June 2022
Investment update
Part 2
Welcome to our latest market update
Yet again, it is one of those month’s where one update isn’t quite enough, given the pace at which things are moving right now. We hope you find these updates useful. And a word of guidance up front. This is a bit of a bumper edition.
And our thanks to our friends at Charles Stanley for their input into this update.
The importance of the complete and unbiased picture
When we consider investments, it is important to always maintain some perspective to mitigate the biases that we sometimes see in the press and on the news. It’s a statement of the obvious, but we will make it anyway. Any distortion of perceptions can easily mislead decision making.
Let’s provide a little bit of context. Over the past few weeks, we have seen a number of examples where misleading information may have helped to distort perceptions. Over the past few weeks, we have read numerous stories about cancelled flights and long delays at certain airports and having spoken to many clients and friends who are finally going away for the first time in a few years, this is unsurprisingly adding to jitters. As a result, this type of news is increasing tension rather than reassuring the travelling public. For example, it is estimated that over the past few weeks EasyJet has cancelled on average 75 flights per day.
Now, this sounds like a large number and these figures are easy ‘news stories’ to sensationalise an issue about a shortage of job applicants and the travel industry not reacting quickly enough to replace staff after lockdown. However, if we put this into perspective and look at the issue from a more realistic angle, EasyJet flies 1700 flights, across Europe, per day. 75 cancelled flights represent only 4.4% of the daily number of flights. Whilst, of course, this is great if you’re affected, it does mean that 95.6% of flights are not affected by cancellation. The media certainly doesn’t give the impression that it is only 4.4% of EasyJet travellers being affected by this problem.
Data and population statistics are another great example. Participants in a recent YouGov survey in America stated that they believed that 41% of American adults were black, whereas the true percentage is 12%. They were off by a factor of 3.5. Closer to home, the wonderfully named Campaign for Common Sense also commissioned YouGov to conduct a similar poll. Unsurprisingly, the UK survey highlighted similar misconceptions. In another example, respondents significantly overestimated the proportion of British adults who are vegan by a factor of over six (20 per cent v 3 per cent). As a result of being constantly bombarded by news, this is leading to distortions, which give a misleading impression of the world in which we live.
Closer to the investment world, there is also a perception that institutions are able to accurately predict trends. The Government is not necessarily very good at producing reliable cost forecasts or predicting spending patterns. During a presentation the other day, we were staggered to see that the Bank of England (BoE) spends £37 million each year on predicting the level of inflation here in the UK. Unfortunately, as you can see from the following chart, they are wrong most of the time. This is the organisation that sets policy on interest rates and issues data that many people will use to calculate cost of living and wage increases. This in itself doesn’t make it a problem - it just highlights how difficult it is to forecast this type of data.
We also read many articles stating that the UK will see a recession in 2023. The cynics will naturally believe (or say that they know) that most economists have an appalling record of predicting recessions. Many others will inevitably believe what they read and become increasingly concerned!
When we review, we may learn that an awful lot of the negativity being reported by the media might not necessarily be that accurate, but the damage has already been done. Despite the misleading bias of the media, we do appreciate that there are a lot of problems out in the real world and there are issues and events that we need to focus on and actions that we must get right. We also need to ensure that we look at information from the correct perspective.
A few weeks ago, we spoke with a leading economist who pointed out that this summer the key metrics to watch are the inflation figures in America and the way in which the central bankers change their dialogue as we move through the summer months. Currently, central bankers are adopting a very cautious, and therefore aggressive, approach as they try to manoeuvre economies through the current cost of living crisis and try to regain some control over the inflation scenario that has spiralled out of their control over the past six months.
The fact that central banks, like the Federal Reserve, are putting up interest rates by 0.75% rather than usual 0.25% is an indication of how aggressive they intend to be. Initially they believed that inflation would be transitionary and would normalise, but it has become far more entrenched, hence the change in strategy. However, as we move through the summer, we could see central banks bow to political pressures and subsequently see the dialogue soften. This in turn should encourage investors and that could be the point at which we will see a recovery in equity markets. We hope it happens sooner, but we also have to be mindful that we could remain in a period of volatility over the next few months.
