Please find below our Investment Market Update as at 21st October 2022, drafted by Andrew Dunn (Gus) as Gary is out of the office today.
Yesterday Liz Truss resigned. Amazing but unsurprising. The markets expected it and to a large extent demanded it.
Stability is what we are all craving but what are the chances? Let’s hope this all settles down and we are spared the sensational headlines on a daily basis next week.
Not only do such events create turmoil, but it also doesn’t do much to help attract international investment into the UK. Dimming the prospects for growth.
The pound rallied 0.4% to trade at $1.126 against the dollar, pulling back from a larger initial spike as international markets responded to Truss’s exit after 44 chaotic days which saw them revolt against a plan to stimulate growth with unfunded tax cuts.
The UK will announce its fifth Conservative prime minister in six years in a week’s time, after a leadership election. “Sterling and gilts rallied as the sorry reign of Liz Truss came to an end. After a flurry of activity we are seeing retracement of these initial moves as markets realise that there’s still huge uncertainty about whether the Tory party can survive in power” said Neil Wilson, Analyst at Markets.com.
Robert Alster, Chief Investment Officer at Close Brothers Asset Management, suggested the direction for markets remained unclear.
“The impact on markets of Liz Truss’s resignation over the short-term will all depend on the fiscal stance of her successor, who they appoint as Chancellor, and how both these events play out in the mini budget at the end of the month” he said.
Markets are looking for a more balanced budget and more political stability for the UK, and sterling is rising in the hope that the new Prime Minister will provide both.
What markets want is certainty and in recent months we have had precious little of that. Putting aside any political point of view, investors will hope that whoever is up next can create a steadier set of policies that will allow us all to have some consistency for a period.
Markets this week
Equity markets were gently, and pleasantly, up this last week across most main indices. This is not off the back of any significant news, just the ‘washing machine cycle’ of mini rises and falls that Gary has regularly spoken about many times.
Nevertheless, a period of relative calm is to be welcomed and has meant that our portfolios have increased in value this week. We remain cautiously positioned, with significant cash holdings available to pick up good quality assets at what we feel is the best time. This is subject of rigorous daily consideration and whilst timing is never an exact science, our clients can be reassured that we will deploy the funds when we feel the maximum benefit will be gained.
We are in an important earnings season where, up to now, generally companies have reported resilient results. Rising interest rates and a slowing economy will now start to show up in these numbers but it will be the forward guidance about the coming period that will be most important to the markets.
At respective ends of the scale in the last few days were Netflix and Tesla – the former having higher than expected subscriber figures and a double-digit share price rise, and for Tesla results well short of expectations as a result of the strong dollar delivery issues (plus perhaps Elon Musk being distracted by his Twitter purchase). Closer to home and picking on two online businesses this week we had ASOS (an online fashion business) reporting an 89% reduction in pre-tax profits and Money Supermarket increasing revenue by 15%. It will probably surprise nobody that the share price of ASOS went up and Money Supermarket down.
The Bank of England (BOE) ended its temporary support for the gilt market with little impact, as it had promised to do this week. This support had been introduced to combat the fallout from the LDI (Liability Driven Investment) issue. This is quite complex but put simply is pension funds borrowing cheap money to try and make a quick turn on their investment to support the payments it makes to pensioners.
This had worked, largely unknown to most people even involved in finance for a long time, until the spike in interest rates and the margin calls this triggered. It has been broadly criticised, and it is quite likely the story has more to tell at some point.
However, The Pensions Regulator (TPR) defended LDI, it said “The approach of using leveraged LDI has helped many Defined Benefit (DB) pension schemes to manage the risks to their funding position”.
Going on to add “Over the past 20 years, as long-term interest rates fell to historically low levels and through market events seen during the Covid-19 pandemic, LDI has meant that the assets in DB schemes increased. During that period, LDI also played a significant role in helping to manage the affordability of DB schemes for employers.”
UK instability continues
I think it is best not to comment too much on what is happening with our Government – most of our readers will be well informed on events and have heard enough already! We appear to be back on a well-trodden path to austerity with mooted spending cuts of up to 15%. We will find out more on Halloween with the promised mini budget and no doubt treats will be in very short supply.
The budget u-turns have been broadly welcomed by financial markets and most commentators. Whilst politically this has created chaos, it is pretty much an economic necessity. The International Monetary Fund (IMF), which had unusually been critical of the UK government, stated “the UK authorities recent policy announcements signal commitment to fiscal discipline and help align fiscal and monetary policy in the fight against inflation”.
The IMF have also cut their growth forecasts for global growth, with the UK barely positive for the next 2 years and well behind almost all major competitors. One thing we can agree with the Government on is the need for productivity gains and all-important economic growth. In addition to the gloomy IMF forecasts, research from Ben Nabarro at Citi Bank estimates that UK trade is about 25% below its level before Brexit.
Small UK businesses are the heartbeat and potential engine for growth making them very important to us all. Unsurprisingly, their confidence has fallen to its lowest level since before covid 2020, with increased costs and reducing revenues. Almost 50% reported reduced revenues in the 3rd quarter of the year and nearly the same amount anticipating a similar story in Q4.
The exposure we have to UK markets is low across our portfolios, reduced further by our infrastructure reduction and we continue to focus on high quality UK quoted companies with a strong international footprint and earnings bias.
