Market Commentary 28th September 2022
I am 5 years older than Liz Truss. This means we have both lived our adult life in a world where governments could borrow money with little real-world consequences. Demand for government bonds seemed insatiable and this made the tricky trade-off between taxing and spending slowly become less relevant. If you needed to spend more, just borrow more. The Liz Truss government looks to be the first major economy outside the Eurozone (which has more constraints as governments themselves do not issue Euros) to run up against borrowing limits. Who is going to buy the bonds needed to finance their £160bn package?
You will hear plenty of commentary on the budget so I don’t want to add much on what is essentially a political decision to go for growth by cutting taxes. Instead, I will say that, from a market perspective, a £160bn stimulus package for an economy with an inflation problem has not been well received. The government is applying the accelerator just as the Bank of England was hitting the brake. This means the Bank of England now has to brake harder. Market interest rates (the brake) have risen as a result. As an example, the 5-year gilt yield (which will ultimately be used to price 5-year fixed rate mortgages) has risen from 0.8% at the start of the year to over 4.5% as I type (and is up over 1% in a week). Investors need to be paid more to take on more UK government debt. Many consumers are going to lose more from higher mortgage rates than they gain from the tax cuts.
From an investment perspective, higher interest rates mean lower valuations (as valuations are future cashflows discounted back to today). This, I am afraid, is behind much of the losses you will see on your valuation statements so far this year. Note, though, that the cashflows themselves are pretty much unchanged. Today’s lower prices also therefore mean better expected returns in the future. This fact is one reason we encourage our clients to take the longer-term view (where you can) when thinking about their portfolios. The value of this is probably much higher in tough years than good ones.
Although the backdrop of higher interest rates is the same for all asset classes, the impact and outlook for them has been different. Below we break down what we are seeing for our equity, fixed income and alternatives portfolios.
Remember, the problem for the global economy is that things are running too hot, not too cold. Earnings have held up although they have of course been squeezed by higher costs. This cost pressure is easing though (oil is down 25% from its peak in USD terms and is 12% cheaper even if you are paying for it in poor old GBP). The losses we have seen in equities this year (down -25% or so before allowing for the effect of dramatically weaker sterling) are mostly down to falling prices, not falling profits.
How much further is there to go? At some point interest rates will have risen enough to trigger the slowdown that central banks want to see. This will of course hit earnings and so the cloud of recession will continue to hang over the market. Once the market is convinced the rate rising cycle is over we think equity markets – which are always forward looking – will be a buy. And even if you are early today, we think equities are priced to deliver their 7%-9% annualised returns (enough to double every 10 years) at current valuations. Putting this together we are neutral equities but will look to add once the rate rising cycle is over.
Here the impact of what has happened so far this year is most dramatic. Consider the return you get from lending to high quality (investment grade) corporates (as shown in Table 1 below). At the start of the year the yield from this was below 2%. Today it is above 6%. The average CPI inflation rate expected by the market over the next 5 years is pretty much unchanged at just over 3%. At the start of the year investment grade bonds could clearly not do the job of keeping up with inflation. There are of course no guarantees but today your expected return is CPI + 3%.
This is a huge turnaround. Our lower risk portfolios in particular have been hurt by the falls in fixed income assets. Though it will take time to make up these losses, we think fixed income is priced for success today.
At the start of the year, our rationale for our alternatives allocation was (i) investment grade returns were not going to beat inflation and (ii) there were cashflow producing assets (such as renewable energy investments) that were available in listed trust format that could do the job. This rationale hasn’t changed. For the first 8 months of the year the inflation linkage these assets had meant they truly were a safe harbour in the storm. The post budget jump in interest rates has seen prices fall this month.
For those that have interest we will be doing a more detailed note on the returns and opportunities we see in this sector separately. For now, however, you should know that the cashflows that ultimately drive your returns are pretty much unchanged by all of this. Higher inflation should help a bit (because of the inflation linkage), higher future leverage costs will be a drag. Price falls mean that the returns we pencil in have risen from 5%-6% to over 7%. Given this is not far off the returns we see in fixed income one question is why not just re-allocate our alternatives exposure to fixed income? One reason is, of course, the inflation linkage. But another is that we think we are looking at a slowdown and recession for next year. These assets (e.g. care homes for example or renewable energy) are chosen to have limited exposure to the business cycle. We think they will be attractive investments to own when the slowdown comes.
The big question then is how much more do interest rates have to increase to slow the economy enough to bring down inflation. For some drivers of inflation (such as oil) it looks to us like the job is already done. Others (such as housing) only work with a lag. Finally, and most importantly, wage growth needs to fall to be consistent with central banks’ 2% target. How bad does the recession need to be to make this happen?
There is a saying in markets that the more bearish you feel about the short run the more bullish you should feel about the longer run. It is hard for me to be too optimistic that we are through the worst of this given that the peak for rate rises looks to be at least 6 months away and it may take longer. We think it will be hard for markets to find a bottom if rates are going up. That said, when we look at our portfolios and their forward looking returns they look as high today as they have at any time in the last 10 years (or more). We will be staying the course with our investment approach and, of course, we will be on the lookout for the opportunities these market dislocations will inevitably throw up.
The value of investments may fall as well as rise and you may not get back all capital invested. Past Performance is not a guide to future performance and should not be relied upon. Nothing in this market commentary should be read as or constitutes investment advice.