Stock Market & Economic Commentary October 2023

Confucius, the great Chinese Philosopher, wrote this beautiful sentence back in 550 BC: “We have two lives; the second begins when we realise, we only have one”.

Events in Israel and Gaza continue to dominate news flow. We live in an information age where news of horrors is immediately transmitted around the world. But at the same time, the manipulation of what we see becomes more sophisticated – so we become unsure of reality. This suspicion ingrains prejudices and promotes alternative narratives. Disturbances in Lebanon, Jordan, Turkey, and the West Bank following the explosion at the Al-Ahli Gaza hospital, and the aggressive comments from Iran, indicate that appearances matter. This is why the US is both supporting Israel but also urging caution. The shuttle diplomacy of Secretary of State Blinken and the comments from President Biden about what the US did wrong in the aftermath of 9/11 show that the US favours Israeli restraint.

From a market perspective, the worsening situation has not yet, at the time of writing, translated into risk-off trades. The oil price has risen but is still below its late September peak. The US dollar has not rallied and there has been no rush to buy US Treasuries. Gold has proved an exception, but its recent spike has been from a year low and is still below its April high. Equities have held up quite well, falling only marginally, helped in part by strong relative performance from energy.

These are dark days for the people of Israel and Gaza and our thoughts are with the innocent victims and the suffering they have to bear. We pray for an early solution to the hostilities. A human tragedy and one with market and economic implications.

Economic Update

Riding the interest rate cycle.

For the last 40 years, interest rates in the West have been trending lower. There have been ups and downs, but the direction has been unmistakably down. With inflation and interest rates heading higher over the last 2 years, has the era of cheap money gone forever?

UK base rates averaged close to 10% in the 1970s and 1980s. Base rates fell to around 8% in the early to mid-1990s and then, from 2000 until the financial crisis in 2008, averaged 5%. The financial crisis, the deep recession that ensued and then the pandemic resulted in a period of record low rates, with UK rates running at an average of 0.5% until late 2021. Sub 1.0% interest rates and negative bond yields became the new normal.

A series of factors pushed normal interest rates even lower. A decline in western growth rates depressed demand for investment capital, a process reinforced by a global shift to service-based, less capital-intensive economic activity. The multiple economic shocks of the last 15 years, everything from the financial crisis to the pandemic, increased uncertainty and reduced risk appetite.

While demand for investment capital faltered, supply increased as ageing populations in the rich world saved more and households in fast-growing Asian economies accumulated savings. The resulting savings glut depressed interest rates.

Ever since the 1980s central banks across the world have been freed from political control and charged with keeping inflation low. This increased the credibility of monetary policy and helped anchor expectations for inflation and interest rates at lower levels. Globalisation and the entry of China into the global trading system in the early 2000s played a role in depressing prices and inflation across the world.

We moved from a high to a low interest-rate world. Instead of worrying that interest rates and inflation were too high, as they did in the 1970s and 1980s, policymakers increasingly worried that deflation, not inflation, was the bogeyman.

That all changed abruptly in early 2022. In the last 2 years, inflation rates in Europe and North America approached, or exceeded, 10%. Inflation has become the number one problem. The Bank of England has taken rates from a low of 0.1% in December 2021 to over 5%, the highest level since 2008. Central bankers worry that some of the structural factors that have kept inflation and interest rates low are weakening.

The pace of globalisation has slowed in recent years, with geopolitical tensions and a greater focus on national autonomy and self-sufficiency creating new frictions and costs. The cost of goods from China and other emerging markets is rising, not falling as they were 20 years ago.

Last year’s inflation shock has increased long-term market and consumer expectations for inflation. Central Banks’ credibility, which had helped to keep interest rates low in recent decades, has taken a knock. Meanwhile a drive for sustainability and resilience across the economy, above all the energy transition, but also in defence, agriculture, technology, and supply chains, will require vast levels of investment.

But now, helped by lower energy prices and weaker growth, inflation seems set on a downward trajectory and is expected to fall gradually over the next few months. The Bank of England thinks UK inflation will get back to its 2.0% target rate by the end of 2024.

The big question is whether interest rates will end up settling at the levels that prevailed after the financial crisis. It seems like a distant memory, but between 2009 and 2021 the interest rate set by the US Federal Reserve averaged 0.7%. The equivalent rates for the Euro area and the UK were just 0.5%.

