Wake me up when September Ends
Summer has come and passed, The innocent can never last, Wake me up when September ends…Here comes the rain again, Falling from the stars…
The summer is a strange time isn’t it? In its infancy, it is full of hope and anticipation of the excitement and enjoyment to come, of warm sun, hot sand and the cool relief from the occasional ice cream along the way. Then reality hits. I’m not conditioned for the hot weather; our homes and infrastructure definitely aren’t. The heat reduces and the melancholy of late summer arrives; the nights start drawing in; trousers and socks again seem like a sensible option and the dreams of a long hot summer start over again.
In markets, it has been the longest of summers, hope rose early in the quarter before the weight of central bank rate rises began to weigh heavy; the continued energy crisis drew inflation higher and made it longer lasting and fears of recession loomed on the horizon. The year can be characterised as one of a constantly darkening outlook. This negative cycle will end, but patience is needed and none of this makes for sitting comfortably.
Boulevard of Broken Dreams
I have bored in previous quarterlies about the importance of the consumer to our economy, so will not labour the point in this edition, suffice to say the answer is ‘important’. The endless headlines about the cost of living crisis, decade-high inflation and the continued war in Ukraine have all contributed to a stomach-churning drop in consumer confidence numbers. In the UK, consumer confidence numbers have been hitting record lows through the course of the summer, whilst in the US, there have been notable falls during 2022, but August’s data did at least show some reprieve.
Looking at spending in the economy, whilst there is weakness in consumer spending in real terms, in nominal terms consumer spending accelerated out of the pandemic lockdowns through the latter half of 2020 and 2021, but has flatlined through 2022 with consumers spending more, but receiving less. A national case of ‘shrinkflation’ is underway.
Rising interest rates are going to affect some households as fixed rate mortgages gradually roll over and need to be refinanced at higher current rates. This presents a problem for some in the coming years, but at the same time should not be over-stated; only 28% of dwellings in England were owned with a mortgage (using latest ONS data), whereas 36% are owned outright (with similar amounts renting privately or in social housing). Of the few that do have a mortgage, less than 20% of those have variable-rate mortgages. The central bank lever to control our disposable incomes has become a blunter toolkit as a result. On the contrary, rising interest rates on cash are providing a relative boon for savers, starved of any interest in years, fixed rates of over 3% are now not hard to find and that can only surely rise. A relief, albeit if only in nominal terms.
In the US, where very long fixed rate mortgages are the mainstay of the mortgage market, their lack of portability (being able to take your existing mortgage on the same terms to a new property) means rising mortgage interest rates create a stagnating housing market. With average 30-year mortgage rates doubling through 2022 from 3% (see chart on following page) in January to pre-financial crisis levels and annual house prices rising at multi-decade highs, a significant cooling and stagnating is likely as mortgage finance becomes more expensive and potential home movers become reluctant on giving up their existing ultra-low rate deals. The negative wealth effect from drawdowns in financial assets plus the threat of a house-price slowdown is unlikely to lighten the mood, with the result of the consumer keeping their spending under restraint.
UK Policy Response – Waiting
(Trying to) disassociate from the politics for now, the UK fiscal support packages put in place are both large and have prompted a significant market response. Whilst the energy support package is an untargeted tool, it is a welcome one in that it will dampen both the threat of even higher inflation in the near-term as well as support spending to an extent. The challenge when it comes to the announcements made towards the end of September by the Chancellor of the Exchequer, which specifically targeted tax cuts to the better paid, is that its impact is unlikely to be felt in consumer spending numbers or indeed spur future growth. It is not devoid of logic, should you be a higher earner who will receive a tax cut, that you may fear a higher future tax burden following the next election and therefore squirrel that money away for aforementioned future tax bill, rather than spend it in the economy today. The immediate market reaction was ferocious and drew a false start from the Bank of England, who initially considered it necessary to pause and reflect before announcing liquidity support for the long-end of the Gilt market after it had seen a collapse in demand for longer dated bonds and 10 year yields spike up to 4.5%. The action taken by the Bank in late September was to ensure markets remain functioning, not to alter their direction. Expect the Monetary Policy Committee to respond more aggressively with interest rate rises too when it meets in early November. At the time of writing, a reversal of the decision to abolish the 45% income tax bracket was announced, softening part of the proposals in the wake of this backlash. This may stabilise sterling and remove some downward pressure, but policy instability remains a weakness for UK assets.
We have felt UK assets have been undervalued versus their global peers for years given the idiosyncratic risks the UK presented to asset allocators following the EU referendum. This cloud of doubt has struggled to lift and even if there is a policy volte-face above and beyond a Bank of England monetary policy response, the legacy of the last few weeks will be to keep the UK under that cloud for longer than otherwise necessary. Overseas investors will demand a higher risk premium for UK assets, but there has not been a diminution in the quality of UK companies and both market and currency valuations look cheap, but the catalyst for recovery has been pushed back.
