Stock Market & Economic Commentary – November 2023.

“Warren Buffett’s net worth is $84.5 billion. Of that, $84.2 billion was accumulated after his 50th birthday” – Quotation from The Psychology of Money

Economic Update

UK companies

A recent Deloitte survey of UK chief financial officers found that levels of confidence rose in the third quarter and are now slightly above the average levels of the last few years. Despite the headwinds facing the economy, and the weakness of growth, large UK companies are in good spirits.

The survey also shows that higher interest rates are reshaping attitudes to the financing of businesses. CFOs now rate bank borrowing as being more unattractive than at any time since 2007. Corporate bond issuance is rated as being even less attractive.

Higher interest rates have turned a decade-old consensus in favour of debt finance on its head. It is a measure of the shift in thinking that equity finance, out of favour for years, is now seen as being more attractive than either bank borrowing or corporate bond issuance.

What differentiates current conditions from those seen in the financial crisis, is that credit is still available. While pricing has deteriorated, much as it did in 2008, CFOs’ perceptions of availability have seen a far less pronounced decline. The financial system is operating efficiently, and larger corporates can access debt, albeit at a price.

Underpinning the shift in attitudes are lingering concerns about the outlook for inflation. CFOs see inflation running at 3% in two years’ time, well above the Bank of England’s expectation for inflation to fall to 2%. Firms’ operating costs have risen in the last 12 months and 84% of CFOs expect them to increase again in the next year leading to a defensive approach, with a strong focus towards cost control and building cash.

CFOs think inflation has peaked for this cycle, but they believe it will take a lengthy monetary squeeze to get inflation back down. That leads to a mood of caution regarding debt finance, but above average levels of business confidence testify to the resilience of the UK corporate sector in a world of elevated risk and slow growth.

The US

The US economy has had a good year. Not only has it evaded a widely expected recession, but growth has accelerated, and the inflation rate has halved. The US economy looks likely to grow by 2.5% this year against expectations in January of just 0.2%. Corporate profit margins are rising and almost 80% of those US corporates which have reported their latest results, have exceeded market expectations.

Instead of slowing in the face of the biggest tightening of US monetary policy in 40 years, growth has accelerated. How can we explain this exceptionalism?

Part of the reason relates to the structure of US debt. US homeowners are insulated from the immediate effect of higher rates by holding 30-year fixed-rate mortgages. Only when they move, and refinance, do households feel the effect of higher mortgage rates.

Corporates, especially larger ones, are also increasingly insulated from the immediate effects of higher rates. In recent years, many US corporates have protected themselves against the risk of rising rates by borrowing at long-term fixed rates.

High levels of consumer savings and corporate cash built up in the pandemic have also helped support growth. The fact that the US was not dependent on Russian natural gas and was a relatively light user of gas in any case, meant that last year’s energy crisis had less impact in the US than Europe.

There is no doubt, 2023 was a remarkable year for the US economy. The question is whether the good news will continue. This is where it gets murky.

The US economy faces two opposing forces in 2024. On the one side, the lagged effects of raising interest rates by over 5% are still feeding through the system. That points to higher credit costs, problems for more indebted corporates and consumers and to higher unemployment. The opposing force comes in the form of lower inflation which will support spending power and corporate margins.

History shows that soft landings for economies are rare. Major inflationary episodes are classic harbingers of recession, but the US has defied that narrative this year and by most accounts it has a fair chance of doing so next year too.

China

And more good news from China where consumer spending outperformed in October with retail sales rising 7.6%. Industrial production also beat expectations gaining 4.6%, but fixed asset investment growth missed target slowing to 2.9% in the first 10 months.

The central bank left its key interest rate at 2.5% and injected a net 600-billion-yuan equivalent to $83 billion into the banking system, the most since December 2016.

Stock markets

“The stock market is the only market where things go on sale, and all the customers run out of the store” – The Psychology of Money.

As we move into the final weeks of 2023 the movements in global bond markets, in particular developed market sovereign debt such as US treasuries and UK gilts, are likely to take the prize as the financial story of the year.

With losses on 30-year US treasuries greater than 50%, peak to trough, and UK gilts and some shorter maturities not far behind, what is the message from the biggest, most liquid markets – from which many other assets are priced?

When moves happen quickly they can feel out of control. Until recent weeks, the rise in US Treasury yields has been relentlessly upward, day after day. This can create an element of fear in markets and poses the question, what does the market know that we don’t?

The most objective and sensible explanation is a repricing of long-term inflation expectations, which leads to higher interest rate expectations. On the basis that long-term yields should gravitate towards the nominal – real plus inflation – growth of an economy (the so-called ‘Taylor’ rule), this suggests yields should be somewhere between 4% and 6%. At current levels, we are near the middle of that range.

This is different from the 2% growth and 1% inflation model of recent years – giving 3% yields – which were then weighed down by central bank intervention through quantitative easing (QE) to keep yields below the lower end of this natural level.

Effectively this means two things are occurring.

