Stock market and economic commentary April 2023

“Good Judgement comes from experience and experience comes from bad judgement.”

Samuel Langhorne Clemens, aka Mark Twain (1835-1910) American humourist, author, entrepreneur, publisher, and lecturer.

Economic Update

Riding the economic cycle

Global economic activity is proving more resilient than expected. Lower gas prices, an easing of inflation pressures and a rebound in China’s economy have all helped. The timeliest measure of activity comes from the Purchasing Managers’ Index (PMI). The global PMI trended down from the summer of 2021, deteriorating rapidly in the second half of last year, but has rallied since December. On this one indicator, far from slowing or even contracting, global activity may have picked up in the first few months of this year. A small decline in manufacturing activity in the UK and Euro area has been offset by a return to growth in the US and a pronounced acceleration in service sector activity in the UK, Euro area and the US.

Results from a recent survey conducted by Deloitte UK involving the Chief Financial Officers of the UK’s largest corporates are strikingly upbeat, with sentiment improving significantly since the start of the year. The survey, which took place between 21 March and 3 April, shows the largest increase in CFO confidence since the UK economy was emerging from lockdowns in the autumn of 2020. Having run significantly below average throughout last year, business confidence has risen to a two-year high and is now well above its long-term average.

The failure of Silicon Valley Bank on 10 March and pressures on some regional US banks seem to have had little, if any, impact on CFO sentiment. On the contrary, CFOs’ perceptions of external financial and economic uncertainty have fallen at the fastest rate in more than 12 years. Moreover, the respondents report little change in credit conditions, suggesting that March’s events in the US banking system have not affected the pricing and availability of credit for UK corporates.

The general picture from the survey is of things turning out rather better than CFOs feared at the start of this year. Worries around Brexit and high energy prices have eased, and CFOs have become more optimistic about the outlook for inflation.

The announcement on 27 February of the Windsor Framework, which aims to improve the flow of goods between Britain and Northern Ireland, is likely to have reduced CFO concerns around Brexit which are now close to the lowest level in over six years. Falling energy prices, with wholesale gas prices down by almost 70% since December, and the absence of power cuts over the winter, also seem to have bolstered confidence.

The survey shows an improvement in CFO sentiment about the US economy that is consistent with recent upgrades for US GDP growth this year. Meanwhile, CFOs report a marked easing of supply chain and recruitment problems while expectations for US inflation in one year’s time have declined from 5.8% to 4.2%.

In the UK, consumer confidence is depressed but has risen from the all-time low it hit last September. Aided by an easing of supply problems, new car sales were 18% higher in the first quarter of this year than a year earlier. Employment has continued to rise, and the unemployment rate is close to its lowest level in 50 years. Although manufacturing profitability has suffered because of high inflation and slowing global demand, companies operating in the service sector and energy continue to post healthy levels of profits.

We shouldn’t get carried away, though. Sentiment about the UK has been helped partly by the fading memory of the financial and political chaos that followed last September’s mini budget. The pound, for instance, hit a 37-year low against the dollar in late September since when it has risen by 13%. While the latest data have been on the firmer side of expectations, the overall picture for the UK remains uninspiring.

Monthly GDP data shows UK activity flatlined between January 2022 and March 2023. Manufacturing output, which accounts for almost 10% of GDP, has been declining for over 18 months. Inflation has outstripped growth in average earnings for most of the last two years, depressing spending power. Housing market activity has nosedived, with housing transactions, mortgage approvals and prices softening. The volume of retail spending was 4.9% lower in the three months to March than a year earlier.

All that said, this year has not, so far at least, proved quite as challenging as had been expected. If Western economies can overcome a bout of double-digit inflation without falling into recession, they will have pulled off a remarkable feat. Whilst an economic ‘hard landing’ is still the more likely outcome, and more consistent with experience – a relatively ‘soft landing’ now looks less improbable than it did at the start of the year.

A third possibility of “no landing” has also crept into the narrative where world economies continue along a flight path that is neither too high nor too low.

Riding the currency cycle

Helped by firmer activity data, sterling has been the best-performing developed world currency in 2023. In recent weeks it has reached its highest level against the US dollar in ten months.

Economists have nudged up their growth forecasts for the UK, as well as the US and the euro area since the start of this year. Who would have thought that the British pound would be the top-performing major currency in the last quarter?

So, what is going on? There are two major factors.

