Please find below our Investment Market Update as at 19th August 2022.
Recession; good news or bad news?
Of course, a recession is not good news ordinarily, but with this outcome being baked into most forecasts, the sooner a recession comes the better is my view.
Central banks are determined to ‘kill’ inflation and get it under control, hence aggressive interest rate rises. The speed and magnitude of these rises, whilst painful, are what is required. The manifestation will be that spending by consumers and business will be reined in quickly and we are now seeing strong evidence of this.
It is almost a perfect storm, with energy prices rising so quickly, but the sooner interest rates rise, the sooner inflation becomes under control and interest rates stop rising. At some point, interest rates will then begin falling, if there is strong evidence that both the Federal Reserve (Fed) and the Bank of England (BoE) are driving inflation back down to their 2% targets. It seems a long way off at the moment, but just as it has risen so dramatically, there is the possibility that inflation could fall quickly, in 2023 and 2024.
Some of the best businesses in the world were born in a recession and a shake up in the landscape allows innovation to flourish. As it says on our website “change can be daunting but, managed properly, it can be the start of something truly amazing”!
Leading into the recession, it’s important that everyone is prudent, flexible and diligent, particularly around cashflow. Once the recession is upon us, then we can look forward to a better future, although there will be a financial hangover and it will take some time for consumer confidence to recover.
Property prices to fall
An article in the Telegraph this week alluded to the triple whammy for house prices. Throughout much of the turmoil of the last two and a half years, rising property prices have, for most, created a degree of comfort and provided a much needed feel-good factor. However, with inflation hitting 10.1% it’s inevitable that prices will weaken.
The article goes on to highlight that plunging real wages and higher interest rates, when combined with rising energy bills, have reduced people’s ability to afford a mortgage. The fewer people there are who can take out a loan, the fewer there are to buy homes.
The BoE warned financial institutions some months ago of the need to temper lending because of a deteriorating economic situation. Whilst we are largely in full employment here in the UK, we could begin to see rising unemployment which would be in danger of triggering mortgage defaults and forcing people to sell their homes for lower than market value.
The property market slowdown has already begun. New buyer enquiries in June fell at the fastest rate recorded since 2020 when the housing market shutdown due to the pandemic, according to the Royal Institute of Chartered Surveyors. They also fell in July.
Andrew Wishart of Capital Economics said “with mortgage rates continuing to rise and the economy on the brink of recession, a fall in house prices looks inevitable”.
Consumer confidence is at its lowest since 1974!
I know this is all appearing very gloomy, but we can’t be in denial about what is unfolding – this is one of the reasons we have parachuted into significant cash holdings within our in-house managed portfolios.
A report in Bloomberg this morning stated that “UK consumer confidence has fallen to the lowest since 1974 as prices jump”.
A survey from Lloyds shows that output is dropping across most industries. The results showed a drop across nine of the 14 industries tracked with tourism and recreation, hit the hardest.
In the Bloomberg article it quotes Linda Ellet, Head of Consumer Markets, Retail and Leisure at KPMG who says“consumers are either already struggling with rising costs or are fearing what’s looming on the horizon. The storm clouds are closing in fast, with higher costs reducing discretionary spending power”.
Another 0.5% interest rate rise expected
According to a Reuters poll, 59% of economic analysts are expecting another 0.5% interest rate hike in September, here in the UK.
However, this means that 41% don’t agree with this sentiment. HSBC’s Elizabeth Martins said “with growth slowing, it is tempting to assume the BoE will be thinking of hitting the brakes and could even be cutting rates within the next year”.
Analysts expect average UK growth to be 3.5% this year, followed by 0.2% next year. A dramatic slow-down for sure!
An article in Investment Week highlighted the view of another economist, this time Luke Bartholomew at abrdn; “UK inflation continues to surge higher, coming in stronger than forecast once again, increasing the risk that it will ultimately peak even higher than the 13% figure forecast by the BoE.
Every upwards inflation surprise tightens the bind the BoE finds itself in, with mounting inflation pressure combined with growing recessionary headwinds. Given the strength of underlying inflation pressure we continue to expect the bank to deliver another 0.5% interest rate increase at its next meeting in September.
With monetary policy having to tighten even in the face of bad economic news, investors continue to have little in the way of a safety net from central banks, which is likely to keep markets volatile”.
I think you get the picture!
Enough is enough, let’s get onto some good news.
The equity markets have proved resilient despite the wreaking sentiment. Partly because the US earnings season has not been as bad as feared, some relief that the Fed isn’t being as aggressive with interact rate rises as feared, and there are signs that inflation is easing. Crude oil prices have fallen from circa $120 to $90 per barrel, although most of us haven’t yet felt the benefit!
There is always somewhere positive to invest
Granted, finding a positive niche has not been easy with both equities and bond prices plummeting since the start of this year. An asset class we have focussed on consistently has been infrastructure and we have highlighted the benefits of holding a good proportion of such assets, even during times when the performance may have lagged other assets.
The performance of the infrastructure sector since the Ukraine invasion has been very strong with a good proportion of infrastructure funds holding a high proportion of renewable energy assets. The western world’s energy programmes have been thrown into disarray and this has seen capital flowing into alternative assets.
We should also not overlook the broadening of this sector, which is nowadays, not just anchored in traditional infrastructure – the digital economy being a case in point. This provides greater diversity and indeed opportunities.
One of the attractive features of the infrastructure space is that circa 70% of all contracts, which typically are long-term, have inflation protection built into their terms. This has helped this sector enormously in recent months. Like any sector, it’s not without its challenges in this fast-moving world but we see it as an important and necessary diversifier to equities and bonds.
Current holdings of infrastructure within our in-house managed portfolios vary between risk profiles, but typically we have 20-25% infrastructure weightings at the moment. We also favour infrastructure because it’s not directly impacted by a deterioration in consumer confidence.
In the last 6 months, Blue Sky’s infrastructure portfolio has risen by 9.02% (not including adviser fees), although it does coincide with the invasion of Ukraine which resulted in a surge in infrastructure prices (source: FE analytics). By way of balance here, our infrastructure portfolio fell from the start of 2022 to the 19th February 2022 in a similar way to most equity indices.
In summary, infrastructure is an important diversifier with some inflation protection whilst investing, for the most part, in real physical assets across a wide array of sectors.
It’s fair to say that its messy out there and sentiment is weakening with every headline and news article.
The sooner recession comes the better, and hopefully this will mean inflation is under control and we can then look forward with greater optimism. What we don’t want is a long-drawn-out recession. We don’t think this will be the case as we are experiencing a short sharp shock.
Following this painful period, we are expecting a positive reaction and the possibility of a boom time as we experience an economic recovery. This will be tempered however, partly by central banks and of course the overhang for consumers and businesses still feeling the pain of the downturn and the extraordinary surge in prices. Believe it or not, this is a good thing to avoid severe peaks and troughs like we are experiencing and have experienced over the last two and a half years.
Don’t forget, we are always here for you. If you are finding the turmoil too troubling, then please get in touch. It’s always good to talk!
Have a lovely weekend.
Gary and the Blue Sky Investment Team
Please Note: This communication should not be read as giving specific advice regarding your personal circumstances. This would only be given following detailed assessment of your individual needs. The value of investments may fall as well as rise; you may get back less than invested. Past performance is not necessarily a guide to future returns.