OVERVIEW OF FACTORS DRIVING MARKETS

 It has been some time since we have produced a commentary on markets.  The complex background we see at the moment of uncertainty, rumour, volatility, pivoting political policy and Central Bank actions means that every time a note may have been produced, it became outdated within a short space of time.  I had started to write once we had a stable Government in place in the UK. That was a few weeks ago. Whether we now have one is still open to debate but the last 2 weeks have at least given an impression of stability and control, but we shall see.   Instead, therefore I thought it might be helpful to give some colour to how a substantial amount of economic data and media commentary impacts the investment markets.  

This note is, however, written with the caveat that things may well change again next week but at least if it provides some background and a general understanding of where things are and where they could go, it will have some use. 

 Markets  

Stock Markets around the world have been both irrational and unpredictable for the last 12 months.  This has led to violent movements both up and down.  In fact, in the last ten months or so there has been more movement, greater than 2% in either direction in a day, than has ever previously been recorded.  Throughout this period some of the biggest and most successful companies in the world whilst continuing to deliver excellent returns have seen their Share prices slashed by as much as 30%.  This is often because Markets are ignoring individual company data and simply treating all businesses in an investment sector in the same way.   

This creates dislocations in markets that present excellent opportunities for the future but at the moment even the most experienced and talented fund managers are struggling to predict what will happen. The wild movements we are seeing in markets are triggered by Day Traders or those using options to drive markets up or down. They are of course looking for instant gains and are not really interested in proper long-term investment strategies.  Unfortunately, their influence is so great at times like these, that long-term active managers such as those that we work with simply need to sit on the sidelines and keep a close eye on their investment selections. 

From talking to our managers, they are constantly reviewing their investment selection processes for each business that they work with.  The data that is being provided by these businesses is often on a weekly basis.  They are able therefore to update their analysis of cash flow and profit forecasts, balance sheet strength and other crucial information.  Regular updates on expected Dividend policy also helps formulate an opinion on the value of a business.  

These experienced fund managers are then able to make decisions as to whether or not they should retain a company. There are some decisions to sell being made but these are relatively rare due to the control that each management team is putting in place.  It is more common for a decision to be made to hold and investment with an expectation that Share prices will improve but in these cases, there is always a time horizon to be borne in mind.   

What is most interesting is the number of occasions where the analysis indicates that a Share price is now so cheap as to make it worthwhile adding to the investment.  This lowers the fund managers’ overall purchase costs and allows them to have lower targets for the Share price to still achieve substantial profits.  In the current climate, this does not necessarily help with growth and returns being achieved but in the medium to long term, which is where all our fund managers are focused, this should help deliver stronger returns. 

 Inflation 

In terms of the investment world, it has been so long since inflation has been a factor that much of what is written on the subject misses key points and lacks clarity.  The thing to remember about inflation is that it is simply the difference between the current cost of a basket of goods and services compared with the cost of that same basket 12 months ago.  It is not surprising, ignoring the horrific developments in Eastern Europe that inflation has risen.  The biggest driver of inflation is always the supply or availability of goods.  When demand for goods is high, prices will rise.  During Covid lockdowns, inflation was negative simply because the price of goods fell between 2020 and 2019.  Global demand was lower in 2020 so prices fell dramatically. Inflation was bound to increase after that for example, oil priced at $20 a barrel in April 2020, $64 in April 2021 and £115 in April 2022. 

The right place therefore to start considering inflation is around the supply chain issues that Covid created.  As the world emerged from various lockdowns, there was a substantial increase in demand for goods of all sorts.  Many of the production lines were not working and therefore a supply shortage occurred.  This was exacerbated by the Chinese policy of shutting down entire infrastructures if Covid appeared.   The closure of Shanghai, the world's largest distribution center for part of the Spring worsened the supply issues further.  That bottleneck does now appear to finally be easing and the goods that were held in Shanghai have been released.  Crucially all of the boats and other methods of transport that were either stuck in or waiting outside Shanghai have now made their way around the World.  

