Welcome to our quarterly investment overview
We have spoken to a number of investment houses who we work closely with, and we would like to share their views on where the markets are heading.
I have described the markets like a washing machine in that there are lots of mini-cycles at play and just when you think everything is going to calm down and come to the end of the program, another one starts. Yet, despite all the uncertainty, equity markets are creating gains and there is becoming a significant dispersion between some asset classes reinforcing the need for active management.
The inflationary cycle is beginning to slow which the markets like, but elevated interest rates are still hurting sentiment. There are mixed views as to how the investment markets may respond in the near term, but it does look as though we are seeing a gradual climb up the wall of worry, helped by the news on UK inflation this week.
This week we saw the UK markets get excited about the reduction of year-on-year inflation. We stated only last week that there was room for positive surprises but on the flipside, there could be negative surprises still to come.
As this is a quarterly review, set 10-15 mins aside, as usual, to digest what’s going on.
Here is the agenda:
- The latest news flow
- How are the markets responding?
- What sectors are favoured?
- What is the immediate outlook?
The latest news flow
UK inflation figures surprised in a positive way this week.
Inflation in the UK dropped to 7.9% in the year to June from 8.7% in May, according to the Office for National Statistics. Forecasters had predicted a fall from 8.7% to 8.2% so that’s a bigger step in the right direction. Falling prices for motor fuel led to the largest downward contribution to the monthly change, while food prices rose in June 2023 but by less than in June 2022.
The futures market repriced its interest rate expectations as a result. Some were predicting that the bank base rate could rise by another 2% and reach 7%. The market now sees the rate peaking around 5.8% in quarter 1 2024. This is down from the 6.5% high the market was pricing earlier this month.
The odds of a 0.5% hike in August have fallen to around 50%. Unloved gilts also found some friends, with the yield on the two-year over 0.2% lower to 4.86% putting it on course for its biggest drop since March. The pound was similarly under pressure after the data, falling nearly 1% against the dollar and the weakest since late May against the euro. (Source EPIC Investment Partners).
The Chancellor, Jeremy Hunt released a statement saying:
“Inflation is falling and stands at its lowest level since last March, but we aren’t complacent and know that high prices are still a huge worry for families and businesses.”
“The best and only way we can ease this pressure and get our economy growing again is by sticking to the plan to halve inflation this year.”
- Mortgage rates fall
Mortgage rates have fallen for the first time in two months following better-than-expected inflation figures. Rates on both two and five-year fixed deals have dropped on hopes that the Bank of England may not raise interest rates as much as previously thought.
The average two-year fixed residential mortgage rate dipped to 6.79% on Thursday from 6.81%, according to financial information service Moneyfacts. Meanwhile, the average five-year fixed residential mortgage rate edged down to 6.31% from 6.33%.
- Corporate profit warnings in the UK rise
The number of profit warnings issued by UK-listed companies rose for the seventh consecutive quarter in the three months through June, marking the longest streak of increases since the global financial crisis, EY-Parthenon said, “Economic uncertainty and rising interest rates being problematic” (ft.com).
In the last 12 months, 17.9% of Public Limited Companies (PLC) have issued a profit warning, making the highest level since the Global Financial Crisis, excluding the Covid-19 pandemic.
According to the EY-Parthenon report, the sectors with the most warnings were FTSE Industrial Support Services, Construction and Materials, followed by Retailers and then FTSE Pharmaceuticals and Biotechnology.
- US banks report strong earnings
The concerns over the US banking sector have largely abated, although some concerns do still exist. The sector was given a boost this week after Morgan Stanley and Bank of America (BoA) posted strong earnings.
- Tech earnings disappoint
Technology stocks have had a strong run in the first half of 2023 but on Thursday Netflix and Tesla shares fell sharply after reporting disappointing second-quarter earnings. Tesla shares fell by 6.2% at one point. A spokesperson said that profit margins slipped as a series of price cuts weighed on earnings. Netflix lost 8.4% having missed sales estimates and posted lower guidance for the third quarter.…and this is just a smattering of this week’s news!!
How are the markets responding?
Following the positive news on UK inflation, both UK equity and bond markets got rather excited. Of course, we have seen this work the other way, with bad news.
Over the last 5 days, the FTSE UK Mid cap index has risen by 3.95% and the FTSE 100 by 2.75%. The Euro first 300 index rose by only 0.57% over the same period, but of course, the focus has been on the UK with its lower inflation figures. The S&P 500 (US) posted a return of 0.45%, the Dow Jones by 2.32% but the Nasdaq has fallen by 0.73%, following disappointing earnings.
UK gilts rose by 1.56% and UK-indexed linked gilts by 2.9% whereas Global bonds rose by 0.79% (all figures up to and including 20th July 2023).
What sectors are favoured?
All our investment houses follow the general view that markets are unpredictable and the one thing we can expect is ‘surprises’. This can be to the downside or the upside like we had this week here in the UK. Heightened levels of uncertainty are not the ideal environment for sustained returns, yet they all recognise that opportunities are unfolding.