First, the UK economy is not in the dire state that the Bank of England was projecting just six months ago. Many commentators are still cautious about the outlook for UK growth, but the actual data has been surprisingly robust. The latest figures showed no growth in February but there was a small upgrade for January, and it looks like Q1 GDP will show modest growth.

Second, the US Dollar has been weak. This reflects the change in interest rate expectations in the last two months. Problems with US regional banks and signs of economic cooling have led to expectations of a material cut to the Fed Funds rate in the 2^nd half of this year and this has made the US Dollar less attractive.

If you listen to US business programmes, a big theme is “de-dollarisation” i.e., the process of substituting the US Dollar as the currency used for trading commodities and reducing the exposure to USD within central banks’ forex reserves. Trends in geopolitics are playing a big part. There are several overlapping developments which are pushing countries to make a choice. Are you on the side of China or the US? Perhaps the question is slightly different: will you align your country with US policy?

It seems that, for a variety of reasons, a growing number of countries are deciding to be either neutral or hostile to the US. In part, this reflects shifting demographic and economic realities, as growing Asian, African, and Latin American countries become more important to the global economy. This fosters more independence of thinking and less reliance on the US.

But it also is due to Chinese policies. Over several decades China has pursued initiatives to embed itself into the economic ecosystems of less developed countries. This has seen China investing in infrastructure across countries representing approximately 60% of the world’s population and a third of global trade. These initiatives have been financed with a combination of debt and equity and it has resulted in greater China’s influence over a range of issues and policies. More recently, the Russian annexation of Crimea and the invasion of Ukraine has moved Russia more into China’s orbit; increasingly, their interests are aligned. Add in China’s brokerage of an Iran-Saudi rapprochement, reflecting China’s growing impact in the Middle East, and a narrative of de-dollarisation sounds feasible.

What are the implications for markets? The demographic trends are clear. Over the next few decades, there will be an economic shift away from Western economies; equity and bond markets will reflect the reality of these moves. Countries like India, Indonesia, and Brazil (these three represent almost a quarter of the world’s population) have massive potential and Western investors will need to widen their horizons. Discounted oil, bought from Russia, is giving many a competitive advantage in a vital area. Investors will address this changing landscape but there will be challenges along the way. Many of these growing economies have different attitudes to environmental, social and governance concerns and enforcement of property rights may be more difficult. It will not be a comfortable transition but, ironically, as globalisation takes a step back the case for more targeted investment into emerging markets increases.

A word of caution though: it has not paid to underestimate the US over the last seventy years.

Stock markets

Markets remain very macro-dominated as investors micro-analyse every data point to try and gain some insight into the future direction of monetary policy. Both interest and inflation rate expectations remain highly volatile. In the space of only a few months, markets have oscillated between pricing in a severe recession, a mild recession, and a soft landing and are now leaning towards a no landing scenario with a flight path that is neither too high nor too low.

Economic growth is the engine which drives returns for investors. Since the Covid pandemic, the world economy has been incredibly strong, and that has caused problems. Problems for central banks, for companies, and for investors.

Central banks determine the cost of capital (interest rates) and the capacity of capital (liquidity) in the financial system. Their formal mandate is to maintain low levels of inflation which has, unofficially, morphed into management of underlying economic stability. It was in this latter pursuit that they injected a level of monetary support in 2020 which was so excessive that it fired the starting gun on global inflation. That gun had substantial recoil.

While interest rates play their part, with a meaningful lag, the deus ex machina which central banks hope for is gently slowing economic growth, and a commensurate slowing in the inflation rate. But when interest rates rise quickly and liquidity dries up, especially to the extent seen in 2022, things break, starting with the most fragile. The failure of Silicon Valley Bank and Credit Suisse is a case in point.

Soft economic landings are rarely engineered from such extremes, and managing the next stages of this cycle will be wrought with complications, but, at least until the recent turmoil in the banking sector, the data has been encouraging.

While central bankers wait to see the lagged impact of their policies, companies are required to act now. Wage inflation is coming through rapidly. The competition for jobs is fierce outside of the technology sector, and firms are paying up. The result is a shift in the distribution profile of economic returns, from “capital” towards “income” and the corporate sector needs to foot the bill.

In turn, this causes concerns and uncertainty for investors. The tension lies between the welcome backdrop of strong economic growth and the likely contraction in corporate margins.

