Stock Market & Economic Commentary - August 2024

“If you’re not grateful, you’re not rich, no matter how much you have.” – Sir John Marks Templeton – 1912-2008, American born British investor, banker, fund manager and philanthropist.

Economic Update

The UK economic outlook has brightened in recent months. Growth has come back more quickly than expected, inflation is running at a third of the levels of a year ago and last month the Bank of England cut interest rates for the first time in more than four years. Agreed, the UK has plenty of problems, above all a low rate of productivity growth but even on this troubled front there has been positive news.

A recent study from the Office for National Statistics (ONS) shows a marked improvement in the average quality of UK management. The study covering a period of three years to the end of 2023, found that firms have become better at managing staff performance and promotion and more effective in dealing with underperformance.

The ONS does not offer reasons for the improvement. It is possible that as the post-pandemic jobs boom fizzled out, the balance of power in the jobs market shifted from workers to companies. With the labour market cooling, and the UK in recession in the second half of 2023, companies seem to have tightened up on performance management.

Unsurprisingly, management quality has a huge effect on productivity. (This helps explain the surge in a company’s share price when a new, highly rated CEO is appointed – and the depressant effect of the loss of a well-regarded CEO.)

Research by Havard Business School Professors Bloom, Van Reenen and Sadun found that management practices explain 55% of the difference in levels of productivity in the UK and the US, countries that lead on productivity and management quality.

In the UK, management scores vary enormously across different types of business. The ONS found that larger businesses do better than smaller ones in terms of management quality. Foreign-owned companies outperform UK-owned businesses. Family-owned or managed businesses tend to underperform on management.

So, the form of ownership has a huge effect on productivity. Previous ONS research found that in the same sector and region and with companies of the same size, foreign-owned businesses were 74% more productive than UK-owned businesses.

A working paper published by the UK’s The Productivity Institute earlier this year found that private equity ownership tends to raise productivity noting that, “active investors, such as PE and venture capital, provide important boosts to managerial skill sets and effective governance.”

Some important messages come out of all of this.

First, and obviously, management quality is a crucial driver of productivity. Second, operating in the same environment some types of businesses – larger, foreign, or PE-owned businesses – outperform in terms of management and productivity. Third, businesses can move quickly to sharpen management practices, as happened in the three years covered by the ONS survey.

Unlike so many of the solutions touted for Britain’s productivity problem, management practices can be improved quickly, at relatively low cost and by the owners and senior management of the business. There is no need to wait until the UK sorts out its infrastructure, vocational training or any of the myriad of other factors that have been blamed for Britain’s low productivity growth.

The fact that foreign-owned firms get this right or that active investors can drive improved management quality, shows that this is a “portable” advantage. The rise in the UK’s ranking in the ONS survey demonstrates that change can happen quickly.

UK management does quite well by international standards. The World Management Survey has been mapping management practices since 2003 and puts the UK in sixth place in a field of 35 countries. The UK comes ahead of France, Australia, and Singapore but way below the US and Germany. The ONS concurs that the UK could do better.

The long and agonised debate about Britain’s productivity problem has produced many theories but no quick, low-cost solutions. Sharpening management quality seems like a good place to start.

Stock Markets

The dog days of summer

“The dog days of summer are the hot, sultry, days of summer.” They have historically related to, as per Wikipedia, heat, drought, lethargy, fever, madness, and bad luck.

While anyone witnessing another disappointing British summer may feel disconnected from this idea, investors will relate to the madness and bad luck of stock markets in the early days of August when most equity traders were working from home watching Armand Duplantis break the Olympic and world pole vault record.

The scale and speed of the sell-off in global equity markets on the first Monday of the month took investors by surprise. As always, share price movements drive the narrative.

At first glance, the wild gyrations in markets appear to have been driven by concern that the US Federal Reserve had been caught napping and had kept interest rates too high for too long thus increasing the possibility that the US economy would fall into recession.

Weak labour market data together with gloomy evidence on the state of the country’s manufacturing, induced sharp sell offs in the crowded and exuberantly valued areas of the US equity market. In short, an army of momentum traders was drastically wrong footed by extreme volatility in thin August markets.

