Stock market and economic commentary October 2022

“We cannot solve our problems with the same thinking we used when we created them.”

Albert Einstein 1879-1955. World Renowned Theoretical Physicist.

Economic snapshot

China’s party congress has confirmed a third five-year term for President Xi Jinping, making him the country’s most powerful leader since Mao Zedong. The war in Ukraine has reached an even greater intensity, as the Ukrainians make inroads on the ground, while Russian missiles pummel the cities and the country’s infrastructure. OPEC countries are attempting to push up the price of oil, to an outraged response from Washington. Midterm elections in the US may well change the balance of power in a country that is growing ever more polarized. US dollar strength against all major currencies continues relentlessly.

And yet, once again, it is the Keystone Cops performance of Britain’s leaders and their attempt to set an economic and fiscal policy that has dominated attention for most of the past month.

Stock markets

As we have alluded to in recent commentaries, we are undoubtedly in a painful bear market.

Bear markets are an unpleasant experience but are a necessary part of the investment journey. During bearish periods, a travelling circus of crises weaves its way through markets. Overloaded with negative sentiment, investors tend to focus on bad news and ignore the good news.

For most of the past six weeks, a cavalcade of chaos has been involved in a series of screeching U-turns around Westminster, Whitehall, and Downing Street with frequent visits to Threadneedle Street from whence it came.

The Bank of England missed a trick in September by not following the example set by the US and Euro Zone central banks in raising interest rates by a full 75 basis points to cool inflationary pressures. Against an already febrile backdrop, the new Truss/ Kwarteng UK Government popped its head above the parapet with a “mini budget” requiring extra borrowing of £45 billion at a time of rapidly rising interest rates, high inflation and a large current account deficit. A market storm ensued. Sterling touched an all-time low against the US dollar whilst UK bond yields surged, triggering a doom loop of disorderly selling by Liability Driven Investing (LDI) pension strategies scrambling for cash to meet derivative margin calls.

The Bank of England had to engineer a violent handbrake turn with a pledge to buy rather than sell long-dated government bonds to restore stability and liquidity. This bond-buying pledge displaced panic selling from fixed-rate gilts to the index-linked variety. This forced the Bank to extend its pledge to “Linkers”, increasing fears of financial chaos.

But the real problem lies with the Financial Conduct Authority, the Pensions Regulator and the Bank of England, all of whom ignored the preponderance of the Trustees of some Final Salary Pension schemes to engage in risky over-leverage of LDI strategies to try to squeeze higher investment returns from an otherwise boring government bond market.

High levels of leverage nearly always end in tears at times of market stress and it would be no surprise if the cavalcade of chaos revisits the home of final salary pension schemes before the crisis fully abates.

Meanwhile, Downing Street, where yet another new PM has now taken up residence, is likely to be bypassed by the cavalcade of chaos at least until publication of the twice deferred Fiscal Statement on 17^th November. A semblance of fiscal stability and political normality is hopefully about to return.

The 10/20/50 Rule

At times like this, it is worth remembering the wise words of great investors such as Warren Buffet and Benjamin Graham. Both were believers in the 10/20/50 rule for equity investing. This states that in most years, equities will fall at some point by 10% due to a non-systemic issue, such as trade wars, and then quickly recover. Every five or six years there will be a recession, leading to a fall of 20% in equity prices. And every 10 years or so, there will be an issue so systemic that equity prices will fall by up to 50%. It’s only a rough rule and not exactly scientific, but it is a useful guide and prepares investors for stock market falls and volatility.

Although the past is no guide to future performance, following previous bear markets, equities always recover, recoup their losses and then make new highs. The last two 50% declines in equity markets were 2000-2002, when an economic slowdown after the technology bubble, accentuated by the terrorist attacks of 2001, led investors to abandon equity investing. The other, during the financial crisis of 2008-9, was led by a near-collapse of the global banking sector.

No one knows, with the US S&P 500 having fallen by more than 25% peak to trough and the Nasdaq down almost 40%, if the current conditions will turn into a bear market of the 50% variety but there is a growing feeling among some commentators that we might be close to the bottom of this down cycle in stock markets, if not the economy. One thing we can be sure of is that we are nearer to the end than the beginning.