As in most things in economics, views vary widely on where interest rates will eventually settle. In a recent report on the World Economic Outlook, the International Monetary Fund confidently predicted that interest rates in advanced economies will soon slide back to the rock bottom levels which existed before the sudden spike in inflation in 2022.

The IMF analysis said unpredictable factors such as rising government debt and fraying trade links between countries could result in deflationary forces which would encourage central banks to dramatically reverse the trend of interest rate rises. The Report suggests a ‘natural’ rate for UK interest rates would be around 1% for the next decade or two.

But if financial markets are right, material rate cuts are still some way off. One profile is suggested by the market pricing of five and ten-year UK government bonds which currently yield about 4.9%. Very simply, that suggests markets are pricing an average base rate of roughly 4/4.5% over the next 10 years, about the same level seen before the financial crisis. In the absence of much higher productivity growth, a 4.5% rate would be highly restrictive from an economic standpoint.

It wasn’t that long ago that central banks were committed to keeping rates at or close to zero before embarking on the most aggressive hiking cycle in decades. Although they are doing their best, they really have no idea how the future will evolve. What is clear though, is that as the higher interest burdens feed through to government budgets, there will be some pointed questions, with debt levels as they are, as to whether these elevated levels of rates can be sustained.

For the UK, interest rates could be somewhere between 4.5% and the 0.5% level seen before the recent inflation shock. Some commentators suggest that 3.0% looks a plausible number, though there’s no science in this. More important are the forces at work which do not point to a world of either 0.5% or indeed 4%+ interest rates.

Stock Markets

Investment Portfolios in an uncertain world.

The past 3 years have proved challenging for investors of all stripes and even to the eternal optimist, it starts to become wearing.

Until recently the entire experience of even the most seasoned investor was built exclusively in a period of secular disinflation. For most people, this meant that some version of a balanced portfolio of equities and bonds did a decent job of preserving and growing the real value of their wealth.

Indeed, the entire investment industry is built around this framework with the ratio between the key asset classes determined by an assessment of the desired level of risk. The less risk the higher the bond allocation.

The issue today is that there is significantly more uncertainty ahead. There could be a global war, a deflationary collapse, monetary inflation or more hopefully, something in between. When constructing a portfolio, we need to be able to create a tolerable outcome in a whole range of scenarios because we genuinely cannot know what will transpire. The future path of events is, to use a ten-dollar word, stochastic. It depends on actions and choices we can’t even frame today, let alone accurately predict the implications.

Is there anything we can do to improve the basic portfolio construction to improve our risk-adjusted returns and leave us better placed to prosper financially, whatever the future holds?

Firstly, let us lay down some basic assumptions.

Over long periods of time holding financial assets gives a better return than holding cash. This is particularly obvious in respect of physical banknotes which get eroded over time by inflation, but it is also true of instant access cash deposits which tend to attract poor interest rates especially when considering the effects of inflation. There are times when short-term cash or cash-like instruments can do well, but this tends to be only during periods when monetary policy follows a similar path to what we have seen over the last two years.

Secondly, the fundamental premise that within financial assets, bonds are less risky than stocks and shares, is sound when we think in nominal terms. However, this may not be the case over long periods when inflation is the most likely threat to the real value of a portfolio.

When considering how to build a portfolio that is likely to be robust in different economic conditions, we need to add assets that can do well during periods of inflation. These include commodity-related equities and inflation-linked bonds. We are not making a forecast that inflation will be elevated on a structural basis. We are simply saying that a portfolio that includes these assets is better balanced to the different potential inflation regimes.

Everything mentioned so far relates to different asset classes that one can own, each with some level of expected return over time. The final category to consider is the return streams derived from manager skill (or alpha as it is known in the industry). The returns from owning financial assets can be considered quite reliable over long periods of time but depending on the exact asset in question, quite unreliable over short periods. Generating alpha is difficult, often transient and expensive to access. Nevertheless, it can contribute to a diversified uncorrelated source of returns that improves portfolio, risk-adjusted returns.

The key to portfolio construction is not optimising around what you think you know about the future but about understanding that you need a portfolio that can deliver across the diverse range of outcomes that are possible in today’s world.

