True lifelong financial planning for the serious business of life.
True lifelong financial planning
for the serious business of life.
True lifelong financial planning for the serious business of life.
True lifelong financial planning
for the serious business of life.
Tags: inflation, interest rates
Category:
Investment management
“Stock market corrections, although painful at the time, are actually a very healthy part of the whole mechanism, because there are always speculative excesses that develop, particularly during a long bull market.”
Rob Chernow; American writer, journalist, historian and biographer
Two things happened in financial markets in the first few days of 2022 which sent a clear signal that this year will not be for the faint-hearted. Both happened in America and taken together, they will set the tone for investors all over the world for the rest of this year.
On the very first stock market trading day of the year, shares in Apple Incorporation rose strongly and for a few days, the company was valued at more than $3trillion dollars. That is more than the combined value of ALL the companies trading on the Frankfurt Stock Exchange. Quite astonishing, although even more astonishing is the fact that Apple now has 750 million subscribers to its high margin services alone and made $365 billion dollars in sales in the year to September 2021.
A few days later the minutes of the December meeting of the Federal Open Markets Committee, which sets the Federal Reserve’s monetary policy, were published. Markets were shocked by the tone of the minutes which suggested that the Federal Reserve Bank of America might raise interest rates faster and sooner than they had expected just a month previously.
Suddenly investors realised that the Fed, the markets’ firefighter-in-chief, was serious about fighting inflation. The end of ultra-easy, cheap money was in sight.
The yield on ten-year US Treasury Bonds, the single most important benchmark in world finance, immediately rose to 1.76%, the highest level since the coronavirus pandemic struck in February 2020. In the first few days of 2022, the yield surged by 27 basis points, equivalent to a full 1% rise in short term interest rates. Long term bond prices fell by more than 10%, demonstrating that the supposed safety of investing in government-backed debt securities can be an illusion.
This opens up, for the umpteenth time, a familiar narrative. Bond yields that have been unnaturally low for years suddenly climbed higher, undermining the case for some wildly overvalued stocks, particularly in the tech sector, and sending risk assets into a tailspin. The shares in highly-valued growth companies which can only promise profitable earnings far into the future were sold off indiscriminately. This dragged down the shares in good, solid, highly profitable companies. The value of Apple Incorporation fell back to below $2.7 trillion, 10% below its value a couple of days earlier.
It is not difficult to see the causes of inflation. The expansion of central bank balance sheets by buying government and corporate debt after the credit crisis was followed by huge monetary and fiscal stimuli put in place to counter the economic effects of the pandemic. Given that the growth in money supply has vastly outstripped the increases in production of goods and services, it is easy to see why the price of those goods and services was sure to rise and ipso facto inflation must follow.
However, this omits another important element of the equation – the velocity of circulation of money. Are people more inclined to save the additional money or spend it? The savings ratio leapt after the credit crisis and again during the pandemic; partly no doubt due to caution but also because there were fewer opportunities to spend, for example on travel and vacations. However, money in circulation is now on its way back to pre-crisis levels, so maybe we have all the ingredients for inflation to take hold.
At this point, slight confusion would be understandable, particularly considering that the authorities spent most of the past decade trying to generate inflation in order to negate the deflationary effects of the credit crisis and its causes. But with inflation, as with much else in life, you need to be careful what you wish for. When inflation takes hold, it may exceed your expectations.
It can be like a bad cold, likely to get worse before it gets better.
The Fed had already bumped up the pace at which it would reduce its bloated balance sheet by trimming back on asset purchases, in what has become known as a “hawkish pivot”. Last year the Fed wanted to move cautiously away from an ultra-accommodative monetary policy to being more neutral but wanted to tread ever so carefully. But lately, it seems to be taking bolder steps to see if the market will throw its toys out of the pram and once again, like a petulant toddler, the bond market was threatening an outburst.
It does not take a stock market savant to figure out that the full withdrawal of monetary support and a simultaneous introduction of higher interest rates, along with the possibility of a Russian invasion of Ukraine thrown in, will present a challenging environment for markets.
But on this occasion, the rise in yields has come suspiciously quickly, in the limited liquidity at the beginning of the year. It also happened during a wave of the pandemic that seemed to be causing as much inconvenience as any previous one and is far from over. Yet the surge seems overdone.
Fund managers are always prepared for volatility. Indeed, volatility is their friend as they use setbacks in the market to add to their favourite stocks & shares, as demonstrated by the fact that buyers took advantage of the fall in Apple shares which soon recovered by +6%. The shares fell back again as Treasury yields rose further towards a level of 2%, a figure that has not been seen for some years.
A cool wind has blown across the world’s financial markets and that wind has been driven by an awareness that the tidal wave of cheap and easy money that central banks have created will come to an end sooner than expected. When that happens, investors will have to figure out what is valuable and what is not.