Uncertainty about the future path of interest rates, inflation and economic growth is currently the dominant force in investors’ minds but investment should never be about the short term. Investors wishing to predict short-term market movements need to assess second and third order effects simultaneously. Will wage inflation be sufficient to sustain the current levels of consumption longer than expected? Will a strong economy drive more hawkish monetary policy, in turn driving a weaker economy? Given events through the Covid years have been so extraordinary, is it possible that, despite the doomster’s predictions to the contrary, the economy is not heading for a recession at all?

“The farther backward you can look, the farther forward you can see.”

The future is inherent in investing and currently, the future is very uncertain, but it is always uncertain. 100% of what we know about an investment is in the past, but 100% of its value is in the future. We, therefore, need to consider the path of future events, even if they are uncertain.

In early 2020, the outlook for the global economy looked strong. Then Covid fundamentally changed that. In early 2022 when we were coming out of Covid, Ukraine was invaded. The future again changed quickly and profoundly.

Taking a 10-year view is something quite different with lots more uncertainty on the one hand but also more time for the average to kick in. Looking back 10 years, what did the world look like in 2013?

From memory, it was about as uncertain then as it is today and that is the point, it is always uncertain. We were five years on from the financial crisis and we were starting to emerge from the Eurozone sovereign debt crisis that followed. The growth of China’s middle-class and the emerging market investment story more generally were front of mind. The conventional wisdom said that long-term investors should have an exposure to the greater growth potential of the developing world.

Plenty of things lay in the future. We weren’t ignorant about the risks of pandemics, there were periodic scares about bird flu for example, but a global health crisis like Covid was not a mainstream concern.

David Cameron was starting to talk about a referendum on Britain’s place in Europe, but few would have imagined how that would turn out. Donald Trump was still just a property developer. Inflation and interest rates were low. Quantitative easing was starting to inflate financial assets but that was not obvious at the time.

Looking back at the performance of the various asset classes and geographical regions in the previous two years it had been something of a rollercoaster. In 2011 there had been quite heavy falls in many stock markets, especially in Asia and emerging markets but 2012 enjoyed a good recovery. In most cases, it had been a round trip that ended the two-year period where it had started.

Diversification had paid off with bonds offsetting shares in both directions. Investors were feeling a bit bruised by the previous few years, but it felt like we were through the worst.

At the time most investors almost certainly preferred shares over bonds as the economy continued to recover from the financial crisis. With inflation still low there was no panic about interest rates, but the expectation was that the long bond bull market was ending.

The US looked attractive despite its outperformance of other markets over the previous few years. Japan also looked promising as Abenomics gathered pace. China was still in the future. Problems in the European periphery continue to cast a shadow over the region.

And how would a diversified equity-based portfolio have done over the intervening decade? Well as ever it has been a mixed bag with some predictions coming to pass but there have been some surprises too.

The US turned out to be as good an investment destination as it looked at the time. It started with a solid performance in 2013 and kept going fuelled by a return to popularity of Big Tech.

The bond bull market was indeed past its best, but an investment didn’t lose money over the next 10 years in the safety of government bonds and holding some alongside shares would have given investors a smoother ride. If that encouraged investors to stick with it when things look shaky, they performed a useful function.

The China story turned out to be more impressive in economic terms than for investors. You would have done almost twice as well investing in Tokyo than in Shanghai and Shenzhen. Europe still viewed as a basket case in 2013 slightly outperformed the Chinese benchmark. Emerging markets did even worse than China in part reflecting in the poor performance of commodities over the period. Oil was the only investment that lost money over the 10 years.

Positioning a portfolio for the many potential futures requires substantial diversification, but also participation. Protecting capital against inflation requires growth in that capital; today, more so than ever. Sticking to cash is unlikely to succeed as interest rates lag far behind inflation. Rainy day investments such as inflation-linked bonds and corporate bonds can now sit alongside equity investments with significant return potential.

In times of uncertainty, it is often best to back strong multinationals which have the capability to withstand tough times. Companies which can cope with inflation and pass it on, companies with resilience and enormous pricing power right around the world.

Investors can take a cautious view of the world and still be fully invested. At times of uncertainty sensible diversification across a range of asset classes, sectors and geographical areas holds the key to beating cash and inflation and, as history has proved time and time again, provides safety by numbers over the medium to longer term.

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

April 2023

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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.