Across our portfolios we are seeing a wide variance of performance between asset classes, very different to what was happening for most of 2022 when most assets were posting negative returns.
This year has been labelled by some as the year of the ‘Bond’. After a terrible year in 2022 when inflation and interest rocketed, forecasts suggested that 2023 was all about bonds. Due to the prolonged concerns about stickier inflation and subsequent rate hikes, the bond market has not performed as anticipated.
At Blue Sky we have had a very tiny bond exposure, but we are now looking at our portfolios with a view to accommodating more bonds. Trying to second guess when to invest though is very difficult, but there is no doubt that with bond yields being elevated, investing in bonds will prove attractive over the long term.
It’s worth remembering that bonds traditionally are instrumental in a balanced portfolio constituting circa 40%. The lack of bonds in our portfolios meant that we had to seek some so-called ballast elsewhere, through the likes of infrastructure etc.
JPMorgan’s Hugh Gimber, Global Market Strategist, believes the opportunities in the bond space represent the best opportunity in a decade, acknowledging though that the timing for investment is very difficult.
Hugh commented that last year’s sell-off in fixed income was a ‘historical’ repricing. He noted that not only was it the worst year on record for global bonds, but it was more than three times as bad as the previous worst year. Hugh went on to say that they favour Global bonds more than UK bonds, partly because the latter have unperformed, but also because they are concerned about the possibility of stickier inflation and the room for policy errors.
An article in Investment Week reinforced that stubbornly high inflation has dampened meaningful fixed-income returns, but hopes are still pinned for a sustained shift in economic data that will push markets out of their current ranges. Perhaps we saw the early signs of that this week!
Francis Chua at Legal & General Investment Management (LGIM) stated that increasingly they like bonds and see an uncertain six months for equities across the developed markets. Sonja Laud, the Chief Investment Officer at LGIM followed this up by saying “This week’s inflation slowdown wasn’t a sign that the UK can dodge a recession”.
All of the investment houses now favour bonds and after this week’s inflation data in the UK, there is more of an appetite for UK bonds, although all warn of the dangers of just buying UK bonds due to possible stickier inflation down the line.
Hugh Gimber of JPM also spoke about the attractiveness of emerging market debt with many emerging economies having a better handle on inflationary dynamics. This reinforces a global approach to the bond market.
Technology has been the stellar performer this year and the excitement about Artificial Intelligence has boosted flows into the sector. As we know, technology stocks are prone to big swings in sentiment but over time, they are likely to produce very strong returns. We have to appreciate that currently, the Nasdaq 100, is driven by a handful of stocks which means there is the danger that this concentration risk can punish markets in times of volatility. This week’s earnings disappointment for Tesla and Netflix is a case in point.
Francis Chua of LGIM reaffirmed that they favour technology and particularly AI. He spoke about how the uptick in technology stocks like Microsoft has helped the Sustainable sector.
All the investment houses like technology but warn of the concentration risks.
I had a long and involved chat with Mike Parson of Foresight last week about the infrastructure space. As we know, this was one of the very few positive performing assets last year, that was until Liz Truss took the reins in government! Liquidity issues unfolded within UK final salary pension schemes and in the race for liquidity, Trustees sold off infrastructure stocks. You may remember this is when the Bank of England had to ride in like the cavalry and shore up the gilt market.
Ever since, the infrastructure sector has struggled, despite periods of hope. Its value as an alternative asset has been difficult to justify at times over the last 9 months but it was still a better outcome than investing in UK bonds. Yet, the economic climate of lofty inflation, should on the face of it support the case for holding infrastructure.
Mike went on to say that the indexed linked contracts which are at the heart of infrastructure don’t feed through immediately and often pay annually and hence delays in the uplift to valuations. The real issue for infrastructure has been how the market has priced the underlying net asset values of the businesses, particularly with real physical assets. This has led to huge discrepancies between sentiment and the underpins of infrastructure as the cash flow and earnings in this sector are not dependent upon the consumer.
With inflation moving to elevated levels and interest rates rising so dramatically, sentiment has weakened for those companies with large borrowings despite resilient earnings. Mike stressed that infrastructure stocks are good to hold in a recession. Our other investment houses agree and are all gradually building positions in infrastructure. Stocks have become attractive over the longer term because of the sell-off.
Ben Palmer of LGT Wealth suggests that we are moving into a world where infrastructure should hit a sweet spot. Inflation at 4-6% would benefit this asset class.
At Blue Sky we have reduced our UK infrastructure holdings because of the UK’s unique economic challenges but have kept our global exposure.
- Emerging Markets
JPMorgan’s Hugh Gimber reinforced previous conversations by stating that emerging market countries look attractive because of their better governance in managing their economy. In many cases, emerging countries are ahead of the developed world’s economic cycle because they raised interest rates earlier and many are now in the throes of bringing interest rates down.
We have reported previously on the economic success of India, helped by a relatively low-cost labour force and cheap energy from Russia. Not forgetting the increased demand from domestic consumption in what is the world’s biggest democracy.
