Stock market and economic commentary September 2022

“The farther back you can look, the further forward you are likely to see”

Winston Churchill

Her Majesty Queen Elizabeth 11 (1926-2022)

The death of Her Majesty the Queen has been a timely opportunity to take stock of our nation and to re-examine what kind of place we have become.

Contrary to the miserable musings of much of the established commentariat and its social media echo chambers, whose default position is always to run Britain down, the condition of the country is actually rather good.

The extent to which the death of the Queen became a global event is quite remarkable and speaks volumes for the reach of our culture and institutions.

It is estimated that almost 5 billion people around the world tuned in at some stage to watch last Monday’s funeral – more than half the planet’s population. No other head of state’s funeral would garner anywhere close to that level of interest or audience. Even as she left, she united the world together one last time. A true inspiration.

I don’t know about you, but it makes me incredibly proud to be British… and I believe we have much to look forward to as the reign of our new Monarch, King Charles III begins.

Ukraine news

President Putin announced a “partial military mobilisation” involving the call-up of 300,000 reservists and a reminder that Russia has the option of using “lots of weapons” if its territorial integrity comes under threat.

Russian-controlled regions of Ukraine Donetsk, Luhansk, Zaporizhzhia, and Kherson announced they would hold referendums about joining the Russian Federation.

NATO condemned the plan and US president Joe Biden described Russia’s nuclear threats as “reckless” and condemned Vladimir Putin’s recent actions as “outrageous acts”.

Turkey joined criticisms of Vladimir Putin’s decision to annex Ukrainian territories and called such attempts “illegal”.

More than 1,300 people across Russia have been arrested following anti-war protests after Vladimir Putin’s mobilisation of the army’s reserves.

Ukrainian president Volodymyr Zelenskyy asked the United Nations to remove Russia’s security council veto as punishment for its invasion of Ukraine.

Ukraine confirmed it exported more than 14m tonnes of grain through “solidarity lanes” since the start of the war, easing fears of a global food crisis.

In another setback for President Putin, non-Western leaders, who until now have stood by Moscow, have begun to distance themselves from the Kremlin’s war.

Russia has been accused of directly targeting Ukrainian infrastructure hitting the power network, district heating plants and hydroelectric installations. Faced with battlefield humiliation, this reminds us that the country can retaliate. A more successful Ukraine might increase the incentive for Russia to cut off energy supplies to Western Europe. That could be Moscow’s best chance to stop the flow of high-quality weaponry to its Ukrainian opponents.

But if the war was going well for Russia the subject of “other weapons” and the call-up of mostly untrained young men wouldn’t be on the table. This hints at desperation and suggests that Putin is becoming more and more isolated.

Economic update

It hasn’t been the best few months for the global economy, thanks to at least four shocks: the war in Ukraine, the energy crisis in Europe, the ongoing pandemic lockdowns in China, and the decision by central banks worldwide to tighten monetary policies to curb surging prices of goods and services. That quadruple whammy according to a growing number of economists sets the stage for a “synchronous global slowdown.”

The reason for such hawkishness is the multi-decade surge in inflation on both sides of the Atlantic, massively exacerbated by the energy shock caused by the invasion of Ukraine.

The Bank of England, the US Federal Reserve and central banks around the world are raising interest rates to cool economies that they believe are growing too rapidly. Higher rates raise debt servicing costs for households, corporates and governments and dampen demand for new credit.

In a contrasting approach to the tightening of monetary policy, last Friday the UK Chancellor Kwasi Kwarteng delivered a mini budget in which he announced a £45bn tax cut package, the largest set of tax cuts for 50 years, funded by increased borrowing. The policy statement from Britain’s new Chancellor was one of the most consequential fiscal events of recent decades.

This is an audacious and radical departure from the previous 12 years of Conservative policy. £45bn of tax cuts, funded by borrowing, represents the biggest easing of UK fiscal policy since 1972. The government aims to roughly double the UK’s trend rate of growth to 2.5%, a hugely ambitious target given the UK’s poor productivity record.

Tax cuts will add to the boost to demand from the huge energy support package announced earlier this month. Monetary policy is pulling in the opposite direction, with the Bank of England raising interest rates to cool the economy. Although fiscal easing will bolster growth in the near term, it almost certainly means higher interest rates further out.

The initial verdict of financial markets to the fiscal statement was negative. Increased public spending has stoked expectations of higher interest rates to come, with financial markets now pricing a peak in UK interest rates next summer of around 6.0%, more than twice today’s level of 2.25% and up from a low of 0.1% less than a year ago.

Together with a surge in government borrowing, this led to a sell-off in UK government bonds and higher borrowing costs for the government. Last week the interest rate on 10-year UK gilts, or bonds, rose by almost three-quarters of one percent, the largest increase in more than 30 years. Sterling also sold off on Friday, dropping 3.2% against the dollar to close at $1.09. The dollar has risen against almost all currencies this year, but the rise against sterling, some 20% since January, has been particularly pronounced.

