
Earnings may well have been rising in nominal terms, but real wages (the important ones that allow you to buy real things and pay real bills), have just gone through a significant spell of negative real terms decline. The chart from the Office of National Statistics should be labelled ‘Mind the Gap’! This has been hugely damaging as consumers have continued to spend more and more, but actually receive fewer and fewer goods in return.
There are other areas that make headwinds for the consumer:
Student Groan
Students are heading to their universities in the UK, but student finance is about to play an oversized part in the US, where student loan repayments are set to restart following the Supreme Court’s decision to strike down President Biden’s student debt relief plan. Interest on loans and repayments recommence for 43 million Americans, having been suspended at the onset of the COVID pandemic. With an average interest rate of 6.4%, and with the interest payment tax deductible, there’s been a rush to repay some of the $1.8 trillion debt pile, but there will be an additional drag on consumer spending as they get reaccustomed to paying for yesteryear.
Oil Rising
Oil markets have been enjoying a stronger pricing environment during the quarter. OPEC+ have been showing supply restraint, but Russia and in particular Saudi Arabia have been implementing production cuts, with Saudi Arabia producing below 9 mb/day, 25% less than their capacity. Other countries have been increasing production, whether that be Iran, Nigeria, or the US. The crux of the point is, if Saudi weren’t cutting, excess supply would exist, and prices would be lower.
There are some broad implications to this. A rising oil price is akin to a rising tax burden on the consumer, taking more money out of consumers’ pockets and transferring them to oil-producing nations, whether directly at the petrol pump or through increased transportation costs in the supply chains of the goods we buy. So higher oil prices tend to equal lower discretionary spending. As we all know, we are in a period of weakening global economic growth, which typically reduces demand for oil. This doesn’t augur well for the price of oil being able to be sustained at high levels. Perhaps a more realistic option is the weakening of global demand for oil as we move through into 2024, mean this year’s cuts by Saudi drag forward the cuts needed to meet next year’s like demand for the black stuff.
This makes for a more slippery path for central banks to navigate as rising oil prices slow the pace of decline in inflation numbers, which more likely means a trickier job in timing future rate cuts, rather than rate rises. US headline inflation rose in August, with petrol prices being the chief culprit (core inflation continued its progress lower).
Growth and Inflation Numbers:
Thanks, as ever, to our friends at Schroders for the latest consensus forecasts, which are:
|
GDP (%) 2023 |
GDP (%) 2024 |
CPI (%) 2023 |
CPI (%) 2024 |
|
|
Global Economy |
2.4 |
2.0 |
4.4 |
3.0 |
|
China |
5.3 |
4.7 |
0.8 |
2.0 |
|
Emerging Markets |
4.0 |
3.9 |
4.1 |
3.8 |
|
US |
1.9 |
0.6 |
4.1 |
2.6 |
|
EU |
0.6 |
0.9 |
5.5 |
2.5 |
|
UK |
0.2 |
0.4 |
7.3 |
3.0 |
Source: Schroders Talking Point, August 2023
Good news everyone. Little ‘ol Blighty, isn’t as little as it thought and can hand over the ‘sick man of Europe’ baton to others. The Office for National Statistics updated its figures on UK GDP data and handily found a couple of percent of GDP tucked behind the sofa. We were less bad than feared in the depths of the pandemic and to echo some of my school reports ‘somewhat improved’ in the recovery during 2021. Happy days.
Sadly, looking forward, the picture still looks sickly. The direction of travel for consensus forecasts is for economic growth next year to be low, but generally slightly better in developed economies than previously thought, albeit hiding beneath that is a weaker relative outlook for countries, such as Germany, with a strong manufacturing base. Stronger developed economies are a positive, but a weak China means global growth is going to remain sub-par for some time.
Portfolio Outlook – Buying straw hats in winter
Whilst the outlook for economies looks and remains challenging, Main Street and Wall Street don’t walk in lockstep as financial markets are discounting mechanisms after all. We are positioning portfolios for an environment that recognises that some value has been created through all this tumult. Cash isn’t the only asset that looks good value today.
In fixed income markets, corporate bonds have fared relatively better than government bonds to date. Credit spreads have tightened after widening during March following the emergence of stress in several US regional banks. We continue to position portfolios for an era of peaking 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.
Equity markets are more sensitive to an economic slowdown, but contrary to that concern, many equity markets have made progress this year. The fly in the ointment for UK investors is the strength of sterling, which has negated much of these positive returns. Areas such as US equities still look ‘expensive’. Others, particularly the UK and Japan are looking attractive versus history but require a catalyst to unlock that value. Pressure on corporate earnings and profits will grow as consumer spending pressures build, but corporate earnings remain relatively resilient for now.
Towards the end of last quarter, we made a number of changes to portfolio construction and fund selection. In summary:
In Core Cautious, we reduced some shorter-dated corporate credit funds and Ruffer Diversified Return and Troy Trojan to add Vanguard US Government Bond Index, where we are hedging the currency risk.
In Core Conservative, we do the same as Core Cautious, but also trim JH UK Absolute Return and CT UK Equity Income in order to add FTF Clearbridge Infrastructure Income and top up Stewart Asia Pacific Leaders.
In Core Balanced, we continue the theme, by adding Vanguard US Government Bond Index and FTF Clearbridge Infrastructure Income. We also add Royce US Smaller Companies and trim the larger cap, Fidelity Index US. We also sell the small position in WHEB Sustainability.
In Core Growth, we add Vanguard US Government Bond Index, FTF Clearbridge Infrastructure Income, Royce US Smaller Companies and Schroder Strategic Credit. We also top up Blackrock Continental European. We sell L&G Short-Dated Sterling Corporate Bond Index and Artemis Global Income, also reducing iShares Mid Cap UK Equity and WHEB Sustainability.
In Core Aggressive, we sell the remaining Baillie Gifford Global Discovery and reduce WHEB Sustainability to add Royce US Smaller Companies.
In Passive portfolios, the broad themes of the adjustments are:
- Reduce short-dated fixed income funds and add Vanguard US Government Bond Index (hedged) (in all but the Aggressive Passive range).
- We add LGIM Global Infrastructure Income Index to Conservative, Balanced and Growth Passive ranges.
- We seek to marginally dilute exposure to the largest US companies, by adding Vanguard US Equity Index, which tracks the broader US market, not just the S&P 500.
- We also reduce currency hedged versions of the Fidelity MSCI World Index and buy the unhedged sister fund.
Conclusion – We could all do with a few good years
Sometimes life feels like running through treacle; progress is slow, and obstacles keep on getting thrown in the way. Investing in recent years has felt similar.
Viewers of the Rugby World Cup may share my observation that the tough, hard yards fought and found in the hubbub that is the pack are, more often than not, the platform that goes on to release the backs to score the try. As we end the era of low interest rates, we remain fighting for those hard yards. We’d love to be up and running to that try line, but that time isn’t now. It will come and will come unexpectedly and without warning, but expect volatility and challenges to remain the order of the day for now.
We have concluded recent Investment Quarterly newsletters calling for the need for continued time and patience. We could all do with a few good years from markets. I’d settle for a multi-decade bull market. Sadly, I fear the rest of the year, nor indeed next, are likely to prove fertile hunting ground for super-charged returns, but the foundations of future performance are being laid for long-term investors. The short-term is littered with noise and multiple different potential pitfalls. Do your best to ignore this. Focus instead on the value that has been created in recent years. A steady flow of income is never a bad starting point and both fixed income and equities are delivering this to you. These are the hard yards that contribute to long-term returns. The glory days for equity markets will return, but that’s for another investment quarterly to talk about.
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.
