Sitting on the conveyor belt of time
January saw markets on good form. The nasty 2022 was in the rear-view mirror and an early dose of optimism was bubbling up to the surface, driven by the feeling that central banks were coming to the end of their rate rising cycle and that inflation would be drifting back to something more ‘normal’ in the not-too-distant future. Then things changed. The events that saw insolvencies in several US regional banks and the takeover of Credit Suisse by UBS in conjunction with central banks continuing to raise interest rates, brought a sharp dose of reality to the fore. Despite a wobbly few weeks, however, the market reaction has been surprisingly muted. The FTSE 100 started the year at 7451 and finished the quarter at 7631. Wall Street shrugged off its local difficulties too, so did the Euro Stoxx 50, both finishing up on the quarter.
Financial markets are caught between the two narratives of a soft(ish) landing (helped by China’s reopening too) and troublesome, sticky inflation that is keeping policy rates higher. As we continue to move through this tricky first half of the year and seemingly past the stresses caused in the banking sector, the negative news flow and continued persistence of inflation are both likely to abate. Whilst we’ve been among many to argue that there are better times ahead, markets remain very much in late winter, rather than spring.
Central Banks: Tighten Up. I’m achin’ now, I’m achin’ now; It’s times like these I need relief
With the effect of interest rate rises taking time to feed through to an economy and a banking system likely to go through a period of lending caution, more real-world impacts are likely, we’re beginning to see the impact of the profound tightening of policy that central banks have pushed through during the last 14 months or so. It is worth reminding how far we’ve come. Since January 2022, the US Federal Reserve has moved its policy rate from a hyper-low 0.25% to 5.0%, following the latest 0.25% increase in its March meeting. The Bank of England has also risen rates strongly over the same period, from 0.25% (although the rate rising cycle started in December 2021, from a low of 0.1%) to 4.25% today. Even the ECB, bearing in mind serious people were arguing not so long ago that it wouldn’t be able to raise rates before we fall into the next recession, has moved its deposit rate from -0.5% to 3% and it is fair to say it is behind both the Federal Reserve and the Bank of England in its base rate adjustments.
Central banks have been looking to feint markets higher in their pricing of what they anticipate markets to be. The US Federal Reserve has led the charge, metronomically banging its drum, trying to entice markets into a drumbeat stupor to take seriously their ‘higher and higher’ rhetoric. In the UK, the Bank of England has maintained its forward guidance credibility adding at least a violin section to soften the tone. With all the musicality of a skulk of screaming foxes, the ECB maintain its higher for longer narrative. As all sensible people do, markets have donned ear-defenders.
Central banks have plenty of tools to deal with the matters separately, containing the bank risks with support packages, mergers and liquidity, whilst using interest rates to combat inflation. These twin aims are not mutually exclusive and will likely result in lower peaks in interest rates than markets were anticipating just a few weeks ago.
It’s all gone Minestrone
I’m a fan of the Italian soup; tomatoes, plenty of veg, some beans and a dose of pasta. An excellent way to feast at lunch. Tinned is fine, no need for the fancy stuff.
What I’m now less a fan of is the price. “Premium” brands sit on your supermarket shelf at an eye watering £1.70, your supermarket-own version comes in at a far more enjoyable £0.60. To my mind, there’s more than a whiff of profiteering underway when a tin of soup goes from less than a £1 to £1.70 in short order. Other examples of a pushing up of profits can be seen in some sectors such as US retail, where profits surged last year or in Europe where the ECB recently highlighted that profit expansion amongst European companies warranted as much attention as rising wages in their fight against inflation.
There’s more than a whiff (and data) that price hikes are being pushed through by some suppliers, producers and service providers above and beyond those just covering costs. Rising prices driven by profit-led “greedflation” can eventually be taken down by central banks reducing the disposable income of consumers through rate-rises, though this is an inefficient method. Once media headlines about a ‘cost of living crisis’ subside, removing the cloak of darkness for retailers to push through profit-led price rises, consumer tolerance will fall quickly as both ability and willingness to pay evaporate amongst the largest falls in real wages since records began in 2001.
Inflation – Long way down
Two steps forward, one step back still gets you moving in the right direction, albeit with a high degree of frustration. That’s where we find ourselves in the outlook for inflation. We’re all desperate for a nice and quick path back to a low inflation environment, but we’re by no means there yet.
We are surfing the third inflation wave. The first wave, goods inflation, was driven by supply constraints as countries and companies emerged out of lockdown and there was a clamour for “stuff”. In the UK, this peaked last October but in the run up to that peaking, the second wave hit as a result of the war in Ukraine as both energy and food costs spiked. 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.
Source: Office for National Statistics, HFMC Wealth
It’s important to hold on to the big picture, which is that this year we are going to see inflation falling and the pace of that decline is likely to steepen, particularly as the quarterly energy price cap is predicted to fall through the year. That’s good news, but it still feels a long way down and some time before we get to levels at which we can all feel a little bit more comfortable and central banks can release themselves from their hawkish tones. While food price rises ease and energy costs fall should see inflation fall back to mid-single digits, getting to central bank target rates will take longer but will be tolerated as other events, such as those in the banking sector, drag forward the time to pause.
Banks – What have the Romans Banks ever done for us?
The scene in Monty Pythons Life of Brian, involving Reg questioning what the [occupying] Romans have ever done for us, only to be confronted with a long list of benefits (aqueduct, wine, public order), echo how banks have been tolerated, rather than accepted, since the financial crisis. The latest events in the banking sector and their ramifications when it comes to the important role banks fill in financing commercial enterprise, will remind us that a healthy and strong banking system help promote a healthy and strong economy.