The UK may be going into an economic downturn, but unemployment is at record lows and consumer and corporate balance sheets, in aggregate, are looking in reasonable shape. As for the economy, inward investment remains robust. The advantage of lower tax rates, labour market flexibility, good universities, a skilled workforce, rule of law, language and time zone are just some of the reasons global businesses head to the UK. In recent years, this inward investment has been twice that of Germany and France combined. This has a positive knock-on effect for smaller companies which often assist with supply chain problems. In turn, this helps to create further employment which is positive for the economy.

Stock markets

A necessary part of investing is to make forecasts. Anyone who owns a share today must believe that it will be worth more in the future.

It can therefore be entertaining, and sobering, to read predictions that fail the test of time. In 1865 as engineers were racing to develop the telephone, a US editor sniffed “Well-informed people know that it is impossible to transmit the human voice over wires… and that even if it were possible to do so, the thing would have no practical value”.

A more recent favourite is a 2007 interview with Steve Ballmer, then chief executive of Microsoft, in which he confidently declared; “There is absolutely no chance the iPhone is going to get any significant market share”. Approximately one in five smartphones sold globally is now an iPhone.

Some predictions depend on so many moving parts that it is possible to be wrong even when right. Pity the poor investors who backed 50-year inflation-linked bonds at the start of this year in the belief that the market was underestimating the trend for RPI inflation. They were right of course. At that time inflation was expected to peak in April at about 8%. In the event, it hit 10% and some economists now expect it to peak in January at more than 12%. In these circumstances, the 50-year inflation-linked bond should have been an excellent investment, but investors failed to consider the response of central banks in raising interest rates and the impact on long-duration fixed interest assets. What seemed to be a pretty safe bet has turned out to be a disaster, as the value of the bonds has nearly halved in just nine months.

While predictions cannot be avoided, it seems odd how much money is invested in areas where there is a history of forecasts being wildly wrong. Think inflation, the number of months before the next credit crisis, how long a war will last and the Brexit Referendum vote.

However, there are predictions that can be made with considerable confidence. Among these are demographic trends, the move towards lower carbon emission power and the increased automation of manufacturing. Timing can be tricky, but the direction of travel here seems pretty clear.

Let’s take demographic trends. One prediction seems inescapable; the world’s population will age. The World Health Organisation (WHO) expects the proportion of the world’s population over 60 to double by 2050, from 12 to 22 per cent (it is already over 30 per cent in Japan).

That is 2.1 billion people, up from just 1 billion in 2020. In the UK, the Office of National Statistics estimates there are likely to be an additional 8.5 million people aged 65 and over. The WHO also estimates that more than 1 billion young people are at risk of avoidable hearing loss due to unsafe listening practices. This must include all those commuters listening to music turned up loud enough to hear against the background clatter of the train.

This trend will result in an even larger market for hearing aids as these working generations age. An ageing population also supports eyeglass demand. There has been an increase in the number of people who now carry both reading and driving glasses but the greatest engine of growth in this field is the young, specifically young people in Asia, where myopia levels have risen astonishingly in the past 50 years.

Studies suggest more than 80% of 20-year-olds in Asia are short-sighted and need glasses – more than twice as many as in Europe. Some believe myopia is associated with greater time spent doing close work such as studying and watching screens; others think the problem is because too little time is spent outdoors.

The evidence is mixed, but China’s recent crackdown on private tutoring and the video gaming industry is in part, a response to the problem. Whatever the cause, it seems safe to predict that the demand for both eyeglasses and hearing aids will increase along with an ageing population.

These “safe” predictions provide the Clarion Investment Committee with a high level of confidence when two of the trusted fund managers in our portfolio funds and model portfolios report that, on recent share price weakness, they have added to their positions in two of the global leading companies in these fields.

Stock markets continue to suffer heavy losses, echoed by the biggest rout the bond markets have seen in decades, if not ever. Many traditional balanced portfolios are down circa 20% YTD (not so the Clarion funds and portfolios).

“Expectation is the root of all heartache” the great poet William Shakespeare is supposed to have said and it certainly played out earlier in the month when Investors’ expectations that the US inflation numbers would show a moderation of this key variable were not well founded. The expected fall in the prices of areas such as consumer durables, transportation, and energy, was offset by rises in other areas such as rent, wages and healthcare. In aggregate, US core inflation, which excludes volatile energy and food prices, increased from 5.9% the previous month, to 6.3%.

The biggest falls often come when expectations and reality collide and on seeing the inflation numbers, global equity and bond markets duly repriced downwards.

This continued inflation problem will embolden central banks to continue increasing interest rates, likely faster and to a higher level than was thought even a few weeks ago. The perceived end game for interest rates in the US and UK has moved from 3-4% to circa 5% with the commensurate impact on the value of equity and debt markets.

