Stock market and economic commentary November 2022

“In the midst of difficulty lies opportunity.”

Albert Einstein (1879-1955). Theoretical physicist.

Economic Update

Two of the most googled words in recent months have been ‘recession’ and ‘pivot’. Recession for obvious reasons; pivot less so but both are interlinked.

Economists tend to think in small incremental steps, missing big turns in the story, which helps to explain why their consensus view has not forecast a single US recession since records began in 1970, until now that is.

For the first time, economists as a group, not only expect a recession in America in the next year but give it a high probability, more than 60%. Given their record, it is worth asking whether the consensus view is in fact unlikely.

With inflation at a four-decade high and central banks raising interest rates aggressively, a recession does seem inevitable.

But there is always the possibility of a “bluebird” event bringing unexpected joy. As the late great economist John Maynard Keynes once counselled “the inevitable never happens but the unexpected occurs constantly!”

The case for the unexpected scenario – no recession in the coming months – would start with inflation declining rapidly. That would allow the Federal Reserve, and other central banks, to slow down monetary tightening in coming months.

Just when the consensus has come to accept that inflation will be higher for longer, and not “transitory” as previously assumed, the easing of supply chain bottlenecks could lower inflation faster than expected.

The signs would also include cargo shipping prices plummeting, delays at ports shortening and the Fed’s supply chain pressure index coming down sharply. Goods price inflation is already decelerating with prices from used cars to energy now in decline. China’s economy has been slowing due to zero tolerance covid policies and is exporting slower inflation to the rest of the world.

A slowdown in US inflationary pressures was confirmed recently by an unexpected “bluebird” event. The most recent consumer price inflation report proved to be much better than expected. Official figures showed that inflation in the world’s biggest economy dropped to 7.7% in October. More importantly, underlying metrics confirmed that this time might really be the peak, in a way they conspicuously failed to do earlier this year when core consumer price inflation last seemed to have started a descent.

So, at last, the inflation problem might be improving better than people had feared.

The market reaction to the sharply lower inflation number was swift and instant as equity and bond markets both rallied hard with bond yields falling sharply. The dollar tanked on hopes of less aggressive interest rate hikes by the Federal Reserve.

Back home

Anyone tuning into the UK morning news on Friday 11th November might have surmised that the Four Horsemen of the Apocalypse were marching down Whitehall. The 0.2% drop in national output in the third quarter of the year was portrayed as the start of the “long recession” forecast by the Bank of England.

One cannot sugarcoat any decline in output. Nevertheless, it is worth pointing out that the 0.2% drop was better than the expected 0.5% decline pencilled in by city economists. Moreover, half the fall was the result of the extra Bank Holiday caused by the Queen’s State Funeral. The fall was driven by lower household consumption which seems quite benign given the economic backdrop.

The Bank’s negative forecast for two years of recession based on a flawed interest rate outlook only adds to the despondency being spread by critics of the UK following the Autumn Budget statement on 17th November.

But the outlook is not all bad and warnings of Armageddon from the UK doomsters are starting to look stale. The speed with which the Truss-Kwarteng government was turfed out and a new administration brought in speaks volumes for the resilience of UK democracy and the flexibility of economic decision-making. The pound has climbed to its highest level since before Boris Johnson left office and gilt-edged stock prices have recovered easing pressure on final salary pension funds.

There is a growing consensus in the wider financial community that the negativity about inflation and interest rates has been overdone. Morgan Stanley chairperson James Gorman is optimistic about the prospects for next year. His big number is “four.” That is 4% for interest rates, 4% for inflation and 4% for unemployment in 2023.

In his view, the scale of the Covid-19 and energy shocks is nothing remotely like the financial crisis earthquake. If the US does dip into technical recession, it will be mild and while the UK and Europe do not always track the American economy, trading and financial connections mean they do so more often than not.

It is often said that a month is a long time in politics and so it has proved to be again. The good news is that the reversal of most of the disastrous September mini-budget decisions, combined with a change in leadership, has brought calm to the bond markets with both yields and volatility falling. Fixed-rate mortgages have also started to fall after the spike in early October and aside from new build housing where the rapid re-pricing of mortgages had led to a pause in activity, there has been no-cliff edge change in consumer habits.

Calm returning to the bond markets was always a necessary precursor to any improvement in risk appetite towards UK equities. Thankfully, this is what we have seen over the last few weeks, with indiscriminate selling at any price appearing to have ended, and in certain cases share prices are no longer falling on weaker news.

Further evidence that peak inflation has arrived, and in turn monetary policy, remains the most likely catalyst for investor sentiment to improve, but when it does the move in valuation multiples will be rapid.

Stock markets

I remember reading an investment book in the early years of my career written in the 1930s by an American ship’s purser who picked his investments using stock price charts while he sailed around the world.

He would only adjust his portfolio when he docked in his home port of New York. He attributed his superior performance less to his charts and stock-picking skills than to the fact that he could neither check share prices nor trade while at sea.