And let us not forget that one of the most important factors, time itself, can bring the greatest rewards.

Teenagers

Markets can be like teenagers—temperamental and easily bored. They love a “new thing”. In the last two years, equity markets have seen most stock prices fall, but a tiny number of shares have risen impressively—mainly technology companies that dominate the global index. But the value of some of these companies is now far removed from that of other stocks and from reality.

AI has been the “new thing” which has caught the imagination of the “teenagers”.

It seems clear that AI applications will be widespread and enhance productivity. They will dramatically affect sectors that rely on data processing, from factory automation to journalism. Doubtless, most companies will look for ways to harness the potential of AI in their portfolios. However, the market value in AI in the long run will be related to the actual consumer benefit from the applications and the realised productivity improvements.

As is well-publicised, around 80% of the market’s return year to date is thanks to the performance of seven technology shares “the Magnificent Seven”. Excluding these, or considering an equal-weighted index performance, markets have basically gone nowhere or have fallen in value.

This extreme repricing of a small subset of the market is due to the sheer weight of consensus opinion. This consensus is now so extreme that these stocks are being touted as safe haven assets, or “one decision stocks” as they were referred to in the Nifty Fifty era.

The time has come to question – are you happy sitting with the consensus? And, more importantly, what do you stand to risk or benefit from if you take the path less trodden? We believe there will be substantial rewards to investing more broadly.

History teaches us that it is not worth betting the farm on hyped-up stocks at spicy valuations. And especially not in the current environment, when inflation and high interest rates mean the bar has been lifted on how much an equity needs to deliver to justify investment.

The immutable law in investing is that every decision is one of relative value. Holding shares in one company has the opportunity cost of not holding shares in another.

Investors have the choice between investing in different stocks, other asset classes, or holding cash, and will exercise that right over time rewarding patient investors who correctly assess these relative valuations.

When you can achieve 4-5% interest by holding cash today, investors have a higher opportunity cost for all their investment choices. That said, 4-5% is certainly not the best you can get. There are swathes of the stock market with current free cash flow yields well in excess of this, with many years of durable growth ahead. It’s here where there is the greatest relative value of all investment choices, as well as the lowest risk.

An example of value is provided by, Tesco, boring, under-hyped Tesco. Their recent interim results showed that some companies are coping well during the “cost of living crisis.” Sales were up nearly 9% in the core UK and Irish businesses. With 27% of the UK grocery market, Tesco has been able to rebuild margins back to long-term levels – despite the economic headwinds. Indeed, the move up in margins to 4.4%, from 4%, was despite problems in their central European operations.

The bigger picture is that large companies, globally, have coped with covid, inflation, sluggish real growth, and higher interest rates much better than expected.

In time investors, and the “teenagers” in particular, will recognise this value and when that happens markets will move forward.

Outlook

As we head into the final quarter of 2023, macro headlines have begun to dominate the market narrative again. Oil prices have risen more than 30% since June and bond yields have risen. This is reigniting the concerns which dominated in 2022 of higher energy prices and interest rates impacting economic activity and creating higher inflation.

This is a change from the first half of 2023 when micro dominated macro. In particular, the evolution of artificial intelligence (AI) into generative AI, which makes its use much easier and application much broader, resulted in strong performance from several stocks.

It is not unusual for markets to switch between being macro and micro-driven; both are important variables in determining investment outcomes. That said, for equity investors, over the long term, micro tends to be more important than macro. The creation of companies such as Amazon, Alphabet, Nvidia and many more, has been independent of inflation, interest rates and economic activity.

This is a particularly important point today, as the outlook for these key economic variables remains unclear and investors making decisions in relation to them are more likely to make mistakes. Yet at the same time, the micro, bottom-up outlook for companies and industries has perhaps never been more certain. Key trends of decarbonisation, digitisation, and progression in cures for major diseases are progressing at pace, and the companies which will benefit from this are relatively clear. If long-term returns are more aligned with micro than macro trends, and micro trends are clear, then it seems sensible to invest based on that premise.

As always, we thank you for your continued support particularly in these difficult and challenging times for investors. We hope you enjoy reading our regular updates. We are always eager to improve and welcome any suggestions as to any topics you would like us to cover in future editions of The Clarion.

Keith W Thompson

Clarion Group Chairman

October 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.