We’ve been in contact with most of you recently regarding a switch notice, and so I thought I would summarise our current thinking and wrap up our sentiment for the time being.
What a crazy world we live in!
I was talking to someone the other day and we were referring back to 2016, an amazing year in so many ways and a year full of surprises.
Who’d have thought:
- Leicester City would win the English Premiership
- Donald Trump would become the President of the United States
- And the UK would vote to leave the EU
Apparently, if you had bet £10 as an accumulator on these outcomes in 2014, you would have won £30 million. Unbelievable!!!
Now fast forward to current times. Who’d have thought we would have had:
- A global pandemic which would cripple the world economy
- A war in Europe
- Inflation moving into double figures
I haven’t got a clue what these odds would have been but probably something like those in 2016 I would have thought!
So, what’s going on?
Weak supply chains
Coming out of the pandemic, the one constant has been weak supply chains, although many companies and indeed countries have been quite resourceful in their response. Weak supply chains have proved inflationary as we all know.
Most companies were short of stock during the main lockdown period in 2020 and into 2021 and in many cases, still are. It went crazy as companies built up inventories, not knowing when they would be able to get hold of stock in the future.
Two years on, we are hearing that many companies are running down their inventories, partly because they want to increase liquidity and cash-flow in anticipation of an economic slowdown but partly because they don’t want to be found wanting down the line, especially if prices begin to fall as supply chains start to ease into 2023.
Inflation has been the problem
Inflation in mid-2021 was beginning to rise, fuelled by all the stimulus from governments and central banks around the world, but also because of rising prices due to shortages. The UK increased its interest rates in December 2021, shortly to be followed by the US, and this worried investment markets.,
Little did we realise the extent of what was to come down the tracks. Here in the UK, today, we saw a 0.5% percentage hike in interest rates and inflation is expected to top 13% according to the Bank of England. This is 2% higher than they expected not so very long ago.
The issue more recently has been on rising energy costs, and this has fed into most sectors of the global economy.
Is inflation nearing its peak?
There are signs that inflation may be nearing its peak, although it is dangerous to generalise. There is the possibility that energy prices could rise even higher which would mean a continuation of aggressive interest rate hikes. The Federal Reserve in the US, increased rates by 0.75% last week but there was some good news as it was feared this could have risen by 1%, on top of the previous 0.75% hike.
Graph of expected direction of travel for interest rates
The Bank of England and the Federal Reserve expect inflation to fall during 2023, although they are likely to fall short of hitting their 2% inflation targets. Interest rates will also be tempered but not back to previous levels. They are likely to normalise over the medium term.
Why have investment markets been so poor?
In many ways this has been a perfect storm; we have had the worst 6 month start for both equities and bonds for some 50 years. We now have inflation at a 40-year high.
Normally, in times of uncertainty, bonds are a buffer against the turmoil in equities and often rise in value when equities suffer. Historically, a balanced portfolio would have circa 40% in bonds and 60% in equities. In this market, bonds have in many cases, performed worse than equities and have exaggerated losses. The ‘seesaw’ has broken in the middle; for the time being anyway.
So, those with a cautious approach have in many cases found themselves in riskier funds and portfolios, through no fault of their own. At Blue Sky we significantly reduced our bond exposure just over a year ago.
S&P 500 against UK gilts
The above graph shows the performance, over the last 6 months of the S&P 500 in the US against UK gilts and index-linked gilts. US Treasuries on the other hand have been the ‘go to’ defensive call, along with the dollar.
However, as the cycle unfolds, we will move into the next phase and as we have seen of late, both equities and UK gilts have risen in value, the question is, will this be sustained, or will this be short lived? If inflation appears under control, then we have no doubt that central banks will signal their intent for no more rate rises and the investment markets will love it.
But what about corporate earnings?
The fear is that with central banks raising interest rates aggressively, coupled with rising energy prices and inflation in general, such conditions will likely impact corporate profitability. Clearly, in some sectors more than others, corporate earnings are a lagging indicator, and the impact all these factors has yet in some cases, to feed through into equity prices. Hence why we have recently switched into a liquidity holding across the Blue Sky/JPMorgan portfolios.
