Stock market and economic commentary February 2023

“Keep in mind that progress is not always linear. It takes constant course correcting and often a lot of zigzagging.”

Buzz Aldrin: American former astronaut, engineer and fighter pilot. Born 20^th January 1930.

Economic Commentary

“Government debt, hospital waiting lists, rail strikes, health workers on strike, slowing economy, inflation, public demonstrations, threat of energy rationing……”

The above, of course, refers to…….France!

The news we read rightly exposes the UK’s economic problems, but other countries’ ills are often overlooked. Germany, for example, has serious concerns over declining exports and a catastrophic dependence on Russian energy. Recession, therefore, seems even more likely there than in the UK. The US is facing yet another debt ceiling conflict with the threat of a default on its obligations unless the matter is resolved, which it will be of course but not without serious political wranglings.

News from around the world reveals that the UK’s problems are not unique although one area of genuine concern is the UK National Debt, which is uncomfortably high at £2.5 trillion. This is more than 100% of gross domestic product and the highest level for 60 years. As a percentage of GDP it is higher than Germany, on a par with Argentina and Brazil but less than Japan, the US, Italy, Spain & France. It is equivalent to £37,000 for each man, woman, and child in the country.

If we include off balance sheet items such as unfunded public sector pensions, student loans etc., then government debt is close to £4 trillion. This number is hard to comprehend, but I tend to use the following to explain – a million seconds takes 11 days to expire. One trillion seconds would take thirty-two thousand years, four trillion seconds would take us back to long before dinosaurs stalked the earth.

Young voters will be the ones who inherit this debt, although there are no signs anyone would vote for a government willing to tackle the problem by raising taxes, reducing public spending and borrowing less. It might therefore be interesting to delve more deeply into how the UK government spends our money but let’s look at the receipt side of the equation first.

The biggest earner, not surprisingly, is income tax. A temporary tax introduced during the Napoleonic Wars, it has proved to be resilient and brings in about 26% of total revenue. National Insurance adds another 18% whilst VAT completes the big three, coming in at 17%. Sin taxes and fuel together account for 11% whilst Capital Gains and Corporation taxes contribute another 10%. Council tax represents about 8% whilst a miscellany of others make up the balance (stamp duty, bank levy, inheritance tax).

If we look at what the government spends on our behalf, there are three big chunks: welfare, healthcare and education. With the rising burden of debt interest payments, courtesy of higher rates and retail price index uplifts, it is unclear how we can easily square the circle of providing acceptable key services whilst maintaining a competitive economy which, fundamentally, will be the source of future prosperity.

As the government tries to balance its books it is looking to increase receipts and reduce real spending. Therein lies the problem. Increase taxes too much and the economy will stall, leading to lower tax receipts and higher welfare spending. But cutting real spending is also a problem, given that welfare, health and education dominate. The cost of servicing government debt is also rising, reflecting higher bank rates and strong inflation.

About £600bn of UK debt is linked to RPI. An index-linked gilt pays a coupon that is uplifted each year by the change in the RPI index. At the end of the term, the capital repayment will reflect the change in prices since issuance – unlike a conventional gilt which just repays in nominal terms. This uplift in redemption repayment is reflected in the Government’s accounts at the time when the change in liability occurs. So, higher inflation now means both an uplift in income payments and a higher accrued liability reflecting the inflated repayment amount.

The UK government is in a bind. Our “net” tax base is narrowing, as highlighted by the Civitas report published recently. However, demands on government spending will continue to grow. This means that we need to become accustomed to relatively high levels of government borrowing and, consequently, the issuance of government bonds.

Quantitative Easing

We also need to look at Quantitative Easing (QE). The Asset Purchase Facility (APF) has bought just under £900bn of gilts as part of QE – with losses underwritten by the UK Government. Over recent years the APF has made payments to the HM Treasury because the income received from the gilts (coupons) was greater than the interest costs of the loan taken to finance the purchases. This is now going into reverse. The cost of the loan is tied to Bank Rate – so as official rates rise so do financing costs. We are now in a situation where gilt coupon receipts are less than the cost of the loan. This difference is a cost to the Government and is reflected in the national accounts.

This will be compounded as QE is reversed and gilts are sold at a loss – another cost to the Government. So, higher inflation and rising bank rates will push up debt financing costs. With over two-thirds of spending allocated to welfare, health, education and debt service costs, and the challenges faced in these areas, it is difficult to see taxes coming down any time soon.

Overall, worse-than-expected public finances figures will only embolden the Chancellor in his Budget on 15th March to keep a tight grip on the public finances which means that he will have to wait until closer to the next general election before announcing any significant tax cuts.

Energy transition

But there is good news out there. For the first time in more than a year, forecasts for growth in the UK are being revised upwards. A recession is still on the cards, but a shorter, milder recession than was predicted only a few months ago. Better news on energy supply, inflation and the outlook for the economies of China, the US and the EU are the reasons for the improvement.

