Stock market and economic commentary December 2022

“Today’s headlines and history’s judgment are rarely the same.”- Condoleezza Rice.

American diplomat and political scientist and current director of the Hoover Institution at Stanford University.

Economic Update

Financial pundits are intent on ignoring the micro, but very important, detail of corporate activity and company results, some of which have been surprisingly good recently. Media attention remains focused on the wider macro-economic view by trying to second guess Central Bank actions and narrative. The good news is that there are now clear signs that inflation in the US, the UK and Europe may have peaked with recent data showing a falling trend on a month-by-month basis. Furthermore, as last year’s energy price shocks work their way out of the inflation figures, it could fall a lot more quickly than official forecasts are predicting.

In the US, supply and demand seem to be moving closer to balance. Inventories have recovered from the rock bottom levels reached at the beginning of last year. The Purchasing Managers’ measure of unfilled orders hit record highs but is now back to normal levels. Supply chain problems have moderated. The price of most commodities – oil, gas, metals, agricultural products and semiconductors – have fallen from their peaks. With the consumer goods boom petering out and commodity prices easing, US goods inflation has fallen away sharply. In October and November consumer price inflation came in below market expectations, supporting the view that US inflation has peaked. A similar trend is beginning to emerge in the United Kingdom and Europe.

But whilst inflation across the world is set to fall over the next six months, it remains far from clear whether one of the core components of inflation, labour inflation, will return rapidly to the long-term trend. Employment data on both sides of the Atlantic remains robust and wage inflation remains elevated. Whilst some companies report that labour shortages are not quite as acute, they remain keen to retain the staff they have, and many are budgeting for mid to high single digit wage inflation next year. The rate of private sector pay growth is accelerating and the public sector is likely to see a catch up as we move through the winter. Latest data shows that regular pay growth in the UK is annualising at 7.2% year on year.

One of the positive consequences of this is that economic growth could also be stronger than current forecasts and the runway for a soft economic landing in the face of tighter monetary policy is wider than generally perceived.

In the UK, volatility in the gilt market has subsided post the second mini-budget and interest rate swap rates have continued to drift lower, with the five-year rate now down to 3.7%. Banks price fixed rate mortgages on this swap rate, and it is now widely accepted that five-year fixed rates will fall to circa 4.5% in the coming weeks. In line with swap rates, interest rate expectations have also continued to moderate. Bond markets are focused on the falling inflation and recession narrative, with a near record inversion of the yield curve pointing to a sharp cut in interest rates coming through from the second half of 2023.

Misery overshadows the good news.

These are not the best of times but there is a tendency in Whitehall, the Bank of England and parts of the media to wallow in misery. Sentiment towards the economy and equities is particularly negative, yet corporate earnings have been resilient, while dividend flows are still prodigious. Recent highlights include strong results from companies such as 3i Infrastructure, IntermediateCapital Group, WH Smith, Ashtead and Mitchells and Butler which is just a small selection of the companies favoured by our fund managers.

The theme of consumer stocks with strong market positions emerging with higher market share continues to come through. The latest example being Mitchells and Butlers where not only is trading accelerating, but the company is continuing to materially outperform the market with like-for-like sales running up 6-7% year-on-year and up over 10% on 2019 levels. How is this happening, given the supposed near record low consumer confidence and the cost-of-living crisis? There are two parts to this answer.

The first is capacity – similar to the hotel industry, the hospitality sector has seen capacity withdrawn with 12% fewer restaurants currently in the UK compared to 2019.
The second is that companies report in nominal rather than real terms. In nominal terms, retail sales are growing strongly. Volumes down, pricing up. Clearly there are cost pressures that companies need to offset. For M&B their utility bill has risen from £80m to c£180m p.a., and there are other costs pressures on food, drink and labour. Driving sales growth is key and with high gross margins, market share gains are allowing them to report still reasonable profits when others are going out of business.

At times such as this, the weak companies fail but the strong survive and get stronger.

In other corporate news, Rio Tinto, a UK mining giant, finally gained control of a Mongolian mine which contains some of the world’s largest copper and gold deposits. This will enable Rio to take advantage of an expected boom in demand for copper as the world shifts towards clean energy technology and electrification.

And BAE Systems has secured a multi-million-pound deal to supply hundreds of armoured vehicles to the Swedish, German and British Armed Forces. The deal carries a price tag of £623 million.

For those who think Brexit is a doom loop for Britain, it is worth pointing out that one of the key benefits of Brexit was to escape the handcuffs of Brussels financial regulation and create opportunity to underpin the UK’s historic role as a financial centre.

The slow passage of the Financial Services and Markets bill has been a disservice to prosperity. The best way to counter the challenges to Brexit is to complete the job. The agreement between the Bank of England and HM Treasury on Solvency11, a last-minute addition to Jeremy Hunts budget, if properly enacted, could be a game changer. There is up to £100 billion of capital to be released from the insurance industry over the next few years. Aviva alone should have £25 billion to invest in infrastructure, life sciences and other growth sectors. Projects with reliable cash flows which can match long term liabilities will clearly be required but there is no shortage of such prospective investments from renewables to new nuclear, rail and road schemes.