We still see believe that inflation expectations will improve over the next few months, and we have to see how quickly they can return to the governments’ arbitrary 2% target level. However, if it remains sticky - around 4 to 5% - on the way back down, then there is still a problem. At this point central banks will be forced to continue tightening just at the time when people are starting to believe that the situation is improving.
On the basis we now know how difficult it can be to accurately predict future events with anything like a high degree of certainty, we have to be very mindful that central bankers may appear to be doing too much and so signal to markets that there may need to be more changes than they actually need to do. The current consensus view, after the 15th of June meeting, is that US interest rates could get as high as 3.8%.
Current problems
The problem investors face at the moment is that although, technically, parts of the US market are in bear market territory, a strong majority of big investors still expect interest rates to be higher than previously expected. This could be tough for the stock market to digest as, for most of this century, investors have benefitted from the fact that interest rates usually fall at times of difficulty. We are now in an unusual position where rates are increasing during a period of difficulty. It is decades since a market sell-off has been met with higher interest rates and few people active in finance today have any experience of this scenario. We need to accept that the Federal Reserve (Fed) and the Bank of England (BoE) aren’t going to arrive like the proverbial US cavalry this time.
After ten years of low interest rates and accommodating central bank policy, we know that a large part of the reason markets have fallen this year has been a reversal of the easy credit we saw in 2020/21. We understand the huge amounts of money governments created to deal with the pandemic. This was the fastest money creation on record, and it has subsequently been followed by the most drastic compression on record. Hence the resulting a period of higher interest rates and tightening economic policy.
Investment houses also have to look at company earnings expectations to work out if a market is expensive or cheap and to try and assess how they should be invested. Common sense dictates that a cheap market can always get cheaper but understanding company earnings expectations is critical to choosing which stocks offer compelling returns over the longer term. These can usually be broken down into two components. Firstly, the earnings you expect a company to make in the future, and secondly, the multiple of those earnings the investors are prepared to pay.
We appreciate that valuations can certainly go lower from here, but the question now remains whether the earnings expectations on which most current multiples are based are accurate. Whilst it may seem obvious that company profits are falling, we know that higher commodity prices will eat into profit margin and revenues, higher interest rates will increase financing costs, higher wage demands will tighten margins and so on.
The S&P earnings expectations are forecast to increase by 3% this year and, more importantly, the fact that there is resilience in corporate earnings, when we would normally expect them to be pulling back, suggest genuine confidence amid the brokering community. If profits do rise this should help restore some form of momentum. So, although the news continues to look increasingly pessimistic, we don’t necessarily share all of the doom and gloom that is written in the media.
We appreciate that it is extremely frustrating when we experience a fall in the markets, but the investment houses we use still believe that the longer-term themes they we have built into portfolios remain extremely relevant.
What do the good people at Charles Stanley think?
In a break from tradition, we are going to hand over the rest of this edition of In Focus to our partners at Charles Stanley for their unique perspective on things, including how they have approached the last few years and their expectations moving forward.
We think it’s important to stress that, whilst it is impossible to predict the future, we believe that the funds in our portfolio remain robust and that the reversal in their performance is not because they have stopped doing what they do well. Rather, it is simply a fact that the cost-of-living increases combined with the war in Ukraine have forced markets to move from looking at things from a longer perspective i.e. the global drivers of the future, to more short term i.e. to less than one year.
It’s important to look at things from a realistic-term perspective. We believe that the themes in our portfolios (demographics, healthcare and nutrition, technology, renewable energy, and climate change) will continue to drive out performance going forward, and that the depressed prices at the moment simply reflect scepticism that they can recover, which we feel is unfounded. We are undoubtedly in a very difficult period, and we are not in any way trying to be complacent, but we don’t feel that it is right to capitulate as this means that clients miss out on the long-term growth story.
We appreciate that, with hindsight, we could always have always done things differently but, last year growth was scarce and therefore assets in that sector were in demand. We do not profess to have the skill in timing markets perfectly, instead we prefer to stick with a long-term view and identify the places to focus on which will benefit in the medium to long term. We are aware that being underweight in the UK market has not helped in the last few months, but we are still very wary of the UK economy and the fact that company earnings will slow quickly as margins are being squeezed. Outside of Europe we are seeing far better economic growth in America and Asia, even in China.