Consensus forecasts now see the UK economy contracting by 0.8% this year, up from previous forecasts of a 1.4% decline in GDP. With the news that the UK GDP growth was flat in the fourth quarter of last year, following a contraction of 0.2% in the third quarter, the UK narrowly avoided a technical recession in the second half of 2022 (a recession is defined as two consecutive quarters of negative growth).

The energy crisis has eased. Europe has sharply reduced its use of Russian gas and filled the gap with imports of liquified natural gas from the US and Qatar. Mild weather has helped reduce energy usage and gusty winds have lifted the power output from turbines to record levels. UK wholesale gas prices are running at about one-fifth of their summer peak, and this is taking some of the pressure off consumers. The UK, and continental Europe, seem likely to avoid blackouts this summer.

While prospects for growth in the US and the euro area this year remain poor, lower energy prices and inflation have reduced the risks of deep downturns. Prospects for China, the world’s second-largest economy, have improved with the ending of the country’s zero-COVID policy. Sharp increases in the value of China’s currency and equities suggest that investors see stronger Chinese growth ahead.

The most intense phase of the energy crisis may well be past. Energy prices are off their summer highs, with European gas prices at a sixth of August’s peak. The oil price is down roughly 30% since last March. Lower energy prices are feeding through into lower levels of consumer price inflation but, as always, there is a flip side. Interest rates may need to be kept higher for longer. This may sound contradictory as inflation comes in lower, but it is the domestic side of inflation that is still a concern, in particular the tightness of the labour market.

Whichever way it is sliced interest rates are destined to go higher for the next few months but with the tightening expected over the next six months, CPI inflation is likely to fall back to a range of 2-4% by the end of year.

Stock markets

We like bunching history into eras: the Anglo-Saxons, (Saxon invasion, the early medieval period); the Normans (intermingling of the indigenous Franks with the Norse Viking invaders); the Tudors (Protestant Reformation and English Renaissance, tough time for monks and royal wives); the Victorians (Empire, from conquered to conquerors).

The stock market seems to have its eras, too. In my time, we have had the 1960s (Bull market interrupted by the Kennedy crash, recovery, a bear market, good time to invest, and then another Bull market), the 1970s (collapse of the Bretton Woods exchange control system and an oil crisis triggering stock market falls of 75%, good time to invest, then recovery again); 1980s (big bang, inflation, long lunches, Black Monday, good time to invest); the 1990s (good time to invest, technology boom); the 2000s (9/11, technology bust, banks boom and bust, good time to invest); the 2010s (quantitative easing, incredibly low interest rates and inflation, good time to invest).

It looks like 2023 will be the first full year of a new investing era – marked by the return of inflation, higher interest rates and attempts to retreat from quantitative easing.

The pain of adjustment

Change points are often when economies and investors feel the most pain. The classic sector to suffer when interest rates rise is property – commercial and residential. For new home buyers, 2022 was particularly tough.

When I bought my first semi, property was cheaper, but the mortgage rate was around 10%. A mid-1980s inflation spike took it to 15%. My monthly payments shot up from around a third of take-home pay to over half. I tightened my belt for a couple of years. I fear for those renewing mortgages today, with higher levels of debt and rates tripling to more than 4.5%. Belt tightening may not cover the deficit.

Governments must also adjust to sustained higher rates. As Kwasi Kwarteng’s mini budget showed, bond markets are touchy. New investment through the European Green Deal and the US Inflation Reduction Act is likely to be funded by debt costs more onerous than originally planned, leaving less tax revenue for other priorities.

Impact on investments

What does this new era mean for equity investors? Loan rates for companies rise more sharply than bank rates – just as for mortgage holders. These higher costs come as margins are being squeezed. The companies worst hit are those with lots of debt and unable to fully pass on the rising costs of materials and labour.

But sectors seemingly with little debt can also be affected by higher interest rates. Young technology companies, including those in biotech, have enjoyed plentiful funding from patient venture capitalists over the past decade. When these investors hear the ticking clock of 4%+ interest rates, they become less patient and less open-handed, sometimes pulling funding from promising projects simply because the time and expense of the commercialisation phase may seem too great a risk.

The combination of rising interest rates, a weaker economy (making selling new products tough) and lower equity market valuations compound the problem.

Something old, something new – A postcard from our Fund Managers

Unsurprisingly, investors are looking for companies with low debt, high-profit margins, and strong pricing power. That may lead them towards some of the world’s largest, quoted companies. Understandable – but not without risk. Remember, new eras also tend to mean a new cast of leading global corporate players.

The largest companies in the world today are Apple, Microsoft, Alphabet (Google), Amazon, Tesla, UnitedHealth, Exxon Mobil and Johnson & Johnson. Of these, only Amazon has much net debt – Exxon normally has net debt but has had a bonanza with high oil prices.

Technology stocks on this list saw sharp share price falls last year, partly because they had reached excess valuations, but also their growth rates disappointed. Some are also now having to rein back costs to maintain margins. However, their ability to carry on making good profits is only modestly affected by rising interest rates, higher inflation or a slowing economy.

