Market Outlook

Spring – A time for optimism?

As the blossom finally dares to start showing its face after a spring that feels littered with the longest of false dawns, the first rays of the sun’s warmth help to lift our spirits as we look forward to a long summer ahead. With inflation falling, central banks flagging imminent interest rate cuts and major equity markets hitting or threatening all time highs, life is good, it would seem…

Interest Rate Cuts – Increasingly confident?

The fervour that markets allowed themselves to get into at the end of last year, predicting the hasty turn from interest rate rises to interest rate cuts, and for those cuts to come much faster and go much further than previously anticipated, has come up against the reality of an economic outlook that is stronger than expected.

For much of this year, central banks have so far been gently pushing back against last year’s enthusiasm and tried to deliver a dose of new year reality. In a broad sense, much is still going quite well. Primarily the jobs market looks healthy and so long as those who want jobs, have jobs and continue to be paid to do those jobs, then whilst the economy may not be making giant strides forward at a headline GDP level, we’re not making giant strides backward either. In our day to day lives, you and I really don’t notice the difference between headline GDP growth being -0.2% or +0.2%, but headlines it makes.

Central banks are focusing on maintaining this status quo. What they don’t want is for their interest rate policy to continue to make matters worse. As inflation has been falling, the real interest rate (the interest rate after adjusting for inflation), has been steadily rising. Think of the sharp rise in interest rates over the last 18 months as being the equivalent of central banks slamming on the car brakes, with the intention of bringing inflation back under control. Stick with that theory for a minute and as the strength of inflation dissipates (the car slows), the pressure on the brakes needed to keep slowing at the same pace steadily declines too. Maintaining the same initial force all the way through only sees the car and its passengers lurch to an unnecessarily dramatic halt (& in the case of economies runs the risk of it going backwards).

Central banks need to begin reacting by reducing interest rates, not to make policy less restrictive, but to maintain a consistent restrictive policy in the context of a backdrop of falling inflation. In the UK at least, some of the resilience to rate rises has been those most sensitive to interest rate rises, such as mortgage holders, have broadly done a pretty good job of fixing their mortgage rate. The conveyor belt of households coming to the end of their fixed rate deal is steadily bringing more people face to face with the reality of higher rates and the pressure that brings to household budgets.

If there has been a trend over the last couple of years, it has been for a consistent and extended gap to exist between the expectation and reality of everything to do with this interest rate cycle. The initial pace of interest rate rises went further and faster in the face of rising inflation. The current period, which is the time between interest rates peaking and the first rate cut, has been extended in the face of a more resilient jobs market and stronger than forecast economic backdrop. The emerging challenge will be marrying the expectation and hope for faster interest rate cuts to keep the consumer spending and the wheels of the economy moving forward, alongside the requirement for central banks suppress inflation. If you were a central banker with no specific growth mandate, such as the Bank of England, you’d be inclined for caution, trading the prospect for higher growth in the knowledge you have in reserve more firepower to support an economy if the economy gets into trouble. We’re all human after all.

Inflation – A bit like hot cross buns?

We keep on promising to stop writing about inflation, but as much as it is true that inflation has fallen dramatically from its highs, just as some seasonally appropriate hot cross buns leave you, the last bit is stickier than you imagined.

Towards the end of March, there were a raft of central bank decisions regarding interest rates. Except for the Swiss National Bank, who unexpectedly began reducing interest rates, the common theme was for policy rates to remain unchanged. The Governor of the Bank of England, Andrew Bailey, was particularly upbeat, flagging that they were increasingly confident they had shown inflation the red card and were preparing the ground for the start of interest rate cuts to come imminently.

UK inflation fell further in February, dropping to 3.4% from 4% a month before and a long way from its peak of 11.1% in October 2022. Food inflation has been one of the main drivers to this recent reduction and this is probably overstated as the inflation bods measure the full ticket price, not the discounted loyalty card price you, me, and everyone else in the country actually pays. It is the pace of decline in food prices that is worthy of note. According to the Office for National Statistics, ‘food and non-alcoholic beverages’ inflation was running at the highest level for 45 years this time last year, falling from 19.2% in March 2023 to 5% in February this year. Assuming no imminent reversal, this will be a continuing disinflationary force for months to come.