There was much excitement about the Far East at the back end of 2022 as countries opened up after Covid-19, and there were hopes that China would bounce back as restrictions were lifted. Demand was stilted, partly down to weak domestic demand following 3 years of something akin to incarceration. China’s property woes were also a worry for international investors. Following weak economic data of late, the Chinese government are introducing stimulus packages to jump-start the economy. All of our investment houses like the Far East and emerging markets as an asset class.
After a poor 9 months in 2022, sustainable stocks have picked up strongly which has helped our portfolios, particularly in the first 6 months of 2023. All our investment houses favour the sustainability sector.
I had a good chat with Phoebe Stone, Head of Sustainability at LGT Wealth and amongst many other things we spoke about the role of bonds in the sustainable sector. I particularly asked about green bonds. Phoebe highlighted that although the UK was making progress there was a limited choice of green bonds in the UK and therefore more of a global approach makes more sense. As a result of our conversation, we are very likely to introduce an active bond manager for some of our internal portfolios and one who is able to diversify across the bond spectrum. More about this in the weeks to come.
Phoebe expressed her disappointment as indeed did all the other investment houses, at the UK’s lack of action around clean energy. The Inflation Reduction Act in the US and Europe’s equivalent response aims to curb inflation and amongst other things, invest into domestic energy production while promoting clean energy. The tax credits given to businesses give them a huge competitive advantage.
Francis Chua of LGIM said they like Europe and now see it as a leader in Sustainability. He went on to say how they continue to see healthy inflows into the sustainability space, and it shouldn’t be underestimated how much investment is being committed by companies, even in the UK, despite the perception that the UK government is sat on the side-lines.
- UK Equities
JPMorgan like UK equities and feel that valuations are attractive compared to some other countries where valuations are loftier. However, Hugh stated that they prefer to embrace the FTSE 100 as opposed to the UK mid 250 for example. This is because the latter is expected to suffer more if the UK goes into recession. Embracing the FTSE 100 means that investors aren’t really investing in the UK though because circa 70% of earnings are from overseas.
Francis from LGIM stated that they are now neutral on the UK but this must be seen from the position that they were previously negative, but there have been surprises on the upside and economic data has been more resilient than expected. Again, they don’t like the UK mid-cap sector at this juncture and see little to drive the market up except short-term responses to macro data. The focus is on the likelihood of deteriorating earnings.
What is the immediate outlook?
Hugh Gimber started off our conversation by saying that he feels this market momentum is too good to be true. He suggested that with markets having moved higher, there were more embedded risks in markets than earlier in the year when they were erring on the side of caution. Hugh believes, there has been a lot of noise but not a lot has changed. Ben Palmer of LGT Wealth warned that we could see a raft of deteriorating earnings playing on sentiment in the short term.
This week’s earnings emanating out of the US highlight the dangers of judging all markets in the same light. Earnings from the banking sector are encouraging after a difficult time earlier in the year and some technology companies posted weak earnings after a euphoric 6 months. Does this mean we are entering into another mini-cycle when a different set of assets come to the fore? Second guessing is very difficult in this market.
The main risks centre around stickier-than-expected inflation, stubborn interest rates, weaker corporate profits, and recessions. Yet, there is room for surprises. Most commentators at the start of the year didn’t expect the UK to be so resilient, the Far East to struggle and the technology sector to boom like it has.
There are opportunities unfolding and we are seeing significant dispersion in the performance across asset classes. Whilst passive investing offers significant benefits, active management is really coming into its own, subject to the challenge of making those correct decisions. Over the longer-term buying stocks which look oversold makes sense but at the same time, we want to catch the waves which are going to deliver positive returns in the short term. Francis at LGIM stated that they are cautious overall but accept that there are pockets of opportunities across markets.
LGT Wealth comments that there has been some good positive sentiment of late but warns that macroeconomic data paints an uncertain picture in parts of the world, particularly the UK. The impact of higher interest rates is taking longer to materialise than expected and the long and variable lags are yet to come. Central Banks are still tightening policies due to higher consumer prices and strong labour data. The UK carries a risk of ‘policy error’ due to potential overtightening by the BoE, given persistent inflation, however June’s inflation data is encouraging. Out of all the developed countries, the UK has the highest inflation, and it has come down the least. As a result, we are cautious about UK domestic companies right now despite attractive valuations. However, if overtightening leads to policy errors and economic activity declines, government bonds (gilts) may rally and hence our position in long-dated gilts.
Well done on making it to the end. This was a challenging write this quarter, as so much has been going on and despite the cautious outlook, positivity is elevated.
We, along with our investment partners will continue to reposition portfolios but we are conscious of making too many switches because markets can change quickly. We are likely to start introducing more bonds into our in-house portfolios in the near term.
We face an uncertain outlook here in the UK but remember there is a whole big world out there and there are opportunities unfolding due to an array of unfolding dynamics.
Have a great weekend.
Gary and the Blue Sky Investment Team
P.S. I’m off to The Open Golf at Royal Liverpool this weekend… I think I might need a boat!
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.