Stock market & economic commentary – February 2024

“Never mistake knowledge for wisdom. One helps you make a living, the other helps you make a life” Eleanor Roosevelt, First Lady of the United States of America, 1933-1945

Economic Update

A recurring theme over the last year has been the unexpected resilience of western economies. Employment has held up surprisingly well, housing markets have softened but not collapsed, and there is little obvious distress in financial markets.

The exception to this story of resilience is business failures. Last year 25,158 registered companies were declared insolvent in England and Wales, the highest number for 30 years and more than twice the level seen at the recent low point in 2020. The UK has so far avoided a deep recession, but it is suffering recession like numbers of insolvencies.

Look beneath the headline numbers, however, and the story looks rather less worrying. Insolvencies have risen, but so too have the number of registered businesses. To get a true picture of stress in the corporate sector we need to look at the rate of insolvencies relative to the population of all businesses (for similar reasons that economists focus on the unemployment rate, not the number of people who are unemployed).

The insolvency rate has edged up, from 49.6 failures per 10,000 businesses in 2022 to 53.7 in 2023. This sort of level of failures was last seen nine years ago, in 2014, a less dramatic comparison than the number of insolvencies, which are at a 30-year high.

The current insolvency rate is roughly half that seen in the recession of 2008/09. Moreover, insolvencies come from an artificially low base as a result of extensive government support for businesses during the pandemic.

It is a measure of the success of the policy that in 2020, a year in which UK GDP contracted by over 10% (one of the worst declines in history) the insolvency rate fell to the lowest level since records began in 1984. From such low levels, and with the gradual withdrawal of government support, it was inevitable that insolvencies would increase.

Even the insolvency rate is a rather unsatisfactory measure of stress since it does not capture the size of businesses that fail. Most businesses are very small, with 44% of the UK’s 2 million businesses employing only one person.

Insolvencies have been heavily concentrated among small and medium-sized businesses. Large business failures have been relatively few, with perhaps the most well-known being Cineworld (which continues to trade) and the retailers Wilko and Paperchase (both relaunched by new owners as online retailers).

Data from other parts of the economy fit with the story of limited corporate distress among large companies. The redundancies that are the natural counterpart to widespread failures among large businesses have been absent.

Bank write-offs of company loans, another indicator of distress, are at low levels. Corporate bond yields are not flashing red in terms of stress in the way they did during the pandemic and the global financial crisis. Corporate profitability has held up well for public companies.

None of this is to understate the pressures many businesses, especially smaller ones, face from high interest rates, elevated energy and wage costs, and weak demand. Small firms typically have less diversified revenues, less cash and find it more difficult to access external funding than their larger counterparts. The insolvency data show that consumer-facing, interest rate-sensitive sectors have been under the greatest pressure, with the highest rates of failure in the construction, wholesale, and retail and hospitality sectors.

Corporate insolvencies have, indeed, hit a 30-year high. But that dramatic fact conceals almost as much as it reveals about the state of the UK corporate sector. It is in better shape than the headline insolvency data suggest.

Lunchboxes and dry January

A recent headline mentioned the increase in the use of lunchboxes in 2023, with 86 million more taken to work and school than the year before. This was attributed to the cost of living crisis, but health factors are also contributing.

More self-made food is being consumed in offices, often with low fat and high protein content, and fridges now have various kinds of milk. Coming from a dairy farmer’s background, I thought milk came from animals, mainly cows, but it seems not. Apparently, pea milk is gaining popularity.

Dry January, gym time, and healthier eating have extended well into February. Is this just a passing trend? Perhaps not. There are some big changes happening. Societal change seems to be happening much faster. The under-25 age group is now more likely to abstain from alcohol than any other group. And this influences others.

I did not attempt dry January or February, but I did drink less alcohol. Despite going to the gym three or four time a week I doubt if I will ever be invited onto Love Island, but body image is playing a role in changing attitudes, with younger people being more health aware – not good for alcohol makers and pubs.

But there is another side to the story. We hear of an obesity crisis among children, reflecting poor diet and lack of exercise – worsened by Covid restrictions. There is also the rise in food banks, as more struggle with food price inflation. A strange mix of real problems.

A recent article in the Spectator was headlined “The Surprising truth about Nanny State Britain”. It argued that the British people are now quite open to government interventions, especially to improve health outcomes. That’s why there was little resistance to the proposed new rules on vaping and the gradual ending of tobacco sales.

On the fourth anniversary of the UK leaving the EU, the idea of reducing the role of the State seems less likely and, in fact, the direction is the opposite. We expect more from government, not less.

It is a theme which keeps coming back – looking past the upcoming election and the talk of tax cuts, taxes will go up in the long term, hopefully structured in a more logical way. The effectiveness of government spending will be a key factor in economic and social progress.

Let’s hope we can learn from the HS2 high-speed rail line, Hinkley Point nuclear power station, and well-documented issues with defence procurement and that we can boost productivity in some critical public sector areas.

Stock Markets.

“Good investing is a peculiar balance between the conviction to follow your ideas and the flexibility to recognise when you have made a mistake.”

– Michael Steinhardt, American billionaire hedge fund manager, philanthropist and CEO of WisdomTree Investments.

Despite economic headwinds and rising interest rates, 2023 was a good year for equities with most major markets posting strong returns.

Many of the fears that caused equities to plummet in 2022 unwound in 2023. It wasn’t a great year for global growth, but fears of recession eased, inflation fell and, by the end of the year, the talk was of interest rate cuts, not increases.

After a dismal 2022, global equity markets were caught off guard last year and on average returned 15%, although with sterling appreciating against most major currencies, returns for UK investors were more muted.

The US did even better, helped by a stellar performance from technology stocks. In Europe, Spanish and Greek equities outperformed partly because of the resilience of their economies in the face of a wider European downturn.

