It is expected to be a short-lived shallow recession. Inflation will be falling next year towards the 4-5% level and interest rates will also go into reverse and the economy will recover quickly.
As always, in an unfolding crisis, we see the extremes of reporting. Just like in the pandemic when there were some commentators saying we were in danger of being catapulted into a global depression like the early 1930s, there are now comparisons with 1970s Britain, marked by high inflation and rising wage demands.
An article in the Guardian this week shone light though on how different life was some 5 decades ago. I shall paraphrase:
- The 1970s was a decade of widespread trade union membership and relatively high benefits for workers, should they have found themselves unemployed.
- Pensioners, on the other hand, were forced to scratch a living on Europe’s lowest state pension. Yet today, there are more pensioners, they are better off and carry significant political weight today.
- It was a time of mass production, mass consumption and the public ownership of utility companies and major employers in sectors, including telecoms, rail, coal, steel and automotive. People worked by the hundreds of thousands in the same industry, for the same employer. From cars to insurance, there wasn’t the variety you see today.
- People of all ages and income levels consumed many of the same things. Today’s economy is dominated by niche production and niche consumption.
- Strikes are sporadic now and confined to relatively small groups.
- More skills are transferable today than ever before.
Austerity or investment?
I’ve spoken before how, after the financial crisis in 2008-2009, the US stimulated their economy and committed significant levels of investment, whereas in the UK we chose a path of austerity. Granted the US was worse hit economically and they had to do something drastic. However, this lack of investment in the UK is beginning to hit home and we can see all around us the biproduct.
A study in May this year by the Royal Statistical Society found that from 2007 to 2019, the UK’s failure to invest as much as its US counterparts did in patents, research and software, often termed ‘the intangible economy’, had resulted in a loss of £2,144 per household in the UK, or 0.5% of GDP a year.
Just to demonstrate there is no political bias here, it is argued that since the 1970s, public investment has been erratic which has manifested in the private sector having to ‘tough it out’ much more than their US counterparts.
The article in the Guardian finished with the statement “If we are witnessing a rerun of the 1970s, it’s the lack of investment that chimes, not the potential for inflation busting pay rises”.
Are we at half time yet?
This is probably what the Northern Irish women’s team were saying yesterday in the Euros, when they were losing 3-0 in the first half! Credit to them, it was 1-1 in the second half, in what was their first competitive match in tournament football. A bit flippant of me when we have money to discuss, sorry!
The title in this context, refers to the transition from fears around inflation to fears around a significant economic decline and here in the UK and Europe, a recession. Have we reached a tipping point and are we moving into the second phase of economic turmoil?
Thank goodness we have seen the oil price fall which has served to lower one element of inflation but in other areas of the economy, inflation is still rising. The Bank of England this week stated that inflation in the UK will likely peak in the UK at 11%. Currently, it is 9%.
If we see inflation peak, let’s say by the end of the year (lots of factors may upset this suggestion), it doesn’t mean everything will be hunk dory thereafter. A year of rising inflation leaves a trail of turbulence in its wake. Economic cycles are relatively slow moving and there is a lag before a recovery takes place. Conversely, the investment markets are quick to react, just like they have this year.
Think about how the investment markets responded in the first lockdown whereas the economy was sluggish for many months, investments rose strongly, following stimulus.
What we don’t want, and it is a dangerous scenario, is lasting inflation and an economic slowdown!
Hands up!
Both the Federal Reserve (Fed) in the US and the Bank of England (BoE) have admitted that they could have performed better with their respective monetary policies. They have been surprised by the extent and acceleration of inflation. As somebody said to me the other day “if the Central Banks can’t get it right with all the data and expertise they have to hand, how are we supposed to get it right”?
They have a tough job in the next 6-12 months as we enter the next phase of the cycle.
This week the BoE informed lenders to prepare for a ‘deteriorated economic outlook’. Banks were told to ramp up capital buffers to ensure they can weather the storm. To reinforce what is expected, sadly, the International Monetary Fund and Organisation for Economic Cooperation and Development (OECD) have warned that Britain is more susceptible to recession and persistently high inflation than other Western countries.
So, what does this mean for investors?
There is no doubt the fall in equity prices has been brutal but worse still there have been no safe havens, as bond prices have capitulated. Normally bonds act as ballast in a portfolio but in the first four months of this year, bond prices experienced their worst ever fall. Bonds do not respond well in periods of high inflation. Deliberately, we don’t have high exposure levels to this asset class.
It will be no surprise to hear that the best performing asset class has been commodities. However, as the oil price has slipped commodity funds/indices have fallen quite dramatically recently, reinforcing the dangers of chasing the market.
The second-best performing asset has been UK commercial property, aided by the recovery from the pandemic. We used to hold a good level of UK property but the liquidity issues which were evident after the referendum in 2016, means we have given this asset class a swerve. Moving forward, we would certainly not want an exposure in times of an economic slowdown.
The only other asset class that has been desirable is infrastructure which responded well immediately after the Ukraine invasion as energy strategies around the world were left in tatters.
Whilst it’s inevitable that we look at things through the lens of the UK, we must realise that the UK only makes up circa 4% of the Morgan Stanley Capital International (MSCI) global index. This is a broad-based global equity index that represents large and mid-cap equity performance across all 23 developed countries.
Strategic moves
Our investment portfolios are typically global in nature and therefore we have the advantage of looking way beyond these shores for opportunities. As we have mentioned previously, the Far East is now seemingly attractive and whilst in the past it has deemed to be of a higher risk nature than developed nations, recovering from previous challenges and the re-opening of economies, it can’t be ignored.
We still like infrastructure, especially for its inflation linking qualities but also because it’s not exposed to changing consumer behaviour.
We have reduced our exposure to UK and Europe previously and we will remain with the large cap UK holdings due to its global emphasis and not being representative of the UK economy.
I have spoken to two of our investment partners at length this week and we cannot ignore how quickly events, date and sentiment is changing. It’s a challenging period and we will respond with our switch recommendations shortly with an emphasis of bringing in some more downside protection.
It’s a very strange time because the Price Earnings (P/E) ratios of many companies and indices look very attractive at these levels. P/E is simply the stock price divided by a company’s earnings per share over a designated period. The question is will company earnings start to deteriorate as we see a slowdown in economic growth across and the answer is most certainly ‘yes’! This however doesn’t mean that all sectors will behave the same.
As we pass through this cycle, opportunities will present themselves. For example, if inflation peaks, then bonds become more attractive. Bond yields have recently fallen from their peak which has already increased capital values. This would create ballast to portfolios.
Furthermore, at some point equities will look extremely compelling but we will need a significant catalyst for a sustained rally. Remember the quote in last week’s commentary “the market certainly is volatile right now. We’re going to go back and forth between these recession fears and these inflation fears. But I think over the next year, anyone who is invested in equities now is going to be happy.”
We now have to decide what to do in the short-term to both protect portfolios and optimise opportunities. I am speaking to JPMorgan and LGT Wealth next week and then we will send out the switch notices for our internal portfolios.
We’ll keep you informed.
Enjoy the sub-tropical weather!
Gary and the Investment Committee
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