Skirting the Danger Zone
There is always something to worry about, but 2022 seems to be delivering more than its fair share of bad news. Interest rate rises, inflation hitting 40-year highs, war in Ukraine, lockdowns in China, the BBC commissioning a second series of Vigil. Plenty to navigate.
We watched the scenes as the Queen celebrated her Platinum Jubilee with a fly past over Buckingham Palace to the delight of the crowds and clearly Prince Louis! The planes were buffeted by turbulence, but the pilots dedicated themselves to stick to the path they were tasked to follow. The same diligence and dedication is now needed by central banks as the narrative seems clear. Inflation needs to be addressed and central banks are going to have to take the steam out of demand by tightening monetary policy, as supply constraints and the war in Ukraine further extend the inflationary peak. Whether that slowdown turns into a soft-landing or a recession remains to be seen and in the near term, equity markets are going to remain under pressure as growth forecasts are cut and the risk-free rate rises.
Through the fire. Is this the end of the Fed Put?
The primary story of the last 15 years or so when it comes to central bank policy is the worse things got, the more likely central banks were to step in and cut rates and provide liquidity support and provide a backstop to financial markets. Inflation was a non-issue and any thought that an interest rate rise was on the cards, let alone a sharply rising series of them, would have sent markets into a tumble. So why is it that the US Federal Reserve raising rates by 0.75% in a single meeting being met with a semblance of relief?
The answer lies in confidence and central banks losing it. Central banks need to have the confidence of markets if their forward guidance signalling is going to carry any weight and hold any credibility, so inflation levels hitting 40-year highs and central bank policy rates still nailed to the floor puts their credibility in doubt. Inflation has existed of course, as central banks pumped liquidity in, asset prices rose, whether it be in equities, fixed income or house prices – they all formed a very acceptable version of inflation for the many. Covid changed the nature of the type of inflation, as demand for services fell and consumers were forced to stay at home, demand for goods increased at a time when making and moving those goods around the globe became more restrictive. China’s zero-Covid policy ensures restrictions in global supply and the persistence of bottlenecks continue today. So too does the desire by many companies to make more secure, but potentially less efficient, supply lines because of their experiences during the pandemic. Now, the tragedy of the war in Ukraine has pushed inflation ever higher as energy and commodity prices were sent higher, further compounding the inflationary fire.
High inflation is good for no-one, sub-inflation pay rounds hurt consumer confidence and spending power – I’ll go into more detail below – but for now central banks only have their eye on one thing and that is to get inflation back under control.
So, is the Fed Put gone? For now, yes. In time, unlikely. As we write in Equities and Fixed Income – The end of a long-term relationship?, markets are facing both an inflation and interest rate shock, which is capital destructive for both fixed income and equity markets. Inflation is high and interest rates are going higher too to reduce demand, whilst a still healthy jobs market allows that to become a secondary concern. The declining wealth effect is, for now, helpful for central bankers (your portfolio value is lower, the less inclined you will be to go on a spending spree). Once inflation alleviates, the ‘traditional’ central bank response of a slowing economy equalling an easing of policy will be reinstated.
Consumer: Being taken Through the Fire
The strength of the consumer is a key driver in the economic growth of the US & the UK representing between 60 and 70% of GDP. As such, the health (& wealth) of the consumer is a key barometer to interpreting the prospects for economic growth.
On the positive side, spending momentum in the US appears to be holding up for now, with continued rises during April, which followed an upward revision in March.
However, the rising number of naysayers will highlight the truly awful consumer confidence figures as a sign that the consumer has succumbed to a tide of rising prices, the dent to confidence from the war in Ukraine as well as a more cautious attitude as a result of sub-inflationary pay rounds. UK consumer confidence is breaking records for all the wrong reasons, hitting record lows in June beating the previous record low set just in May. In the US, consumer confidence has been on a downward trend since the middle of 2021 and in Europe, ever since the start of the war in Ukraine, consumer confidence has been in free-fall.
There are some mitigating factors shining a small ray of light in an otherwise darkened room. First, whilst acknowledging this is not a universal truth for all, there remain significant amounts of savings that were accumulated during the pandemic that are yet to be diminished. Whilst there is good evidence this sits within wealthier households, up until the end of March this year, there was estimated to be over 10% of nominal GDP retained as excess savings in the US, and only fractionally less in the UK. Some time ago the argument may have gone that this would be used to stimulate economic activity and generate growth in a post-pandemic rebound; now, it is more likely to serve as a parachute payment for households as they use this to maintain their standard of living. There are other reasons to remain hopeful too, the jobs market remains solid and a combination of persistent labour shortages and sky-high job vacancies means the economy could tolerate some deflation in the number of vacancies without delivering large swathes of unemployment. Finally, UK consumers have generally been willing to increase their debt to maintain their standard of living, so long as the employment picture remains intact. Furthermore, households have been pretty good at fixing the terms of their mortgages. Over 80% of all the mortgages in the UK are now on fixed rate deals, postponing any day of reckoning for mortgage holders refinancing for a little while yet.
Growth & Inflation Numbers
The long era of low and stable inflation is well and truly over! Inflation is leaping forward across the G7 economies at a pace not seen since the early 1980’s and central banks are nervously looking at inflation levels way above their target policy rates.