As we have said before this remains the only game in town. It is the most powerful factor, when under some degree of control, that will be the catalyst for economic and market recovery. UK inflation now sits above the psychological 10% barrier, powered by food and drink. The pound’s recent weakness has aggravated the cost of imported goods alongside transportation and fertiliser shortages. Inflation of this kind is hard to shift as it is in areas that it is hard to cut back on to any real degree.
Many commentators see higher inflation putting extra pressure on the Bank of England to hike rates higher at the November meeting. The theory is that higher costs will deter consumers spending so much and encourage saving, where possible, which both aim to bring prices down.
As an academic aside, and in part supporting the idea of growth, are the comments made by World Bank president David Malpass who suggested policymakers could look toward boosting production rather than just focussing on reducing demand (which is what higher interest rates seek to do). This could be done by making workers more available where needed, increasing the availability of raw materials and speeding up supply chains. The talk that appears to have led to Suella Braverman resigning – immigration for certain jobs to help fuel growth – was possibly aligned to this approach.
Increasing interest rates can do much harm to some people, businesses and economies and perhaps there is merit to other less traditional options but done at the right time and in the right way. The other side of that coin is, of course, many will welcome better savings rates.
We would like to thank our clients who have so quickly replied to our infrastructure switch notice this week, which has allowed us to quickly make the adjustments we feel are right.
Before making any change, we give serious consideration about the best way forward and we spoke to our friends at Foresight at the start of this week. We retain great confidence in their approach and infrastructure as an asset but felt a reduction was the right decision.
We have retained about 50% of our holdings as in the longer-term the defensive nature and prospects remain intact. That said, the Government price cap and our belief that infrastructure may lag other assets when recovery comes, means a reduction is in our clients’ best interests. It is highly likely that infrastructure will again be a great place for us to add to in the future.
The UK property market prospects
Residential property is many people’s largest asset, the topic of many dinner table conversations and a bellwether for the health of the wider economy. It has also been defying gravity for some time when you consider what is happening in the economy and the fact that many of our largest housebuilders have seen their share price fall by 50% in the last year.
The Office for National Statistics has recorded 10 years of unbroken growth in house prices fuelled by the low cost of debt and so strong affordability, a housing shortage and perhaps our love of housing.
Government policy, at times supportive around stamp duty, has also kept the train rolling. There will always be a wide range of views on the direction of prices and for perspective we have summarised a few here. Knight Frank in the last couple of weeks became the first major agent to talk of a 10% fall in prices in the next two years as a result of higher mortgage rates. Savills agree a price fall is on the cards but do not put a number to that reduction. As ever, different sectors of the market will react differently with prime London possibly to benefit from the weak pound which makes it highly attractive for international buyers.
In any market, there are always differing views and Fred Harrison who has one of the best records for predicting property values says that he sees no correction before 2026 as Liz Truss will want to do anything other than “offending home owning voters”. That ship may have sailed but a quote from a London agent Henry Pryor best summed up the position “there are only two types of ‘expert’ when it comes to house price predictions – those who don’t know and those who don’t know they don’t know”.
Whilst there is no real direct link it is also informative to look at UK commercial property, which we do not invest in, as this is becoming an increasingly difficult place to be. Rising rates are causing concern not just in terms of the extra burden of costs against rental income but the ability of tenants to continue paying rent and the potential for void periods. Some companies are restarting their ‘gating’ process which restricts the ability for investors to access their funds in a timely manner, which was the factor that led to us exiting this space.
LGT Wealth update
We are in regular touch with LGT who run a number of investments with us. The following is a distillation of some of their current thoughts:
- Markets remain volatile but the higher than usual cash holdings have helped the funds reduce this and provide some dry powder for reinvestment
- An active approach is even more important than normal with volatility likely to remain elevated
- Dramatic moves in sterling, particularly against the dollar, has helped a number of the funds which are generally unhedged
- Central banks have backed up their tough talk and are starting to raise rates more aggressively and will continue this trajectory
- They remain cautious about the UK market especially domestic focussed funds
Some possible good news!
We’ve talked previously about how sometimes fears are overdone in relation to investment market expectations. Markets have a habit of overshooting on both optimism and fear! Gary has written about how we shouldn’t ignore the possibilities of surprising positive news, nor the active intervention of the powers that be. Central banks and governments are hamstrung somewhat in this high inflationary environment, as we have seen in recent weeks. We are just going to have to let this cycle wash through, but the question is, how long will the cycle last?
A Sky news report last night hinted that interest rates may not rise as much as expected. This was the conclusion drawn from a speech delivered by Ben Broadbent, the Deputy Governor of the BoE yesterday. Reading between the lines he more or less told financial market participants that they were pricing in too many future increases in interest rates. Interesting and unusual rhetoric from the bank. No doubt intended to further calm markets.
He commented that back in August financial conditions were consistent with interest rates rising to 3% but due to price pressures they are now expected to rise to 5.25%. It is currently 2.25%.
In his concluding remarks, Mr Broadbent said: “Whether official interest rates have to rise by quite as much as currently priced in financial markets remains to be seen.”
His comments immediately had an impact on market expectations. On Wednesday, the market was pricing in a peak for bank rate of 4.785% but that has slipped today to 4.68%. A week ago, prior to the new chancellor Jeremy Hunt tearing up most of Kwasi Kwarteng’s mini budget, market expectations for peak bank rate were at 5.099%.
Wishing you a peaceful weekend.
Gus 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.