If he had embarked recently, he might have been shocked at how far global equities and bonds have fallen since the turn of the year. Markets have faced three serious challenges this year; inflation, rising interest rates to control that inflation, and the growing risk of recession that those higher interest rates might induce.

These issues have caused equity and bond markets to fall in tandem, but they have also created interesting opportunities for the fund managers in which the Clarion portfolio funds invest.

There is a saying that ‘investors pay a high price for a cheery consensus, and a low price for a miserable one’! This cannot tell us when and how investment markets will find their lows in the coming months, or indeed if they already have, but it can remind us that uncertainty creates lower prices and opportunities that long-term investors can benefit from. Investments are one of the few purchases that buyers typically want less of the cheaper they get.

Prices may sink further before they bounce back to previous highs and markets are likely to remain volatile but if you invest and sail the seas for a while you are unlikely to notice. Just remember to diversify, to focus on quality assets and to use the best fund managers.

The ‘pivot’

Top-down macro sentiment continues to dominate markets, with every economic data point being analysed to provide clues on the outlook for inflation and in turn the peak in monetary policy.

Currently ‘pivot’ is the most overused word by financial commentators. It is used in the context of central banks shifting from raising to reducing interest rates i.e., changing direction or at least easing off on the brake.

At every sign of a pivot occurring, such as comments from central bankers or better-than-expected inflation numbers, equity markets tend to rise as they did in early November when the inflation numbers in the US came in better than expected. As those hopes are dashed, a new sell-off ensues.

So, are investors right to focus so acutely on a pivot? Yes and no.

The market is of course forward-looking, but the extent of its forward vision varies according to the circumstances. In times of volatility, global uncertainty, and turbulence the horizon comes back in, and myopia is more prominent. In calmer times the horizon moves out, confidence rises, and more value is placed on earnings and cash flow forecasts further out. This change in paradigm can affect sharp changes in sentiment and market interest.

So, it is correct that markets have become highly attentive to any signs of a pivot by central banks as it would give visibility over what is the terminal value of interest rates and allow investors to value assets better. It is, however, only one part of the equation.

The more nuanced and relevant question is “what is the economic cost of central banks pivoting?” A pivot will only occur when central banks believe they have inflation under control, and the only way they can do this is to induce an economic slowdown or recession. Whether we are entering into a slowdown (now a certainty), or a mild, or deep, recession is important for forecasting the future profits of a business, which is the other element alongside discount rates in valuing an asset.

It is possible that markets are much closer to discounting the terminal value of interest rates, at least in the short term, than they are in discounting a recession. The recent earnings season has been weaker than previously, with several companies, across a range of industries, noting a deterioration of prospects linked to a weakening economy. That said, most forecasters still expect profits for overall stock indices to grow next year, which may prove to be optimistic as the economic impact of much higher interest rates begins to be seen in the economy.

In summary, what we need to know to understand the correct valuation of many key asset classes is not just the level of interest rates when central banks pivot, but the impact on the economy of those interest rates. Currently, we do not have visibility on either of these two variables, hence the reason investment markets remain volatile and are not able to rally in any meaningful way.

But as the peak in inflation and interest rates gets ever closer, businesses with strong fundamentals and strong cash flows will begin to rerate, and when they do, the improvement in valuations could be swift.

Lessons from the past

This year has been one of the most difficult ones in recent times for most investors. We have not seen markets like this since 2000-02 and 2008-09. The pandemic-related falls were over so fast they do not really count.

This year has also seen a strong correlation between all asset classes due to the impact of rising interest rates, something that has not been seen for several decades. This has meant asset allocations, which have allowed a degree of protection in down markets in the past, have not worked in the same way.

The two bear markets noted above were quite different, indeed all bear markets are different. The bear market of 2000-02, caused by the end of the dotcom boom of the late 1990s and exacerbated by the impact of the 2001 terrorist attacks, was a long and grinding affair. The global financial crisis was shorter, and markets collapsed towards the end of it. Each was unpleasant to go through, but both ended right at the point that many investors lost all hope that they ever would.

Bear markets are the price investors pay for good investment returns. They allow assets to be bought at more attractive prices and they allow economies to reboot after periods of excess. Although there is no precision in forecasting them, one every 10 years is a reasonable rule of thumb when looking historically. This means most long-term investors will see several of them throughout their investment lifetime. Accepting that they are part of the rhythm of markets and learning to deal with them is crucial.

This bear market will eventually end, as all the other ones have in the past. In the meantime, good fund managers, and the ship’s purser before he sets sail around the world, continue to invest in high-quality businesses, which will weather the storm and come out stronger.

I would like to thank all our clients and supporters for your continuing support. As this will be the final edition of the Clarion for this year, I would also like to take the opportunity to wish everyone a very merry Christmas and a happy, successful, and healthy 2023.

The next edition of the Clarion will be in January, and we look forward to updating you regularly throughout 2023. We invite you to get in touch if you have any questions.

Keith W Thompson

Clarion Group Chairman

November 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.