Stock market and economic commentary July 2023

“Headlines, in a way, are what mislead you. Because bad news is always a headline and gradual improvement is not.”

Bill Gates; American Business magnate, philanthropist, investor and co-founder of Microsoft.

Economic update – the inflation conundrum

Economic booms tend not to end well. Strong growth generates inflation, which in turn causes central banks to raise interest rates, pushing the economy into recession. As the US economist, Rudiger Dornbusch, memorably put it, “No post-war recovery has died in bed of old age – the Federal Reserve has murdered every one of them.”

The economies of the West have certainly boomed and, in the process, generated levels of inflation not seen since the 1980s. Central Banks have responded with sharply higher interest rates, with the US Fed funds rate going from 0.25% to 5.50% in just over a year. Yet instead of ‘murdering’ growth, as Professor Dornbusch put it, the Fed has merely dampened it. Most forecasters expect the US to avoid a recession and, indeed, to keep growing.

Getting inflation down from a peak of over 9.0% in the US and around 11.0% in the euro area and the UK without causing recessions would be quite a feat. The general thinking is that central banks will slow growth enough to cure inflation, but not so much that they cause economic contractions. On this view, we are heading for that much desired, but rather rare thing, a soft landing, although on current evidence the US has a better chance of pulling it off than both Europe and the UK.

The US inflation rate has halved since last October and is now running at less than 4.0%, well below the euro area’s 6.1% and considerably less than UK levels of 7.9%. The Fed is feeling more confident about inflation and at the June meeting elected to pause its campaign of rate hikes, the first in ten meetings in which the bank did not raise rates.

The European Central Bank and the Bank of England are less relaxed. Inflation is proving stickier in Europe than the US, in part because Europe is more exposed to high gas prices than the US, where oil and cheap coal have kept energy costs lower than in Europe. The day after the Fed kept rates on hold the ECB raised euro area rates by 25bp and the Bank of England went even further, with a rise of 0.5% to 5%.

But monetary policy works with famously long and unpredictable lags. The precise effect of a move in interest rates on the economy can only be roughly estimated ex-ante. The impact of higher interest rates has been compared to pulling a brick on a rubber band. A lot of pulling does nothing, until suddenly a brick is flying towards you.

Despite the encouraging numbers for June, when UK inflation fell to 7.9%, down from 8.7% in May, the Bank of England’s task of engineering a soft landing for the economy is made harder by resilient activity and sticky inflation. The bottom line is that the economy continues to generate jobs and the labour market is tight. It looks as though the only way to get inflation back in its box is to “murder” growth – and, having failed miserably to recognise the threat posed by inflationary forces early enough, the BoE is trying hard to do just that. This is through a combination of squeezing the consumer (housing costs), making savings more attractive than consumption, increasing business costs, buoying the currency and, in general, sending out a strong message that inflation will be defeated.

Yet it is not all doom and gloom. A recent Deloitte survey of UK Chief Financial Officers confirms that recruitment difficulties have eased significantly since the start of the year. Supply chain disruption and labour shortages have dropped lower on CFOs’ list of concerns. While credit conditions are tight, CFOs see the Bank of England cutting base rates to 4.5% by the middle of 2024, well below the rate of about 6.25% priced into futures markets.

And CFOs often have a better forecasting record than the Bank of England economists and financial markets.

The price of time

‘The price of time’ is the title of a book by British financial historian, Edward Chancellor. It seeks to explain the history of interest rates going back many centuries and looks for precedents that can be applied to the current debate around monetary policy and the appropriate level of interest rates.

The more objective part of the book is the evidence that economic troubles tend to follow prolonged periods of low interest rates, as these create imbalances and distortions in the economy, which ultimately lead to bubbles and large-scale misallocation of capital. The book posits that we are in such a time now.

It isn’t hard to observe that this argument is proving to be at least somewhat correct today. The bursting of a technology bubble in 2022 and the recent issues in the US banking sector could be argued as reflective of problems created by low interest rates. As to whether this is the start of a broader trend of difficulties as higher interest rates are absorbed by economies and societies, only time will tell.

For those financial institutions that have relied on cheap liquidity by taking on too much leverage and aggressively mismatching their balance sheets, times will be challenging, given their magnified exposure to bond duration risk. Should confidence in the banking system weaken further, this could result in contagion risks in other financial markets, particularly leveraged pension funds. However, it is acknowledged that the major global banks are more robust than in the lead up to the global financial crisis with regulators requiring much greater capital and liquidity buffers.

Despite the financial challenges faced from higher interest rates, economic growth has been more resilient than expected. Aided by a decline in energy prices, with a mild winter in the northern hemisphere helping to reduce demand for natural gas, growth appears to have picked up in 2023.

The overriding sense though is how much ambiguity there is about what is the appropriate interest rate policy. Given this is one of the most important and analysed variables in investment decision making, it may be assumed there is a bit more clarity about it but the degree to which forecasts for future interest rates were wrong back in early 2022 shows how little certainty there can be.

Current expectations for interest rates are that we are near to the peak and rates will fall early next year. But predictions are difficult, particularly when they concern the future! Being prepared for the unexpected and always allowing for a margin of error would seem to be the most prudent approach when it comes to forecasting the future path of interest rates.

Interest rates and mortgages

The surprise 0.5% interest rate hike by the Bank of England at the June meeting, in response to persistently high inflation, to a base rate of 5% sent the rate markets scurrying to reprice expectations of how many more hikes are to come. Markets now expect rates to peak at somewhere close to 6% early in 2024, although the surprise fall in inflation in June has provided some relief.