Japanese equities had a strong year, helped by loose monetary policy and good growth. After a lengthy period of more than three decades, the Nikkei 225 indexed recently regained its 1989 peak.

Not all markets did well, however. Chinese equities were the big under-performer last year, losing almost 10% on investors’ worries about deflation, poor growth, and the property sector.

The performance of equity markets does not, however, move in lockstep with economic growth. Many equity indices are dominated by multinationals that do not reflect the makeup of national output in which small and unquoted businesses and the public sector play a large role.

Moreover, financial markets respond as much to changing expectations of future growth and interest rates as they do to current performance. German equities returned 15% last year despite the German economy sliding into recession partly on the hope of better times ahead.

Globally the sectors that suffered the greatest losses in 2022 – including financial services, consumer products, and industrial goods – saw the biggest rebounds in 2023. Markets were in “risk on” mode, with cyclical sectors outperforming while defensive ones, including health care, consumer staples, and pharmaceuticals, lagged. Oil and gas stocks soared in 2022 but saw much more modest gains in 2023 as energy prices fell.

The biggest swing in performance came from the US technology sector. Having lost over a third of its value in 2022, tech stocks returned over 40% in 2023.

Falling interest rate expectations and enthusiasm for generative AI were major factors. The Financial Times estimates that the so-called “Magnificent Seven”, comprising Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla, accounted for more than 70% of US equity returns last year. Nvidia, a major supplier of chips for the AI sector, saw its share price more than triple in 2023.

The value of America’s tech giants is staggering. Microsoft and Apple vie for the title of the world’s most valuable company, each with a market capitalisation around the $3 trillion mark, more than the whole of the UK FTSE 350 equity index.

Returns outside the equity market were mixed.

Bonds delivered positive, if modest, returns as the inflation tide ebbed, having previously suffered significant losses as inflation soared in 2021 and 2022.

The price of agricultural commodities and base metals fell in 2023 unwinding some of the gains seen after the pandemic. Gold did well, returning 13%, its best year since 2020, boosted by investor demand for a safe haven from geopolitical risks, and by central bank purchases.

On the currency side the dollar weakened slightly, and the Japanese yen dropped in value for the third consecutive year. In a world of rising interest rates, low Japanese rates have dented the appeal of the yen. The Economist’s Big Mac index rates the pound and the dollar as being almost 90% overvalued against the yen, testifying to how cheap Japan has become for foreign visitors.

Last year interest rates in the US and Europe reached the highest levels in more than two decades. This has boosted the return on cash, with deposits in the US and UK yielding around 5.0%. This is a decent cash return by the standards of recent years, but, with US and UK inflation rates at circa 4%, a distinctly unattractive real return.

House prices weakened in many countries last year, but the scale of the decline was modest. Popular indices show that UK and German house prices fell by around 2.0% while US house prices grew by a similar amount. In a possible sign that the worst may be past, the 12-month rate of change in house prices has turned up in recent months in the US, the UK and Germany.

Bitcoin did well in 2023, almost doubling in value. The second largest crypto, Ethereum, gained almost 40%. But these gains need to be set in the context of the large losses seen in 2022 in the wake of the failure of FTX and other crypto-related assets.

Asset markets generally had a pretty good 2023. Much of this reflects the dwindling of worries about inflation and growth, and growing hopes of a soft economic landing. Institutional fund managers surveyed by Bank of America earlier this month reported growing optimism and said they are running higher than normal holdings of equities.

Almost 80% of fund managers expect to see a soft landing for the global economy. What happens to asset prices this year largely hinges on whether that expectation is fulfilled.

Looking ahead

In recent months, stock markets have gyrated in response to movements in government bond yields. Recent inflation volatility has caused large swings in bond markets as investors question whether interest rate cuts will come because of lower inflation or lower growth or both.

The market focus is still on central banks and when interest rates will fall. The US Federal Reserve (Fed) has kept rates unchanged and indicated that a reduction is not likely in Q1 – more proof that good inflation data is needed with special attention to labour markets and wage trends.

Likewise, the Bank of England (BoE) decided to keep rates steady although two members voted for an upward move to 5.5% while one preferred a cut to 5%. The wording in the minutes was less hawkish than before – services inflation and pay growth are key to BoE thinking.

Recent US employment data has been surprising. The number of jobs added in January exceeded expectations, with a large positive revision for December. The increase came from various sectors, such as professional/business services, healthcare, retail trade, and social assistance categories. The unemployment rate fell more than predicted while wage growth rose faster than anticipated.

This is not likely to persuade the Fed and other central banks to lower rates soon and global bond markets were unsettled by the further delay to the soft-landing scenario of lower inflation and rate cuts. But equity markets in the US, Japan and Europe remain seduced by the Goldilocks scenario of falling inflation, lower interest rates, and above trend economic growth and have made new highs albeit powered by a small number of big tech companies in the US.

UK markets are the cheapest of the major markets on several measures but still lag because international investors are not yet convinced that UK growth can return to pre-Brexit levels. Perhaps a lower interest rate pivot from the Bank of England will be the catalyst to releasing value.

The truth, however, is that nobody knows. People often say there’s lots of uncertainty, but when was there ever certainty in the markets, the economy, or the future? At Clarion we concentrate on trying to understand the present. Our approach does not involve trying to predict the future but investing in the world as we see it today, which continues to be highly unpredictable.

We aim to provide our investors with both ballast in the form of diversification across all geographical areas and sectors alongside propulsion in the form of investment in quality businesses which can take advantage of underlying trends in the global economy and grow their earnings and fundamental value.

As always, we thank you for your continued support and we look forward to updating you regularly throughout 2024. Please get in touch if you have any questions.

Keith W Thompson

Clarion Group Chairman

February 2024

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.