Edging towards the global top 10 is TSMC, the world’s biggest advanced chip maker. It has pricing power and at 12x earnings with a 2.5% yield is reasonably valued. It even has net cash on the balance sheet. In every sense, then – technologically and financially – it looks to be a new-era company. So does ThermoFisher Scientific. Though ‘only’ a $200bn company, it provides much of the equipment needed for biotech and materials science.

Perhaps a surprise shout for a new-era company is Mitsubishi UFJ. In eras past, Japanese banks regularly featured in the global top 10. A few interest rate rises would massively improve its profitability. If it traded on the same price-to-book as American banks it would be valued at ¥2,000 – not ¥820, as it is today. Its book value per share is ¥1,350, so it looks like you get a lot of company for your money and 3.8% yield in yen.

So far, the corporate results season for 2022 has been better than feared. Rumours of the demise of the consumer have proved exaggerated (or even unfounded?), with most retailers reporting good trading over the key Christmas period. Despite inflationary pressures, employment is still high and, particularly in the US, there is still a significant amount of unspent stimulus money in consumers’ bank accounts.

Another key issue has been the reopening of China. This largely unexpected event is providing a boost to Asia-oriented companies, most immediately in the consumer sector. After being locked down for three years, consumers in China have record savings and are very keen to spend them. Recent reports suggest, as the Unilever CEO described it, ‘revenge consumption’. This is something we saw in the US and Europe following lockdowns – and was inflationary as well as positive for growth.

Corporates have also dealt with inflation well. It seems much easier to pass price increases through to end customers in an 8% inflation world than a 2% one. This comes down to expectations, with inflation broadly visible in the economy, it has a habit of feeding on itself, something worth bearing in mind when considering how it might remain sticky in the coming months. Overall, there is not yet compelling evidence of a recession from the corporate sector, nor of falling inflation.

Positive surprises

After a dismal 2022 and despite a few wobbles towards the end of February, markets have started the year on a positive note. Chinese and European equities are leading the way – the FTSE 100 is close to an all-time high and even some of the epic ‘falls’ from last year’s sell-off are enjoying a decent bounce (Bitcoin +50% and Peloton +70%).

With the economic outlook seemingly still quite bleak, no one is quite sure what lies behind this surprise rally.

Alan Greenspan was the 13th chair of the Federal Reserve, occupying the office from 1987 to 2006. He was well known for his style of communication, which was honed over 19 years of congressional hearings. In a 1988 speech, early in his tenure, he came up with arguably his most famous comment: “If I turn out to be particularly clear, you’ve probably misunderstood what I’ve said.”

This comment could just as easily apply to investment markets today. If they are clear to you, then you’ve probably misunderstood them. So, what are investors thinking?

It appears that investors have increasingly been discounting what could be described as the ‘immaculate disinflation’ scenario, in which inflation eases back to long-term target levels without a significant or prolonged recession. This painless transition back to the world of pre-2022 investing, when all asset classes performed strongly, is an attractive proposition. It has been supported in recent weeks by evidence that inflation is indeed falling rapidly, helped by declining energy prices, and economic activity is proving more resilient than expected. This is a much more favourable scenario for financial assets than a deep recession to bring inflation down, or an acceptance of higher long-term inflation as the price of economic growth.

Stock markets, although volatile at times of uncertainty, are often 6 to 12 months ahead of events and investors are beginning to think that things may not be quite as bad as feared a few months ago. There is an about-turn in sentiment and the gloom is lifting. Several reasons are offered, all with some validity:

Inflation has obviously peaked…the immaculate disinflation theory.
The pace of raising interest rates has slowed and will soon halt altogether.
China has reopened from Covid Zero in a big way.
Europe’s energy crisis has been averted by the warm winter.

It is hard to know if all this is justified; markets often only really make sense looking backwards. Although there is some bemusement about the recent rally in asset prices, that doesn’t mean that the market is wrong. There was significant scepticism in May 2020 in the first weeks of the Covid-19 lockdown about the rebound in markets, but it became clearer as the year unfolded that the unprecedented speed and scale of the policy response of central banks – and the subsequent accelerated vaccine development – justified it.

The ‘wisdom of the crowds’, as represented by financial markets, is often stronger than the conviction levels of individuals and should not be ignored.

We cannot be sure what the decade ahead holds, but history suggests the future is unlikely to be the same as the recent past. Higher inflation, higher interest rates and no quantitative easing signals a new investment era but this can be a world to look forward to, not to fear.

As always sensible diversification in quality assets will be the key to future returns.

I will end this commentary with my nomination for bond manager of Q4 2022 which is awarded to the Bank of England for making a nifty £4billion profit on its well-timed intervention in the government debt market post the botched Truss/Kwarteng mini budget last September. A pity about its three, five, and ten-year record though.

We thank you for your continued support and we look forward to updating you regularly throughout 2023. Please get in touch if you have any questions.

Keith W Thompson

Clarion Group Chairman

February 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.