We will also shortly be enjoying lower household energy bills as the energy price cap reduction kicked in on April the 1st, which is expected to push inflation below the 2% target during either April or May. Whilst inflation in the services sector continues to be elevated, it too is falling slowly but surely and is the one variable which is likely to split the difference between the first rate cut coming in June or August, with more forecasters now leaning to the former, not the latter.

Bank of Japan – Flip a switch

Well, it may have taken a third of a century but on the 22nd of February this year, the Nikkei 225 surpassed its previous all-time high set in the closing days of 1989. As the sun was rising on the cultural phenomenon that was the 1990s music scene here in the UK, the sun was firmly setting on Japanese equities as a great unwinding of excess valuation began to unfold.

We have previously talked about Japan and some of the forces that are helping drive their equity market forward, with one of those being the negative interest rate policy being employed by the Bank of Japan. This has had the effect of depressing the yen, which has been beneficial for both Japanese exporters but also to companies listed in Japan whose source of earnings are coming from overseas. The policy has also meant that after years of living with deflation, the ‘right sort’ of inflation is beginning to emerge in Japan. Rising prices and wages, alongside the successful ability for Japanese companies to be able to pass on rising costs to consumers are all creating a positive inflation outlook, with CPI above the Bank of Japans 2% policy target.

As a result, the Bank of Japan has been preparing the ground to begin withdrawing from its ultra-supportive policies of both negative interest rates and yield curve control (buying government bonds of certain maturities to control the market yield). In March, the Bank of Japan raised its short term policy rate from -0.1% to be in a range of 0 to 0.1%, breaking a 17 year period since the last interest rate hike, whilst also putting an end to an 8 year regime of yield curve control. This ‘historic’ shift in rates was heavily wrapped in verbal cotton wool supplied by Governor Kazuo Ueda in the meeting that followed the announcement and was further softened by the Bank confirming that despite dropping their yield curve control, they’d still be hoovering up at tens of billions worth (in US dollar terms) per month. The yen weakened as a result.

What is clear is that despite the policy move, the Bank is at pains to smooth a transition without giving the market any excuse for kneejerk reactions. The risk is, after a period of significant yen weakness, the yen strengthens thereby turning into a headwind for Japanese exporters and undermining the return of inflation. Should that not occur, Japanese equity markets still look relatively attractively valued versus their own history and other markets, such as the US. With a positive and ongoing corporate reform programme well underway in Japan, the outlook for Japan remains promising.

Growth and Inflation Numbers: Hard out here

Thanks, as ever, to our friends at Schroders for the latest consensus forecasts, which as at February 2024 are:

‘Meagre’, remains the word to describe UK and European growth prospects, whereas ‘Robust’ would be a better choice for the US economy as Jerome Powell, Chair of the Federal Reserve, continues to prove the doubters and naysayers wrong (guilty as charged) by navigating the US economic supertanker into a port called ‘soft-Landing’. Better to be lucky than be wise, my old boss used to say.

The emerging trend is for developed economies, albeit led by the US, to have proven more resilient than anticipated to the significant interest rate rises they have been subjected to in the last couple of years. Whereas a few quarters ago, the expectation was for a recession to be highly likely and for it to weigh on the jobs market, the reality has been for both the jobs market and the economy to have proven more resilient.

At a headline GDP level, less convincing prospects remain in China as it continues to struggle resurrecting consumer demand, a weak property market and an economic rotation to a more domestically-focused consumer economy. This is more than the headline GDP number though. China is focused on its own aims which are managing the technical ‘cold war’, which is often lost looking through a Western lens. China’s focus is on supporting its domestic production of electric vehicles and solar panels alongside managing the loss in imported technology, as a result of the technology blockade. Alongside this is their Common Prosperity agenda, that seeks to narrow the gap that has emerged between rich and poor, catalysing itself with fewer concerns for speculators nursing losses in the property market or wealth management products.

Inflation is in a disinflationary phase and the consensus is for this to continue through this year and next, with expectations for inflation to fall suspiciously close to target levels in the US, UK and the EU.

Worth it?