Consumers are the main driving force of growth in the US and UK economies. Since the pandemic, US consumers flush with dollars sent straight from the government were happy to spend and then subsequently drive down their accumulated savings. Stresses are beginning to emerge as the personal savings rate has fallen well below pre-pandemic levels. Mortgage applications have fallen in the US and rising credit card balances have increasingly been taking the strain, reaching almost $1tn of outstanding credit card debt.
In the UK, the relentless headlines of a cost-of-living crisis have made for a more cautious consumer, who is better served to weather economic chills. The rate of household savings is still above the pre-pandemic years and bank deposits are also at highs. In the UK however, the minority with mortgages are still living with the fallout from the Liz Truss/Kwasi Kwarteng budget and the shock that had to mortgage interest rates, which will continue to impact those with old fixed rate deals as they roll off and need to be refinanced.
What is not yet known is the level of impact the insolvencies in the US regional banking sector and the takeover of Credit Suisse by UBS will have on the appetite for banks to continue lending and at what rate. It isn’t unrealistic to begin presuming that banks will be more cautious when it comes to providing loans to businesses and households. This reduced flow of credit into the economy, will work with central bank tightening to help to constrain demand and appetite for borrowing, especially if there’s an albeit diminishing concern about savings in banks.
Growth and Inflation Numbers:
Thanks, as ever, to our friends at Schroders for the latest consensus forecasts, which are:
Source: Schroders Talking Point
As discussed above, the real economy is in for a hard time during this year. The threat of stricter lending policies resulting from the recent banking failures and their impact on the broader economic scene are as yet unknown, and certainly won’t be included in the above numbers.
Looking at longer term expectations for inflation helps frame the ability to adopt patience when inflation remains so stubborn. The Bank of England anticipates inflation of 3% this time next year and 1.5% for 2024; the Office for Budget Responsibility forecasts a very similar ending point this year, but then for the middle years of this decade is forecasting inflation below the Bank of England target rate, not returning to target until 2028. Yesterday’s news is tomorrow’s fish and chip paper as Elvis Costello and The Attractions once said!
In fixed income markets, 2023 has seen a marked shift from 2022. Bond yields have moved lower (& prices risen), reinstating their diversification benefits in portfolios, which is welcome. 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. The yield available from fixed income, whether it be government of corporate bonds also serves as a positive, long-term backdrop. In recent years, defaults have been kept very low as pandemic support kept businesses going and ultra-low interest rates made debt servicing very cheap. We need to be aware that defaults will likely rise as companies refinance at higher interest rates.
In equity markets, valuations still look attractive after a miserable 2022. This makes prospective long-term returns from equities look more positive than they have been for some time. Whilst valuations steadily fell through 2022; areas such as US equities really only saw their valuation move from ‘expensive’ to ‘average’. Others, particularly the UK and Japan are looking cheap versus history, but both require a catalyst to unlock that value. Pressure on corporate earnings and profits will grow as consumer spending pressures build.
Broadly, we remain comfortable with the asset allocation and fund selection in portfolios and are more optimistic for future positive returns than we have been for some time. In the Core Cautious, we reduced some cash and money market holdings to increase fixed income allocations. We did the same in Core Conservative and also switched Baillie Gifford International to Baillie Gifford Global Income Growth, for its focus on dividend paying companies. In Core Balanced and Aggressive portfolios we added to JPM Natural Resources. In the Income model, we increased fixed income and switched from Fidelity Index World to Fidelity Global Dividend and Baillie Gifford Global Income Growth.
All other portfolios remain unchanged.
We are fast running into a period of falling inflation and less aggressive central bank policy, which are ultimately favourable backdrops for the long-term investor faced with more attractive asset class valuations than we’ve seen for some years. In the near term though, headwinds from this crisis in confidence and slow economic growth remain.
Since the beginning of February some of the early-year market enthusiasm has disappeared from the market. The relentless tone coming out from central banks that interest rates are going higher and higher and higher, is a burden that markets are still struggling to digest. Matters such as the insolvency of some US regional banks, add to the level of uncertainty and risks.
Having said that, the first part of this year was always going to be a tough. In the last Investment Strategy, we concluded that we are not entering 2023 with a hop, a skip and a jump as much of the impact of what happened during 2022 is yet to be felt in the real world. The emergence of that pressure into the real world is what we are seeing today.
There are a number of equity markets where valuations don’t look particularly challenging, from which patient investors should be able to achieve decent long-term returns. The same can be said for fixed income markets (for the first time in over a decade) which have seen yields rise significantly since the beginning of 2022 and can now do two things. First, they can deliver a headline level of yield which warrants attention and a place in portfolios. Second, they should be able to return to that previous role, which was to serve as an offset to the equity market risk.
We are not blind to these economically tough times, nor the likely pressure this will bring on corporate earnings, nor the numerous geopolitical risks still to be navigated. Now is the time to be even handed, rather than get swept along in a wave of bear market negativity. 2022 was tough because financial markets are discounting mechanisms after all. Like the weather outside, we may not be in high summer, but we’re not in dark winter either. Time and patience remain an investors best friend.
From all of us in the investment team, Emma, Will, Becky, Kim, Hayley and me, we thank you for continuing to place your trust in us in managing your portfolio.