Yet the recession fixation borders on perversity given the US economy was growing at 2.8% in the second quarter and that a weaker labour market is a pre-condition for achievement of the Federal Reserve’s 2% inflation target. A reminder, if one was needed, that one of the hazards of data dependent monetary policy is the constant overreaction to the release of new economic information.

There will of course be a recession at some point. Most investors thought this would occur last year, but it didn’t, and some investors missed out on a year of strong returns. Will one occur this year? Maybe, but recent evidence is that economic growth has been quite strong and interest rates throughout the world, with the exception of Japan, are now beginning to fall.

Recessions are the exception, not the rule, in economies. This is worth considering when building an investment decision around the possibility of one and the consequences of getting that call wrong.

A growing disenchantment with the power of AI to transform the business world was also cited as a possible reason for falls in the share prices of the US “Magnificent Seven” tech stocks.

It is not unusual for doubts to creep into investors’ thoughts when the hype surrounding mind blowing new technology dies down. Ebullience followed quickly by despair, followed by more ebullience, was seen when the internet came to pass in the late 1990s. New technologies always go through peaks and troughs of enthusiasm, and the skill is not to become over or underexposed at these times.

And yet a more fundamental reason behind the sky-high volatility is the relative monetary shift between the US and Japan. While the Federal Reserve has hinted that a rate cutting cycle will begin in September, the Bank of Japan has shifted policy aggressively and raised interest rates for the second time this year. It also signalled an end to its bond purchase programme and a start to quantitative tightening.

The consequent rise in the yen, which has long been the school chump of the currency markets, caused a rapid unwinding of the yen/dollar carry trade whereby investors borrow in the low-interest rate Japanese currency and invest in high yielding assets elsewhere, particularly US tech stocks. The panic caused Japanese stocks to fall more than 12% in a day, the biggest daily fall since 1987.

Rapid recovery

But within a matter of days, global equities had rebounded from their early August slump after investors were buoyed by a run of reassuring good news from around the world.

US economic data showed that the economy was slowing, although that is to be expected after two years of a rate hiking cycle but was holding up much better than feared. Consumer spending was proving to be resilient and confirmation of lower than expected new jobless claims provided further evidence that the US economy was moving smoothly towards a soft landing.

Inflation figures showing that annual consumer price rises had eased below 3% for the first time since March 2021 provided a further boost to investor confidence.

In short, the data was neither too hot nor too cold and just the right temperature to encourage the Federal Reserve to begin cutting interest rates at their next meeting in September.

In the UK, the doom-mongers were once again proved to be wrong about the resilience of the economy. In the first half of the year output powered ahead supported by a buoyant services industry, improved investment, and an uptick in exports. In the three months to the end of June output grew by 0.6%. This followed a surprise 0.7% expansion in the previous three months.

Investec Investment Bank declared that “The sun is breaking through the storm clouds” as the UK was confirmed as being among the best performing of the group of seven (G7) richest countries.

The engine of the UK economy is the hugely dominant services sector which covers financial, professional, and business, IT and tech innovation as well as the creative industries but, in the past three months, manufacturing and construction have also contributed to the healthier picture.

Soothing words from the Governor of the Bank of Japan that future interest rate rises would be “measured and take into account market volatility” calmed the currency markets allowing an orderly unwinding of the yen/dollar carry trade which many commentators thought was the root cause of the market volatility in the first place.

Market volatility

And so almost as quickly as it started the stock market panic was over, but August’s market activity was a reminder, if one was needed, that markets do not go up in a straight line. This month’s rollercoaster ride demonstrates how market narratives can swing based on single data points and lead to increased volatility which can test the nerves of the most seasoned investor.

The VIX index, often referred to as the fear index, a measure of market volatility surged from 14 on the 1st of the month to a high of 65 on 5 August reflecting heightened investor anxiety.

Volatility is a feature of investing but when markets fall suddenly and dramatically for no apparent reason, investors can become nervous and wonder what to do. Ignoring panicky headlines, or panicky charts can be a hard task.