As the charts show, the dominance of both the US equity market and the US dollar since the Global Financial Crisis is the long-established trend that has been underpinning investor returns since the banking chaos took us to the edge of a global depression. Nowhere more so has this dominance been demonstrated than in the largest of US companies, the top few being monickered as The Magnificent Seven.

As labels go, the ‘Magnificent 7’, namely Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA and Tesla is already beginning to sound a little “oh, so 2023”, as Tesla’s share price has been under pressure and its market cap has been surpassed by Eli Lilly (a US pharmaceutical company that is at the front of the latest market fascination, weight loss drugs). As a consequence of the dominance of a select few companies, the US equity market has been getting increasingly concentrated. Since 1990, the concentration of both the top five and top ten S&P 500 companies has never been more concentrated than it is today (even during the tech bubble of the late 1990’s).

As much as cycles are a recurring theme in investment markets, so too is mean reversion. Whilst the strength of these top companies and their ability to convert revenue into cash remains unquestioned (not a common feature in the 1990’s example), both analyst expectations and market valuations for these companies get ever more elevated. There are some magnificent businesses in the Magnificent 7, but the premium being paid for their quality is just very, very high. Inevitably, it’s a fools game trying to time any rotation and with a strong flow of investor cash continuing to come through passive index tracking funds, there remains a ready and willing supply of money completely at peace with disregarding valuation as an important metric for future investor returns. That’s something we continue to struggle to rationalise. Plus ça change, plus c’est la même chose?

Portfolio Outlook – Think Bookends

If I could paint an image to summarise markets over the last 15 years or so, there would be a mantelpiece with two strong bookends firmly placed on its supporting beam. The first book end represents the sea change signalled by the Global Financial Crisis and the second, newly added bookend is formed from the interest rate rises that started back in 2022 and ended midway through 2023 (if we remain focused on Fed policy for now). On the outside of both these bookends is a “normalised” interest rate environment, whereas inside the book ends is an experiment with ultra-low interest rate policy and unremitting supplies of liquidity from central banks, on which history books will now be written.

It is possible to venture, that as a result of the period we have just been through, market dislocations have had the potential to become embedded and hide in plain sight. We continue to believe that valuation is an integral and important part of the investing equation. As such, over the last few years, we have been gradually edging away from areas we believe to show signs of elevated valuation and have sought out (or remain happy to continue to hold) pockets of assets which look relatively attractively valued that can also deliver an ongoing dividend or interest payment. We have written quite extensively about fixed income in recent investment quarterly’s, the succinct summary being we feel fixed income is now alive and well as a source of future investor returns.

It will vary across different risk profiles admittedly, but some common themes within the portfolios we manage on your behalf is the gradual addition to fixed income assets as a proportion of the overall portfolio, as well as the introduction of more government bond exposure, whether that be the US government or more recently with the addition of UK government debt. We have also added (or, as with the other changes discussed here, are in the process of adding) to global infrastructure assets, attracted by the regulated backdrop to the sector as well as the strong income focus these companies demonstrate. In more risk accepting portfolios, there have been some strong returns from Japanese equities that were added to during the course of last year. We have written above about the challenging valuations in the largest of US companies, however in small and mid-sized companies valuations do not look as stretched and, if history is allowed to serve as any sort of guide, are potentially well placed to benefit from a strengthening of the economy. In more risk accepting portfolios, we added to US smaller companies during the final quarter of last year and we have recently topped up those positions as well as adjusted UK equity fund selections.

Conclusion – In a holding pattern

An improving economic backdrop is helping to dilute some of the bearish sentiment that has been plaguing markets whilst a series of major shocks have had to be worked through. The economic shock that resulted in economies being locked down during COVID caused dislocations that reverberated through the global economy that are not as distant as the memory thinks. The war in Ukraine that sparked an energy crisis and the highest inflation in 40 years also combined with the fastest interest rate rises for decades too, all of which provided some hostile market conditions.

We remain in an inelegant “muddle through” phase where economic growth will remain muted. Everything is becoming ‘less bad’ than feared, which is a positive of sorts, albeit not a rock-solid branch of triumphant optimism to hang your hat on. We are in a holding pattern but recognise the opportunity of where we are. The foundations of future performance are being laid for long-term investors who have the patience to allow this value to emerge, whilst picking up interest and dividends in the interim and this remains the strategy of the day.

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.

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