Firstly, the natural level of interest rates is moving up for economic reasons and secondly, central banks are no longer artificially pressing down on rates through QE with most enacting the exact opposite, quantitative tightening (QT). These two changes are happening simultaneously, which is leading to aggressive repricing of some elements of the bond market.

Consequences

The secondary question becomes, what are the consequences of this debt repricing? There are two impacts, one on the economy and one on financial markets.

With respect to the economy, there is an adjustment going on to a higher cost of borrowing. In the US, 30-year mortgage rates are now above 7%, compared to the average rate being paid today of slightly higher than half that figure.

To give an idea of how impactful that is, a median house with an average deposit has a monthly payment of more than double the amount of two years ago. Logically, this should result in lower house prices over time as affordability is key.

In the corporate world, businesses and industries which rely heavily on debt are equally troubled. This includes real estate and infrastructure.

To be clear, many of these businesses will be able to readjust by passing higher interest costs through to their end users, but some will not. London offices are an example of this, where some rent rolls do not cover the interest payments on the loans taken to buy or build the property. Some of these properties will be handed back to the lenders.

Financial markets also need to reprice to reflect higher yields. If an investor can achieve a 5% per annum return from owning US treasuries, then corporate debt needs to offer a premium to this, and it does. Equally equities need to reprice to increase their future returns to above investment grade credit. This can be done by lower prices, or higher growth, or by both. This adjustment has come a long way, but it is hard to be certain it has ended especially in some equities markets which, particularly the US, remain near recent highs.

Although dampened economic activity and lower asset prices is a downbeat combination, the readjustment process will take its course and eventually reboot markets for future growth and better investment returns.

Don’t worry, be happy

As Bobby McFerrin sang prophetically in 1998, in every life we have some trouble but when you worry you make it double. Markets have a habit of taking worries and problems and doubling down on them.

It can seem to be an overwhelming world at times, especially when reading the news every day. What is consistently underestimated is the remarkable ability of society and markets to adapt to changing circumstances.

Problems which seem intractable are resolved and each generation has the opportunity to live a better life than the one before. Whilst this may seem a superficial comment, it is a reminder that in investing, optimists tend to achieve better returns than pessimists, and that equity markets, when looked at over history, have had many more good years than bad.

There are several exciting and highly investable areas developing all over the world and innovation seems set to accelerate in the years ahead.

Whether it’s the ability to treat diseases such as obesity, Alzheimer’s and cancer, the use of generative artificial intelligence to make our lives more productive and interesting, or the continued efforts to decarbonise economic activity, all these are transformations at the early stage of their development.

It seems highly likely that we will be talking more about these in 10 years’ time, and less so about some of the issues that trouble markets and society today.

Santa Claus comes a-knocking!

One of the stranger aspects of investing is seasonal trends. Looking back over many years, in certain months of the year equity markets are typically down, and up in others.

For example, September and October are notoriously poor months, as we have seen again this year. November and December are seasonably favourable however, and upwards moves in these months are often labelled ‘Santa Rallies’. It isn’t clear why seasonal trends exist, and they aren’t perfect predictors, but in recent weeks it has felt like the Santa rally has arrived bang on time.

The recent rally in equity and bond markets took hold when the most recent US inflation data came in better than expected. This was quickly followed by UK data showing the same thing. Despite much scepticism to the contrary, inflation is indeed turning out to be transitory, at least in certain cases.

It helps to separate out inflation between goods and services.

Goods inflation is the area which has seen the most progress, with Walmart noting that they expect to see deflation in their product categories in the coming months. In hindsight, the pandemic lockdown created huge demand for physical goods as we had nothing else to spend on. This elevated demand created tension and bottlenecks in the global supply chain resulting in inflationary consequences. Expenditure on physical goods has reverted to trend, and even below trend in some cases, at the same time as supply chains added extra capacity. This has resulted in prices stabilising and, in some cases, coming down. Transitory indeed.

Services inflation has proved to be stickier, as anyone who has tried to book a holiday or flights can attest to. This area is still seeing pent-up demand from lockdowns, particularly in parts of the world which have only relatively recently come out of them. Even here though, there are signs of softening demand and lower inflation.

This improvement in the inflation outlook, whether it be temporary or not, has resulted in falling bond yields and renewed optimism that central banks can bring inflation back to their targets without inducing a recession; the so-called soft landing or ‘goldilocks’ scenario. Were this to occur, it would be positive for both equity and fixed income investors.

I would like to thank all our clients and introducers for your continuing support. As this will be the final edition of the Clarion for 2023, I would also like on behalf of all my colleagues at Clarion, to take the opportunity to wish everyone a very merry Christmas and a happy, successful, and healthy 2024.

The next edition of the Clarion will be in January, and we look forward to updating you regularly throughout 2024. We invite you to get in touch if you have any questions.

Keith W Thompson

Clarion Group Chairman

November 2023

Creating better lives now and in the future for our clients, their families and those who are important to them.

Risk Warnings

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