JP Morgan has chosen Britain as the launch pad for a digitally enabled retail bank, Chase. Freeing the UK from onerous EU regulation provides a great opportunity. And a landmark £1.4 Billion deal between US tech giant Microsoft and the London Stock Exchange proves London is the major stock market in Europe, not Paris or Frankfurt. In a post Brexit era when so many UK Companies have shown reluctance to invest, an overseas entrepreneur company has taken advantage of the freedoms offered by the UK’s new status in the world and recognised the City of London as a leading financial centre.

Boldness of ambition does not have to be sacrificed on the altar of caution.

And over in the US, tech software giant Adobe recently reported record revenue and operating income for the fiscal year 2022.

So, the economy is not quite the disaster that naysayers seem determined to project. There is an alternative, brighter narrative. If more widely adopted, it has the potential to shift consumer confidence and encourage business investment. An economic downturn is inevitable but if we focus on the glass half full rather than the glass half empty narrative, we can end 2023 in better shape than we start it. The year ahead need not be as dire as people fear. With leadership and a change in sentiment it might even show a marked improvement on last year.

Stock Markets – A time for reflection and a time to look forward.

It seems strange that a little more than 12 months ago, an investment in a 2-year German government bond received a yield of less than nothing. Investors had to pay for the privilege of investing in government debt. German debt was not an isolated case, as negative interest rates on short-dated government debt throughout the world was pretty much the norm.

But as 2021 ended Jay Powell, Chair of the Federal Reserve Bank of America threw out the rule book global investors had used for more than a decade.

Inflation, dormant for so long, had been picking up as pandemic lockdowns eased, but for months central bankers, led by Powell, had urged households, businesses, and investors not to panic. The rapid burst of price increases would be transitory. However, on November 30^th,2021 Powell publicly accepted that assessment might be wrong.

Speaking at a congressional hearing, he said that inflationary pressures were “high”. The annual rate was running at 6.8 per cent, well above the Fed’s 2 per cent target. Ending the Fed’s stimulative bond purchases might need to accelerate and interest rates would need to rise, forcefully.

Looking back, Powell was effectively calling ‘time’ on an entire era of super cheap money that began after the 2008 financial crisis. He could not have known that the Russian invasion of Ukraine three months after his remarks would super charge inflation through commodity prices and make his task, and his stance, much tougher in 2022.

The paradigm shift Powell signalled a little over a year ago has formed a key factor in a massive reset in markets, and investors are still learning to live with the reality of higher interest rates and lower investment returns. In early May interest rates in the US and UK stood at 0.5% and in the Euro area at -0.5%. Monetary policy seemed out of line with inflation which was running around the 8.0% mark.

The ensuing six months saw the most rapid tightening of western monetary policy in more than 30 years. Since the 1990s central banks have tightened policy slowly, usually raising rates by 25bp or, less frequently, 50bp. It is a measure of the scale of the inflationary challenge today that the Federal Reserve, which last raised interest rates by 75bp in 1994, has implemented four consecutive 75bp rate hikes since May. US rates have risen from 0.25% to 4.25% in just nine months.

Western interest rates are at the highest level in 15 years. Tighter policy is slowing growth and inflation looks at, or close to, a peak. Monetary policy no longer looks desperately behind the curve.

From an investment perspective there were few places to hide in 2022. Inflation, monetary policy tightening, geopolitical risks and war in Ukraine all marked a stark contrast to the drivers of returns in 2021 and the decade before. The backdrop ultimately forced a revaluation of fixed income and equity assets. From low to high inflation, and from low to high interest rates, returns suffered as markets adjusted to the new paradigm.

The classic investment blend of bonds and equities put in the worst performance since 1932. At its lowest point last year, the S&P 500 index had shed $11 trillion in market capitalisation. To give an idea of the scale, that figure is similar to the entire annual economic output of Germany, Japan and Canada combined.

Markets change direction.

All fund managers want to deliver positive risk-adjusted returns and outperform their benchmarks, and the way to do this in the 12 years following the financial crisis of 2009, was simple: buy growth stocks, preferably in the technology sector. This is the strategy which underperformed the most last year, and for those with exposure to the more speculative areas of technology (not Clarion, thankfully) it has been particularly painful.

Has this strategy reached the end of the road? And if so, what comes next? The answer to the former is probably, and to the latter is evolution.

To understand the outperformance of growth investing in the last decade, some perspective and historical context is helpful. No investment style or asset class has a divine right to deliver investment performance. Investment returns are derived from the operational performance of the underlying asset and the price paid to own it.

In the 2000s, the best combination of operational performance and valuation was in areas such as mining, due to the emergence of China and its need to build infrastructure. Equally the global economy had much less ongoing technological disruption than seen today, which meant that buying underperforming businesses, on the basis they could be turned around by new management teams, was also profitable. This was known as ‘reversion to the mean’ investing and would often be classed as ‘value’ investing.