Sharply higher rates are driving up mortgage rates. Analysis by the Resolution Foundation think tank estimates that annual repayments for those remortgaging in the next year are set to rise by £2,900 on average. People in their 30s, those on lower incomes or those living in areas where house prices are highest, are worst affected due to higher levels of indebtedness.

At an economy-wide level, higher mortgage rates are likely to act as a further headwind to activity, rather than an immediate knockout blow. Only 30% of UK households have mortgages and 85% of those deals are on a fixed rate, so the pass-through from the bank rate to higher mortgage costs is gradual and takes time. Estimates suggest that just over 1% of all households will be impacted by higher mortgage rates each quarter over the next 12 months.

Inflation will decline, and interest rates will fall. The only question is how quickly – and whether it takes a recession to get there.

The UK equity market

The most eagerly awaited news in financial markets is the monthly inflation numbers. Investors are desperate to call the peak in the current interest rate cycle. On that front, as in previous months, there have been mixed messages this month.

Despite the softening of the inflation data reported in June, price rises remain stubbornly high in the UK, while slowing elsewhere, which has caused expectations for interest rates here to widen versus the rest of the world.

This “interest rate differential” is the traditional currency traders’ compass, which was buried for the last decade under a sea of liquidity and zero interest rate policies. The result has been a steady strengthening of sterling. When compared to the US dollar, the rate has risen from a Liz Truss-inspired low of $1.04 to within touching distance of $1.30 in the last month.

Relative political stability from the Sunak government has helped. This means that, at precisely the time when investors need higher returns to compensate for their loss of purchasing power, any returns generated internationally are being diminished.

For example, since the end of last September, the US indices are up on average close to 25% in US dollars, but this translates to only 5% for a sterling investor.

Investing internationally, which is the mandate followed by the Clarion portfolio funds, carries extra risk over time which needs to be actively managed. Doing so fits squarely within our philosophy of never concentrating risk exposure within the funds, and not taking market timing or macro positions.

But as ever, when there is increased risk there is also opportunity. If currencies continue to move as they have, then UK assets are increasingly attractive to foreign investors. Given the higher yields on gilts compared to US treasuries and the vastly lower PE ratio of domestic markets, there is a chance that the long-awaited “mean reversion” could take place.

There is much debate about the reasons for the disappointing performance of the UK equity market and when its prospects will improve.

One thing on which almost all investors agree is that UK equities are abysmally out of favour with both domestic and international investors. This disenchantment has resulted in an ostensibly low valuation for the UK market as a whole. The FT All-Share trades on 10x earnings according to Bloomberg, compared to the MSCI World Index on 18x and the United States S&P which commands a 22x multiple. This rating for the US market is at a record premium to the All Share.

Persistent core inflation, tight labour markets, a central bank with its foot on the brake, dull growth, possible recession around the corner, hapless politicians facing an election battle next year, a distorted stock market – it’s not the ideal investing backdrop. Little wonder then that the UK stock market is out of favour.

UK-listed investments such as BP and Tesco trade at notable discounts to similar US-listed peers despite generating similar financial performance and offering comparable prospective returns. On a price/earnings basis, BP trades at almost a 100% discount to Exxon, despite having only 15% profits exposed to the UK. Tesco similarly trades at close to a 100% discount to Walmart.

Markets can stay frustratingly cheap for a very long time but when a market is as out of favour as the UK, there is an increased or improved chance of identifying wonderful companies that are wrongly priced. Over time, if you invest in wonderful companies that are cheap, it is possible to earn potentially exceptional returns, even if the UK market remains out of favour for a lot longer than is justified.

It is for this reason that the Clarion Portfolio Funds are overweight in the UK and underweight in the US.

A memo from the Fund Manager of one of our underlying holdings:

“We made a new investment in Inchcape, the world’s largest independent car distribution company, which has exclusive relationships representing over 50 brands in more than 40 countries. Some of these relationships date back decades. Inchcape is consolidating a fragmented market as car manufacturers need strong partners in the smaller markets, to provide the latest digital capabilities to consumers and to manage an increasingly complex industry structure. We had sold out of Inchcape shares on valuation grounds in 2021. Since then, the company has grown rapidly via acquisition, with almost half group profits now coming from Latin America. Some short-term concerns over a large recent transaction upset investors and provided us with an opportunity to re-invest at what we believe was a compelling valuation, and below the price we had sold at in 2021.

The high level of activity in the portfolio, with the introduction of four new holdings, reflects the large number of compelling opportunities we currently see within a modestly priced stock market, that is highly polarised. This represents the flipside of a long period of selling off UK equities by domestic institutions and retail investors, with some of the stock price movements looking indiscriminate. However, history shows that buying shares on low valuations is more likely to lead to superior returns for investors, compared to paying high valuations. We believe that the portfolio is well positioned to deliver income and total returns in line with our long-term objectives”.

It was a privilege to watch the Wimbledon Men’s Final a couple of weeks ago. As well as an exceptional sporting event it encapsulated other themes. The natural cycle of succession and the mental toughness required to compete at the highest levels. The ebbs and flows of psychological advantage were brilliant. It reminded me of how the investment landscape evolves over time and how long-term winners can be overtaken by new talent and innovation, highlighting the advantages of active investment management and the need for a robust, financial plan with regular reviews.

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

July 2023

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

Risk Warnings

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.

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.