Shares in companies such as Microsoft, Apple, and Amazon which have a lot of profitable growth ahead still look an attractive home for long term savings but what about things that only exist in the form of lines of computer code; non fungible tokens (NFTs) and cryptocurrencies such as Bitcoin? What about the high growth tech companies that are yet to make a profit and whose future revenues have been discounted back to the present day at a negligible rate of interest to arrive at a stratospheric valuation? What about companies with low gross margins and no pricing power? Values could collapse.
We take comfort from the probability that the world is still in the early stages of a cyclical expansion. Despite the challenges, economies all over the world are booming. The cocktail of pent-up animal spirits, household net worth at all-time highs plus hefty measures of monetary and fiscal stimulus is a potent one. The fly in the ointment is inflation, from energy and housing to wages, raw materials and food. Too much money is chasing too few goods.
This will lead to higher interest rates but historically increases in interest rates associated with economic upswings have generally been good for stock markets. That is partly because economic growth will deliver solid profits but also because good businesses do give some sort of protection from inflation. If scepticism of the hyped-up tech valuations persists, and interest rates do indeed rise faster than expected, then investors will want to invest in exceptional companies that might be highly rated but not necessarily expensive, not poor companies that are lowly rated but are cheap for a reason. Exceptional businesses produce exceptional returns over the longer term.
The main challenge presently is trying to determine when the cyclical rotation narrative will come to an end. Sentiment is bound to remain fragile, particularly with the chilling hand of Vladimir Putin being felt on financial markets, but our Investment Committee thinks that we may be close to the bottom of this interest rate and long duration linked reset. Indeed, some fund managers are looking to selectively invest cash over the next few weeks. Cash weightings have gradually crept higher in readiness for a market pullback of the type we are now experiencing.
The key takeaway from this is that we at Clarion are not concerned about company fundamentals and are comforted by the higher quality attributes of names in which the fund managers invest. That said, we are very aware that the share price in a wide range of good companies can be correlated to lower quality tech names, which, after benefitting from the effects of quantitative easing, are seeing their inflated valuations pull back as interest rate expectations rise. This mini-tech bubble in the lower quality part of the market may be beginning to burst, in turn dragging everything down with them. We do not believe this to be a longer-term headwind and we know that the fund managers we select are concentrating on the earnings profile of their holdings, rather than fixating on the recent share price movements.
Technologies such as the internet, mobile, artificial intelligence, automation, learning and training are spreading out and impacting a far broader range of Industries. The golden era of technology may yet be ahead of us.
When it comes to interest rates, it is likely we will see three or four rate hikes in this and next year, with rates capped at 2%. Additionally, the peak rate for this cycle will be lower than that in previous cycles. This is due to the wider deflationary trend resulting from the effects of digitisation, reduced productivity and ageing populations. In terms of the market reaction to the Fed’s eventual rate hikes, it is likely that the market will price these in, so equity prices should not be negatively affected when rates rise. However, this is dependent on the Fed sticking to their agenda.
Further to the above point about the deflationary trends, it is worth reminding ourselves that whilst inflation is currently the buzzword, deflationary forces are still at work. These could lead to a levelling-off of inflation later in the year and put a cap on interest rate rises. Some additional points that will influence investors’ thinking in the months ahead are:
In conclusion, despite a difficult and unsettling start to the year, we are not presently planning any significant changes to the positioning of the Clarion funds and model portfolios. We will be paying close attention as the quarterly earnings cycle kicks off in the coming days, focussing on the fundamentals of the companies in which the fund managers we select invest. This normally marks a shift away from the market’s focus on the macro environment and we believe that it will be quite revealing in differentiating the profitable, high margin stronger companies from the lower quality, speculative tech names.
An increasing number of officials have uttered the word “endemic” more frequently in recent weeks while internet searches for the term have jumped.
It’s not just governments hoping that 2022 is the year Covid-19 can finally move to the back burner of public discourse. A weary public is also desperate to escape, and there is growing optimism in the air that life may soon return to normal.
Because Omicron is proving less malevolent than previous variants, even as it spreads faster, there has been growing talk that the worst pandemic of the past century may soon be known in another way: as endemic. Endemic would mean the disease is still circulating but at a lower, more predictable rate and with fewer people landing in hospitals.
It’s inevitable that governments will eventually need to regard Covid as one of many public health challenges that can be managed. But health experts are preaching caution, saying there’s too much uncertainty about how the virus will evolve, how much immunity society has built up, and the potential damage if people stop being careful.
Plus, endemic diseases can still cause a lot of suffering. Tuberculosis, which takes second place after Covid among the world’s leading infectious killers, caused about 1.5 million deaths in 2020.
As always, we thank you for your continued support and we look forward to updating you regularly throughout 2022. We invite you to get in touch if you have any questions.
Keith W Thompson
Clarion Group Chairman
January 2022
Creating better lives now and in the future for our clients, their families and those who are important to them.
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.
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