We are not alone in using cash positions, it’s interesting to note that many investment houses are now doing the same. At Blue Sky, we took this recent ‘bounce’ to take some risk off the table.
Earnings are still encouraging!
LGT Wealth reported this week, that 56% of companies have reported earnings so far this season. Despite a difficult quarter, over half of these companies have beaten analyst estimates, surpassing the long-term average of 47%. This figure however, does lag behind the precedent set over the last five quarters, where an average of 62% of companies beat estimates.
Notable winners of this season include big tech and energy giants, while consumer heavyweights struggled in the face of record inflation and dampened consumer sentiment.
How have portfolios fared?
Sadly, there have not been many hiding places over the year. Technology and Sustainable stocks have been badly hit and so have so called ‘safe haven’ assets like bonds. Interestingly, over the last month or so, it is Technology and Sustainable funds which have risen strongly. We are retaining our exposure to both asset classes.
Let me share some quotes with you
I thought I would share with you some quotes from various investment specialists which support the narrative we believe is most likely.
Barclays strategists
In Bloomberg this week, Barclays commented that “European stocks may be entering a tough period. They have rallied in the hope the Fed can prevent a hard landing.”
- August & September just happen to be the worst months for the Euro Stoxx 600, returns wise, over the past 25 years
- Barclays state that “this rally feels unsettling to us…we would fade it. Markets are ignoring the risk of an economic slowdown that would cause further headwinds”
The Institute of Directors
According to their latest survey, UK business leaders are slashing investment plans amidst soaring prices, Brexit trading difficulties, and political uncertainty which is leaving bosses pessimistic about the economic outlook.
BNP Paribas
As reported in the Telegraph BNP Paribas stated, “officials face a balancing act as the risk of recession grows and rate rises dampen demand”.
Quilter Investors
Marcus Brookes, the Chief Investment Officer at Quilter Investors, commenting on the recent 0.75% interest rate hike in the US said that “while markets had been expecting a rate hike, it will stoke fears that the US is nearing a recession”.
Charles Schwab
Richard Flynn, Managing Director at Charles Schwab UK added “the announcement from, the Fed is concerning and reflects weaknesses in the stock market and the outlook for corporate profit margins”.
Don’t despair, there is lots of good news too!
- Inflation projections vary but there are indications that inflation is likely to start weakening in 2023 and then fall strongly in 2024
- Interest rate hikes will peak when it’s obvious that inflation is under control
- The Bank of England still has an inflation target of 2%. Whilst they will be hard pushed to hit this target next year, their policy is clear. Their announcement today suggests more like 2024
- Alternative assets not directly impacted by consumer sentiment, like infrastructure, should be more resilient
- Banks are well resourced with strong balance sheets
- If there are to be recessions, they are likely to be short lived, like 2020 when Covid-19 hit
- The Far East has largely been ‘mothballed’ but now it’s starting to ‘open up’ again. This should also help supply chains
- We are still seeing a strong appetite for Sustainability and companies are having to meet stringent regulations. This makes it easier for the investors to demarcate between companies when investing
- A large proportion of companies and consumers are not heavily leveraged with debt, like in many previous recessions, which should provide a buffer against an economic slowdown
Summary
Our conclusion is that the second half of the year could be very uncertain economically, and hence why we are being prudent and moving some money into cash and embracing bond elements once again across the portfolios. Earnings have held up quite well for the quarter but there are signs that more companies are beginning to struggle in the current climate, and we expect weaker earnings moving forward.
Whilst the news-flow is certainly not upbeat, it’s important to understand that equities tend to respond well once we have experienced an economic slowdown. When inflation peaks, we expect a change in rhetoric from central banks and we believe that equity markets will then surge. Timing the markets can be difficult, but we are primed ready to deploy the cash holdings when we believe it is right.
I hope you found this a useful summary.
Thank you to all our clients for their recent co-operation.
Gary & the Blue Sky Investment Team |