As you can imagine we have considered the market moves very closely and we still feel that the bigger picture hasn’t changed. We still think that many of the thematic issues that we have been talking about remain extremely relevant.
-
As governments try to regain control over power generation, we will see increased demand for renewable energy to reduce the reliance on oil and, more importantly, gas. It is going to take some time to expand the infrastructure but that has already started.
-
Healthcare is going to remain a very important sector as populations continue to grow older and with life expectancy continuing to expand. This will increase demand on healthcare systems and stretch budgets. In addition, governments need to encourage their healthcare providers to move from reactive medicine to preventative medicine and reduce costs but, more importantly, improve the patient outcome. Therefore, we think that many of the topics within healthcare are going to become much more important over the next few years.
-
Asian populations continue to expand and the growth in middle-class earnings is expected to increase phenomenally. Therefore, we think that these economies will increase in their importance. I appreciate that China has been quite volatile but, looking forward, the innovation and growth in that economy will provide the power behind which the Pacific Rim will continue to grow.
-
We appreciate that technology is looking wobbly at the moment, but it is still going to drive innovation and productivity improvements over the next few decades, and we still expect to see some good returns from the sector. Prices may continue to experience volatility as they seek their new base level and once that’s found, we would expect returns to improve significantly.
It is important that we continue to avoid going down the wrong path and hoping that things will go back to the way they were could be a big mistake, hence the reason why we feel that the long-term trends will eventually kick in. Unfortunately, we just don’t know when, so we have to keep some exposure to markets so that we don’t miss out on the best returns.
American inflation is important and the fact that we saw a dip in April led some people to believe that we could be over the worst. However, we were always mindful that the figure could creep back up again in May. This has obviously had a big impact on markets over the past week but wasn’t necessarily unexpected given the movement on the price of gas and oil. We are monitoring the situation very carefully and hope that the American markets stabilise, which would in turn mean that the rest of the world should follow suit. Unfortunately, here in the UK, we could be in for a slightly rougher time as we don’t necessarily have the economic growth enjoyed by Asia and America of late. Hence why we still have an underweight UK exposure.
As you can imagine, we read a lot of commentary about movements in the market; some very optimistic and some less so. One of the most optimistic we’ve read was from JP Morgan analysts, who are not normally known for being overly optimistic. They believe that the interest rate rises expected over the next few months, will not go quite as far as many investors expect. As a result, they believe that a near-term recession in America will ultimately be avoided. They expect markets to recover the year-to-date losses in the second half of the year and, as a result, stock market will finish roughly flat for 2022. They do, however, concede that markets will remain choppy over the next few months as investors continue to worry about inflation, central bank policy, and the slowdown in economic growth. But they also believe that we have passed peak ‘hawkishness’.
We have also seen a report from Berenberg highlighting that, despite a significant equity mark sell-off in the last few months, there is little sign of capitulation from equity investors and, whilst volatility is expected to remain high, price movements are likely to remain positive in certain markets. They are not predicting a significant further market fall - just periods of volatility with the general trend being sideways.
At this moment in time, we are watching markets very carefully because the UK is likely in a recession already and we have to be mindful of what happens in America. There is still a lot of growth in the US and therefore the action by the Federal Reserve is to try and slow down this growth without stopping it altogether. We don’t believe that America will go into recession but, if it did, then that would have other implications for markets.
Our traditional save havens in the fixed income markets have all but disappeared and with all the signs still indicating that interest rates are going to increase further from 1.75 up to potentially 3.8% in America, this will compound the weakness in fixed-income markets and that isn’t a safe haven anymore. We are therefore mindful that there are still a lot of unknowns at the moment. The problem we have is, if we capitulate and sell out at the wrong level, we may not be able to get back into markets in time to benefit from the recovery, especially as the markets could swing back very quickly. Many assets are also producing a good income, which helps to minimise the downside.
We know that it is important that we try to get the cycles as right as possible and appreciate that some investments that go up some of the time will then go down when others are going up etc. This is an important part of diversification and helps us to create a balanced portfolio. We therefore continue to watch this space carefully. We are also listening to clients who comment on their differing time horizons and ability to ride the current wave of volatility.