However, these trends came to an end in the 2010s. After the recession induced by the financial crisis, interest rates were reduced on an ongoing basis to levels which were highly favourable to valuations of long duration growth stocks. At the same time, technological disruption and innovation accelerated – creating the large technology companies which now dominate society. The best combination of operational performance and valuation was therefore in growth and technology investments.

These evolutions are not coincidental. Both happened after bear markets, the first after the bear market of 2000-2002, following the technology bust of the late 1990s, with the second seen after the Great Financial Crisis. Bear markets change leadership, and it is a bear market we are going through now.

Where should investors be looking to for the next decade?

This is a debate which should be treated with a degree of caution. There were many theories of how markets would evolve post the financial crisis, and many were wrong. One example of this was the idea to buy high dividend yielding equities in a low interest rate environment, which proved to be an underperforming strategy. That said, there are some observations which are useful.

The last decade has been an aberration in many ways, ways which are becoming more apparent now. First, it is the only decade in recent history with such low levels of interest rates and inflation. Second, it was a time of extreme narrowness in markets, with only a small number of sectors delivering investment performance. Finally, it was a time when the valuation of assets was not important, it was simply the ownership of them that mattered.

It would seem sensible to plan for an investment environment more like the decades prior to the 2010s. One where interest rates and inflation are more in line with historical levels, as in the 2000s when inflation was in the 3-4% range and interest rates were circa 5%. One where a broader exposure to a range of industries is better than a narrow focus on a few. And one where valuation reasserts itself as an important part of any investment decision.

Back to the future

Of course, none of this is particularly revolutionary. Indeed, these are the skills that many investors and fund managers were taught when joining the industry, they have just been quashed by multiple years of cheap money and a prolonged bull market. The essence of what is needed going forward is more evolution than revolution; a reassertion of what fund management should be about rather than a reinvention.

There is nothing to fear about what the next decade will hold for investors, so long as we accept it may be different to the last.

When we apply this to the Clarion investment portfolios, which have been significant beneficiaries of the major market trends of the last decade, it does create some evolution of how and where we choose to invest. Higher valued investments, particularly in the equity market, look increasingly asymmetric, with minimal share price upside should they operationally continue to deliver, but material downside if they don’t. This is an area we have been gradually reducing exposure to when opportunities allow.

The technology sector will remain a critical part of any investor portfolio, given it is one of the truly innovative sectors. However, as we saw in the 2000s after the technology bubble of the 1990s, it is unlikely to be the sole driver of markets and adding diversification into areas alongside it – which we have always had to some degree – is sensible.

Finally, looking at historically more lowly valued areas of the stock market, ignored for many years, is a good use of time. Areas such as banks, which have improved sustainably and financially in the last decade, look much more interesting in a higher interest rate environment and one where finance will play a key role in the transition to a more sustainable society.

Any changes we have made and will make will be consistent with our core principles of investing in positive, value creating businesses. After all, it will be the operational performance of companies and the price paid which will determine whether or not an investment is successful which in turn defines our success. If we can do this effectively it will allow us to maintain what has made our funds successful over the last decade whilst enhancing them with new and interesting areas.

Goodbye 2022 and welcome 2023.

In reflecting on 2022 and looking forward to 2023, here are three observations:

The future is unpredictable – when an unknown event like the invasion of Ukraine can so fundamentally change investment markets, it reminds us that predicting what will happen in the future is difficult.
Reward happens slowly, risk happens fast – fundamentally flawed investments can look good for many years but can lose all their gains (and more) abruptly. This is the lesson of all booms and busts, of which speculative technology and crypto currency investments are the most recent examples.
Bear markets are the price of long-term returns – bear markets happen infrequently enough for investors not to get used to them as part of the process of delivering long-term investment returns. Very few things have permanence in markets however, this too will likely pass soon.

Looking at the data going back three decades it is clear that hopping out of stock markets and hopping back in just at the right time is extremely difficult. Sticking with the US S&P all that time would have delivered annualised returns of just less than 10% but missing the 10 best days would slash that return to 5.6%. Missing the 30 best days cuts the return to a measly 0.8%.

The best bet for this year appears to be that stock markets will likely remain volatile in the early part of the year as an economic downturn bites, but then stabilise somewhat and eventually recover. Bonds are broadly expected to do a better job of balancing out any pain, now that juicy yields provide a thicker buffer. That is much more of a normal cycle than we have seen for at least the past decade and a half.

As we move through 2023, we will get the answer to many of the questions vexing markets currently. Some of these answers will be good, some will be bad. However, we believe that the premise of investing in a blend of good fund managers and index funds with global and sector diversification remains strong. The fund managers we deploy invest in a range of attractive companies which will thrive in the long term, whatever the future may bring.

Thank you to everyone who has used our bespoke financial planning services and invested in the Clarion funds and portfolios over the past few years. It is massively appreciated. We never take anything for granted. We do our best to keep you all updated and not waste your time. We are always looking to improve the service we offer, so if you would like more of something…or less of something, please let us know.

We wish you all the very best for the forthcoming year.

Keith W Thompson

Clarion Group Chairman

January 2023

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.