The picture here remains pretty clear. Economic growth is falling, and inflation forecasts are signalling a higher and more persistent level of inflation. The UK looks particularly weak when it comes to next year. Anaemic growth and high inflation tend not to win you any prizes in an economic review of the year.
As ever, with many thanks to our friends at Schroders for these latest consensus forecasts.
Market Outlook – Looking for the hard floor
Challenges weigh heavily on the outlook and timeframe is an important caveat. The near term presents plenty of opportunity for further losses. Central banks raising rates even faster than anticipated is not an outlier scenario, nor too is Putin doubling-down in Ukraine to try and rescue what better placed people than I, have all concluded to have been a largely disastrous military advance and hugely costly to its image as a modern military force. Either will trigger further drops from here. Our sense though is the market has accommodated a strong degree of anticipated interest rate rises and some slowdown in growth. However, the near term is unlikely to see any respite until there are more concrete signs of inflation coming down or, admittedly less likely, the ending of the war in Ukraine. Good news can potentially come from China as small advances are being made in lessening some of the existing Covid restrictions and the Chinese government will be keen to support the economy in in the lead up to the 20th National Congress of the Chinese Communist Party.
Whilst it has been an incredibly difficult period for fixed income markets, there are some reasons why we should think about the short-duration position held in portfolios. Whilst, relatively at least, short duration has been a sensible place to be (to reduce sensitivity to falling prices as yield rise) as we go through this year and towards the point where rate rises and falling consumer demand push growth lower, equities and bonds are likely to break apart from their three-legged race to the bottom. Whilst equities may remain challenged by falling corporate earnings, fixed income is likely to provide an offset with bond prices rising as yields fall in anticipation of central banks beginning to support their economies again with inflation less relevant and growth a more important concern. In the meantime, the starting yield on an investment grade bond fund is around 3% and a high yield fund around 5% making it a slightly more attractive starting point for income-hungry investors and certainly a more competitive environment for income seekers than they’ve been used to.
In equities, valuations have fallen too but the outlook for corporate earnings is cloudier than usual with a slowing economy on the near horizon. Stock prices have been falling but earnings expectations have not been falling significantly, which is not an unusual event in itself as stock prices tend to move in advance of changes in profit forecasts. The question to ask of these stock market falls is how much of them represents a response to the change in bond yields (aka the risk-free rate, which equity analysts discount future earnings by) that has been driven by high inflation and how much have they fallen in response to anticipated falling earnings. To restate, our sense is markets have accommodated a strong degree of anticipated interest rate rises and some slowdown in growth. According to the earnings bible, Factset Earnings Insight, US equity market analysts (a clearly optimistic bunch) are projecting earnings growth on S&P 500 companies to be 10.4% albeit with this backloaded towards the latter half of the year, raising the likelihood of earnings disappointments through the balance of the year. Corporate profit margins still look resilient but will need to be watched.
Agonising over quarter by quarter earnings or global growth can mean missing the big picture, which leads us to valuations. As markets have fallen, a semblance of value has begun to emerge. UK equities for example have fallen from 12.5x forward earnings to 9.6x, US from 21x to <16x. We write about emerging markets and their prospects in Emerging Markets – Facing the Wall of Worry. The UK remains unloved, suffering a valuation discount that never recovered from its falls after the EU referendum before ploughing into the pandemic lockdowns. We are now at the point where UK equities look ‘cheap’ and the US more like ‘fair value’. Within UK equities, small caps are at a discount to their larger cap peers, but clearly after many years of missed steps a catalyst for this value to emerge may take some time to be realised.
Whilst we retain the asset allocations and fund selections in the Passive, Positive Impact & Offshore ranges, we have made several changes in our core portfolios. The Cautious Portfolio remains unchanged, but in others:
We sold BNY Mellon Real Return and split proceeds between Ruffer Diversified Return and Troy Trojan, which we feel are better funds at preserving capital. We are not making any changes to the UK equity weighting but switched Franklin UK Managers Focus to the lower cost Franklin UK Equity Income fund.
We sold BNY Mellon Real Return and reallocated the proceeds to Ruffer Diversified Return, given its ability to better protect capital in downward markets and to Artemis Global Income, which has been in the portfolio for many years and looks underrepresented versus the percentage allocations in the other global equity income selections.
Balanced, Growth & Aggressive
For some time, we have wanted to introduce more small company exposure and added a new smaller company fund we had completed research on some time ago but had been biding our time on for a more attractive entry point. In the Balanced risk portfolio, we also marginally increased overseas equity weighting as we felt it was under-represented versus other risk profiles.
Conclusion – Searching for some calm
2022 has proven to be a year of painful adjustments in the price of most major asset classes. In portfolios, we have not been immune from the headwinds markets have thrown at us and it is never a comfortable place to see client portfolios in negative territory. The summer months are likely to face further challenges, but the fears the market is focused on currently are no greater than have been faced in our collective histories, whether that be the 1970’s oil crisis, the near threat of thermo-nuclear war during the Cuban Missile Crisis or even the threat of the collapse of the banking system during the financial crisis. The chief, long-term and consistent lesson we can learn from all these historic market events is to stay calm, stay in a portfolio with an acceptable level of risk and stay invested for the long-haul.
As we turn toward the summer holiday plans may I wish you all a very happy summer and thank you for continuing to place your trust in us in managing your portfolio.