How do bear markets end?

Currently sentiment in markets is very negative. Measures of investor sentiment, often used as contrarian indicators, are near historic lows. Most investors are now aware of the inflationary and economic problems the world faces, in a way they were not, only a few months ago. Counter-intuitively this is a good thing, as it suggests expectations in key investment markets are starting to reflect reality.

At current levels stock markets could be more sensitive to unexpected, good news (Europe’s energy crisis may not be as bad as feared; Russia’s military position in Ukraine is weak and Putin’s position is fragile; signs that inflation is nearing a peak; a change in central bank policy; the US dollar may weaken) than further bad news. The economic outlook is darkening, and inflation is not yet under control, but everyone thinks that which is noteworthy.

Bear markets tend to end quickly. Hemmingway was asked how he went broke, to which he answered “gradually, then suddenly”!

Bear markets are like that. They start gradually as many investors don’t see or acknowledge the change in circumstances. They accelerate as investors see the reality, then panic and sell for emotive rather than rational reasons. This tends to lead to the last leg of a bear market which happens quickly as investors capitulate.

Bearing in mind the severe market falls of the last few weeks we may already have witnessed investor capitulation. We will only know with the benefit of hindsight.

Once this has happened, the next bull market begins, born from despair and low valuations.

Bear markets always provide some very interesting buying opportunities and throughout the downturn, active fund managers have been picking up the shares of quality companies at cheap valuations, low multiples and strong balance sheets protect longer-term value.

There are risks but also many opportunities which is the nature of markets.

What is the future worth?

We are living through a time of falling asset prices. It started with the most liquid assets – equity and fixed income – and will very likely soon appear in less liquid assets, such as property and infrastructure.

This fall in asset prices has its origin in rising inflation, and therefore interest rate expectations. Interest rates, alongside future profits, are a core input into the value of assets and given that the value is based on the future profits created from it, discounted back at an appropriate interest rate, it begs the question, what is the future worth?

In recent decades, the future has been worth much more than in the past. If we go back to the early 1980s, it was a world of high inflation and double-digit interest rates. Over the next 40 years we saw a steady downtrend in inflation and therefore interest rates, as technology and globalisation, among other things, had a favourable influence. Equally, there has been a sustained and material increase in the profitability of companies, as a combination of innovation and operational efficiency has allowed businesses to make much higher profits.

Falling interest rates and rising profits have been a potent and positive influence on asset prices, one feeding on the other to result in a material increase in value. We are now in a time of concern about the path of both these variables, which in turn is leading to stock market volatility and lower asset prices.

So, is the best time to own assets behind us? Yes and no.

There is little doubt the tailwind from falling interest rates is behind us. In a mathematical sense, it had to end. Falling from the 15% level of the early 1980s, we had reached levels close to, and in some cases below, zero.

At best, interest rates would have remained flat, instead they have ratcheted higher as central banks seek to rein in inflation. The speed at which interest rate expectations have increased has been astounding. At one point, shortly after the UK government announced its new, now abandoned, fiscal plan, fixed-income markets were discounting 6% interest rates in the UK by the end of 2022. Stepping back from the market panic, this seems highly unlikely due to the economic damage it would inflict, but it is symptomatic of how unanchored expectations have become.

At current levels, stock markets are strongly suggesting that interest rates in the range of 5-6% would be a massive overkill, as reflected by double-digit falls in September and October.

Whichever way we cut it though, we will have to get used to a higher level of interest rates, at least for the foreseeable future, than in recent years.

Good news

More positive is the long-term outlook for the profit side of the equation. One way of thinking about the world is atoms, bytes, and genes. Everything around us is made from one of them, so following trends in these areas is a great proxy for innovation and future profitability. In recent years we have seen the evolution of artificial intelligence (bytes), mRNA (genes) and semiconductors (atoms) in ways not predicted even a few years ago.