Absolutely everyone is desperate for there to be a peak in inflation and for there to be tangible signs of it falling, so in true-to-form ‘you can’t always get what you want’, there is no sign of there being tangible signs of it falling and its resolute persistence continues to cause maximum pain for the maximum amount of asset classes. We know central banks will not blink, so we are set for a ‘get what you need’ period of higher interest rates over a longer time. Inflation hurts everyone, unemployment hurts the few and in a ‘heads I win, tails you lose’ option, central banks are choosing the former, whilst accepting the latter.
In our Q1 Outlook we wrote “We’re likely to be entering a period of higher (but not high) than targeted inflation. This should not be read with alarm! Where the years after the global financial crisis were characterised by central banks being unable to hit their inflation mandates and employing policies to get inflation to lift off; the coming years are likely to see central banks more focused on trying to keep a lid on inflation, rather than trying to generate it. This will create a ‘mindset’ shift in central banks. The primary tool at central banker’s disposal has for years been rate cuts; going forward it is likely to be rate rises but all within the framework of interest rates staying low versus their historic norm…”
Apologies for the ‘should not be read with alarm’ bit. As mentioned previously, the energy policy support will help reduce the peak in UK inflation numbers, but the weakening of sterling will be pushing inflation higher through the rising costs of imports. Given inflation is measured on a 12-month rolling basis, during the early part of next year, inflationary pressures will begin to weaken significantly, reflecting lower energy and transport costs. However, in an unsettled world with plentiful of plausible near-term outcomes, it would be foolish to lean in too heavily to one potential ‘plausible’ outcome over another. The pandemic (remember that?) caused huge distortions that are still reverberating today.
The rhetoric through the course of 2022 so far has been one of almost relentless bad news. There are tentative signs of some positive news flow. Signs in Ukraine of a significant and swift advance by Ukrainian forces may not signal the end of the war, but they could well signal the direction of travel which is one that sees Ukraine, with the support of western weapons, push back Russian forces away from the ground that they had won earlier in the year. This would be a significantly different outcome than anyone in those early days of friendly would have forecast.
There remain long-term, structural forces such as the demographics of ageing populations and declining working age populations that we have covered in previous quarterlies. If central banks target policy to impact the inflation they can impact, rather than those they cannot, then the coming quarters should see some strongly falling inflation numbers coming into focus.
Growth and Inflation Numbers:
Talking of which…thanks, as ever, to our friends at Schroders for the latest consensus forecasts (note these are to the end of July 22, so expect continued revisions next quarter):
Clear trends are underway. Inflation will be higher and more persistent, extending further through 2023. Growth is slowing very sharply in the coming quarters and will continue to do so. Looking at longer term inflation briefly, elevated inflation is not being embedded at elevated levels. Markets are currently pricing average US inflation for the five-year period, starting in five years time at 2.3%. This is broadly in line with the average over the last 20 years.
When I Come Around
It has been a tailspin of a year, with markets buffeted left and right. The ‘father of value investing’, Benjamin Graham, stated that “in the short-run, the market is a voting machine, but in the long run, it is a weighing machine.” If we can detach ourselves from the immediate headlines and avoid letting our moods darken too much in the face of declining asset prices, it would be a mistake to look through the value that is emerging in multiple asset classes. Fixed income yields are far higher than at the beginning of the year. Since the pandemic, when yields collapsed in the face of central banks driving interest rates to the floor, the prospect of returns from fixed income assets had become muted. Today, the prospect over the coming years for fixed income investors to not only be rewarded with a reasonable yield but also receive some diversification benefit from their equity allocations is a welcome position to be in, particularly as corporate balance sheets remain strong and prospects for large scale defaults low. In equities, valuations have crept lower; US equities started the year over 20x forward earnings, whilst they now sit at 16x. Not cheap admittedly, but a much better starting point. In UK equities, versus their history, they look cheap trading at under 10x forward earnings and a dividend yield of 3.6% (before any special dividends).
Trying to predict market returns over a short period is a fool’s errand. Trying to understand what the potential market shape could be over the coming quarters is, however, a necessity to position portfolios. Sadly, markets are offering no freebies in this regard with the level of plausible outcomes very broad and wide-ranging. We should expect to be unsurprised by more surprises in what is a very fluid ‘macro’ world.
It is not implausible for fixed income markets to begin seeing a semblance of recovery during the coming quarter or two as central banks will have got through a large part of their interest rate rising cycle by the year end and there should be signs of inflation falling. Equities are likely to follow, but with an expectation that any recession is still going to look relatively light when compared to 2020 and the financial crisis of 2007-09, a recovery during the first half of the year 2023, seems a reasonable prospect to anchor to. Markets are falling and pessimism is high, but value is beginning to emerge in several asset classes, so taking the long view remains the order of the day.