Yet even if it was possible to successfully cash a portfolio before the worst of a market dip, there is an even bigger problem, when and where to reinvest. There is always a long list of seemingly compelling reasons to avoid buying back in, and while pondering these risks months can tick by and long-term investment plans can start to go off course.

One reason for this is that big market falls are often followed by very quick rebounds as investors realise that short term noise is not as gloomy as first thought.

Consider, for instance, the events of March and April 2020 in the early days of the Covid induced stock market panic. Or, for a more recent example, look at Japan in the first few days of this month. The Nikkei may have fallen 5.8% on Friday 2 August and 12.4% the following Monday but rose by 13% over the next five days.

In fact, over the past 15 years, Japanese equities have plummeted by more than 5% in a single day 10 times. Leaps of 5% or more occurred eight times and these happened on average within a week of the sell off. For investors who missed the rebound days, the total return over the period would have been 140 per cent instead of 184 per cent for those investors who remained fully invested. That is a hefty sum forgone for just 8 days.

The US S&P 500 fell by more than 3% on Monday the 5th of August, the biggest one day fall in 2 years and then rebounded by almost the same amount a few days later, the biggest one day rise in 2 years.

In summary, while the recent volatility has been unsettling, history suggests periods like this are more likely to pass than not. Forced and panic selling helps to build long-term returns for those who can take advantage of the market falls. Thinking long term is the answer and whatever happens do not try to time the market.

Read more about this volatility and the need for patience in this interesting article..

Investing for the long term

The most over-used claim by market participants is to be “long-term” but long-term as an investor should really be measured in decades, given most investors will begin their journey multiple decades before they need to harvest the fruits of their investments.

For professional investors, the decrease in investment time horizons has been the most notable trend of the last few years. It has become much easier to buy and sell shares, and the media industry has gravitated towards short-term headlines and a “bad news gets clicks” mentality.

None of these developments have been positive as it has created an army of traders, not investors, and built a fundamental mismatch in how many investors invest and what drives long-term returns.

For equity investors, what happens in any given year should be relatively immaterial. For example, for a company whose shares are worth 20x its annual profits (or earnings as the industry calls them) each year of profits is worth 5% of the current share price.

In theory, if that company made no money for a year, perhaps due to a recession, it should have minimal impact on the long-term value of the company. It would however have a major impact on its share price, which based on past experience could be down 30-50%.

What really matters in valuing a company and in long-term investing, is not what happens in the next few months, or even the next few years, but what happens further out on the horizon. This is the premise of our approach to investment. When we look out many years, we expect to see a cleaner, healthier, safer, and more inclusive society than we have today.

We can also see many avenues to get there, and good companies will thrive in creating value for their investors and for society. In this context, what value is there in trying to forecast recessions or understand yen/dollar carry trades?

Of course, the answer is none. All investors need to be aware of economic, geopolitical, and other types of risks but these issues do, over time, usually shrink in importance relative to societal progress and corporate profit growth. Unfortunately, media headlines do not support this. Few media outlets ever write “billions wiped onto the value of shares” which has been the actual story of the last two years.

If, as an investor, you are struggling to think long-term then there are some things which can help.

First, very few things are as important in the moment as they seem in the fullness of time. Even Covid, the most invasive event that many of us have had to deal with, has found its respectful place in history and equity markets are higher than they were before it. Becoming less sensitive to short-term events is a positive in investing.

Second, as we have said many times before, optimism is the only rational mentality to have as an investor. There is no long-term investor in equities in history that didn’t have a positive outcome remaining invested in a broad range of good quality companies. To be pessimistic is unlikely to be successful. Of course, there is a caveat. We must be able to judge the success of investments over many years, not over a few months, or in today’s world of instant valuations, daily.

Interestingly in a recent interview, Magnus Carlsen, five-time world chess champion, noted that being an optimist had made him more successful as a chess player as it had allowed him to see scenarios and moves that a more pessimistic bias would have missed. Investing is the same, being optimistic about the future allows us to see opportunities and gains that pessimists often miss.

We remain optimistic about the future and confident that high quality investments will continue to deliver good long-term returns for investors.

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

August 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.

Stock Market & Economic Commentary – August 2024