In many ways, we are only just getting started and there is a high probability that innovation will continue apace. Investors who focus on innovations that make the world cleaner, safer, healthier, and more inclusive will see corporate profitability increase in coming years. In the short term, this may be impacted by weaker economic conditions, but the trend towards innovation, decarbonisation, digitisation, and improved healthcare will continue.

We are undoubtedly facing a stormy winter economically but there is plenty of good news out there. For instance, the Global Innovation Index is a league table we seldom read about. In 2022, of 132 countries ranked worldwide by this Index, Britain was fourth, only behind the US and two smaller European economies, Sweden and Switzerland.

The UK is an attractive destination for international companies because of our outstanding universities, our legal system, the ubiquity of the English language and skilled workforce. The weakness of sterling, whilst a negative in some respects, makes the UK even more attractive to overseas investors.

In the first half of the year, British technology firms raised close to £25 billion in venture funding alone – second only to the US. Apple & Google, which already have a sizeable presence here, have unveiled major plans to expand their British outposts. Amazon is hiring 4,000 new employees in 2022 in the UK taking its workforce to 75,000.

The vision of Britain as a post-industrial, failing economy which currently pervades the financial markets and national debate, could not be further from the truth. The nation’s world-beating research universities – Oxford, Cambridge and London’s Imperial and University College – are huge sources of pride with their technology and life sciences spin-offs.

Thanks to the success of AstraZeneca, and that of its rival GSK, in developing vaccines and treatments for diseases including meningitis, HIV, respiratory conditions and not least our world-leading Covid vaccinations, the UK has become a magnet for inward investment in pharmaceuticals.

Britain also remains the number one venue in Europe for new high tech, ranging from artificial intelligence to fintech and the online gaming sector.

In aerospace, Britain has two European champions in BAE and Rolls-Royce, as defence budgets around the world are ramped up in the face of Russia’s brutal war on Ukraine.

The fall in sterling has been destabilising in recent weeks. But as we learnt after the UK was ejected from the exchange rate mechanism in 1992, when the pound depreciated, it was followed by a golden period of above-trend growth.

Putting all this together, future returns may be lower than in the past as only one of the two variables, profits, driven by innovation and advances in technology, will be a tailwind in the coming years. That said, this does not mean that future returns for investors cannot be attractive. Indeed, fixed income looks much more attractive now after its correction, and equities have removed any overvaluation that may have been present at the end of last year.

Better news on inflation

Meanwhile, back to the US battle against inflation, there were some encouraging communiques at the end of September. First, the National Federation of Independent Business, a lobby group of small companies, published the monthly survey of its members’ opinions. Over the half century it’s been running, the survey has proved to be very useful as a leading indicator. When it set extremes for the proportion of executives complaining that it was hard to recruit people, and saying they planned to raise prices, this was (very reasonably) taken as bad news. While both measures remain high, they were down sharply in September, particularly in the case of planning price hikes.

Then on the issue of inflation expectations, held by some to be a crucial driver of price rises, the latest survey of consumer expectations from the New York Fed is also extremely encouraging. Expectations for the next year remain high but are coming down swiftly. Expectations for three years from now ticked up very slightly but remain below 3%, the upper range of the Fed’s target:

It’s only a survey, but it’s one on which the Fed puts a lot of weight. And if inflation were becoming entrenched, we would expect the three-year expectation to be rising still. So, some real evidence that the flight path to an economic soft landing, while still uncomfortably narrow, might be there if the economic authorities can navigate a steady course.

And back in Europe, natural gas storage in the EU is now almost back up to pre-war levels thanks to a supply switch from Russia to Norway and Algeria. Wholesale gas prices, and several other commodities, have fallen significantly in recent weeks.

Unfortunately, the political ructions in the UK, and anxiety about CPI data, ensured that nobody seemed to notice these snippets of good news.

Amid all the recent pessimism, there are encouraging nuggets of good news suggesting that the present time is undoubtedly a favourable entry point for investors. In conclusion, we firmly believe the future is worth more than the past, and that will be to the long-term benefit of investors. Better times lie ahead; they always do.

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

October 2022

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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.