Adding to this is a sense that the global economy will not be able to withstand this level of interest rates without going into a recession. Indeed, it could be argued that a recession is the price of bringing inflation back down. Rising interest rates and falling economic activity is a pincer movement for asset prices, and unusual, given that interest rates are usually falling at times of economic weakness. Consequently, there is no shortage of bearish commentary on investment markets with most stock markets now in “bear market” territory classified as falls of more than 20%.

Bear markets are part of investing; they come, and they go. Equity markets rise around seven out of 10 years. For the other three, usually a recession or a shock, such as Brexit, dominates. We are undoubtedly in a bear market today. Depending on which market is used, it started around the turn of the year, which makes it nearly nine months in length, with key markets such as the US S&P 500 and Nasdaq down circa 25-30%. Some markets are down even more, although the UK Footsie 100 has fared better.

Bear markets are a uniquely unpleasant experience. They test the resilience of investors to the core, and some do not come through it. This is a great shame, as what follows is always a bull market of a size and scale that can enrich many people’s lives.

The key challenge of operating in bear markets is psychological. News tends to be relentlessly negative and gets worse as the bear market progresses. This cumulative effect is corrosive and often leads to bad decision-making.

Even the worst bear markets end. Over time, economies grow, and corporate profits benefit from that. Bear markets are the exception, not the rule. The beginning and end of bear markets are only obvious in hindsight. This is because they usually start and end with a largely unforecasted event. Timing them is hard to do.

For truly long-term investors, bear markets allow the accumulation of investments at more favourable prices (as the saying goes, you pay a high price for a happy consensus, conversely a low price for a miserable one!) They must be tolerated to deliver a successful long-term outcome.

Bear markets often end quickly, and markets can turn around and recover sharply before investors have time to react which is why staying invested, although difficult, is vitally important.

None of these points is to say we, or indeed anyone else, knows where markets will move in the next few months. No one has privileged access to the future. They are, however, points which, after this bear market is long gone and we look back at it as we do now the financial crisis, will make a lot of sense.

In the meantime, knowing that economies will eventually return to modest inflation, interest rate cuts and steady growth, shrewd investors prefer to search through the rubble of fallen stocks for bargains. Certain cyclical sectors are already priced to reflect sharp earnings contractions. Many US housebuilders now trade on five times earnings, certain world-class industrial businesses trade on less than 10 times earnings, as do some consumer discretionary businesses. Even Alphabet is now trading on a very reasonable price-to-earnings ratio of less than 20.

In these difficult times when wild swings in stock market valuations can be so unnerving for even the most experienced investors, I will conclude this month’s commentary with a prediction from the American personal finance expert and author JL Collins who, in the depths of the economic heart attack that was the 2008 banking crisis, confidently stated: “The market always, and I mean always, goes up. Not each year. Not each month. Not each week. But relentlessly up”.

In the years since the Collin’s post, “the market” has faced a life-halting pandemic, repeated geopolitical supply chain shocks, and what some have described as the start of the end of globalisation, and yet, the market has gone up.

We are living through challenging times, and it is a fool’s game making forecasts about inflation, the economy and short-term movements in share prices, but that is one prediction in which I have absolute faith and which I know will stand the test of time. I hope you agree.

As I come to finalise this month’s commentary, the Bank of England has today (28^th September 2022) intervened in the UK government bond market, stating that they would buy, as a temporary measure, long-dated gilts. This contrasts with a Quantitative Tightening programme (selling gilts) that they recently announced.

So why the change?

Basically, for the last three days we have seen the following:

Weakness in Sterling
A massive rise in nominal yields
A massive rise in real yields
Lower implied inflation

The problem has been made worse by the liability-driven investing positions of pension funds – where the move up in nominal and real yields has required collateral to be provided to bank counterparties.

This has meant selling of government and corporate bonds – thereby creating a vicious circle.

The BoE move on Wednesday morning resulted in:

The 30-year conventional gilt yield moving from 5% to 4.5%
The 30-year index linked real yield moving from 1.9% to 1.7% (after a peak of 2.4% mid-morning). In price terms this govt bond moved up 30% in one hour”

As always, we thank you for your continued support and we look forward to updating you regularly throughout 2022. We invite you to get in touch if you have any questions.

Keith W Thompson

Clarion Group Chairman

September 2022

Creating better lives now and in the future for our clients, their families and those who are important to them.

Risk Warnings

The content of this article does not constitute financial advice and you may wish to seek professional advice based on your individual circumstances before making any financial decisions.

Any investment performance figures referred to relate to past performance which is not a reliable indicator of future results and should not be the sole factor of consideration when selecting a product or strategy. The value of investments, and the income arising from them, can go down as well as up and is not guaranteed, which means that you may not get back what you invested. Unless indicated otherwise, performance figures are stated in British Pounds. Where performance figures are stated in other currencies, changes in exchange rates may also cause an investment to fluctuate in value.