Supply chain issues were then aggravated by those looking to exploit opportunities or make substantial profits after periods of lower incomes.  A good example of this is OPEC who reduced the supplies of oil and gas around the world to make some money by pushing up oil prices further.  Those factors were always going to put inflation on an upward spiral, something that markets seemed to ignore, and younger traders have never experienced in their lifetimes.  Central Banks on the other hand quite like the idea of some inflation as it allows them to reduce the overall value of the long-term debt their Governments had just created.   

The invasion of Ukraine by Russia early this year had a multiplier effect on inflation just as things were beginning to ease.  Suddenly, the whole supply chain through Eastern Europe into the West was compromised.  Not only did supplies of oil and gas come under pressure, but a whole range of other goods and food basics produced in the area saw a reduction in supplies.  All of this results in prices being pushed up substantially.   

That is broadly where things are now but if we look for a moment at where the expectations for inflation will be, that may be helpful.  Firstly, supply chains are normalizing.  What is interesting is that not only are the raw materials and goods held up in the supply chain now arriving where they are needed, whilst production has continued and those goods are being delivered as well.  Effectively there are reports in certain areas of a glut in supply of key components for manufacturing industries, such as semiconductors.   

The likelihood is therefore that escalations of prices will slow down and in certain overheated areas, reduce again.  Other issues such as the supply of gas to Western Europe appear to have been eased by effective overordering of supplies in the summer and retaining any excess for the winter.   

Looking at prices, bearing in mind the rate of inflation is the comparison between current prices and those from last year, there are a number of deflationary effects that could appear in the first half of 2023.  For example, this time last year the price of a barrel of Brent Crude Oil was around $90.  That is slightly above where it is today.  In the Spring of 2022 however, this had risen to between $130-$140 per barrel.  If prices remain where they are, which is not unreasonable considering the stability in prices we have seen recently, then in April 23 there will be almost a 50% reduction in the cost of oil over a 12-month period.   Not only will this reduction in cost feed directly through to the inflation figures, but there will then be a secondary effect where the cost of production or transport is also reduced as a result.   

Another factor, much closer to home, is the comparison of the three-month forward pricing of natural gas in the UK.  12 months ago, the cost of 1 Therm was £2.60.  As we know prices have risen dramatically so that in the summer they exceeded £5.00 and at the end of September actually reached £7.00.  All of that is driving the cost of our utility bills.   

The staggering fact that no-one seems to be commenting on is that the price on 31st October 2022, of 1 Therm was £2.93.  Effectively we have seen a drop of more than a half in the cost of wholesale gas over a six-week period and in fact, contrary to everything we are reading in the media, gas prices are now not far off the level they were last year on the wholesale markets.  The market is even more volatile than the Stock Markets with prices trading in a range of around 150%, so between £1.80 and £5.00 in a month.  There are a number of other factors involved such as currencies, but those prices tend to reflect the supply issues around natural gas and are considerably less worrying than they were a few weeks ago.  Energy price inflation in all aspects could potentially be much lower by the middle of 2023, which should also have a lowering effect on inflation.   

As we have learnt over the last few years, nothing is certain and whilst a week is always a long time in politics, it seems to be a long time in the investment markets and economics as well.  This is why Central Banks are still aggressively raising interest rates, to try and be seen to keep inflation under control.  They are acutely aware of the fact that increases in supply and reductions in costs will have a natural effect of lowering inflation, but they cannot be seen to be doing nothing.  The natural longer-term trend for inflation from here is downward, but that cannot necessarily be easily conveyed when most media outlets prefer to pedal gloom.   

The important thing to remember once again is that markets are usually looking at between 12-18 months into the future and whilst they can be derailed by unexpected events, their focus will increasingly become – “where are we going to be in 2023 and 2024 despite all of the difficulties the global economy is suffering today”.   

 Interest Rates 

In practical terms, over the last 15 years the only actual tool that Central Banks have for fighting inflation is the manipulation of interest rates.  In the USA, the Federal Reserve is acting strongly in terms of its approach to dealing with inflation by escalating interest rates rapidly.  In the UK, the Bank of England has been more circumspect.   

It is interesting as an aside to note why this may be.  Jerome Powell, the Chair of the Fed does not want to be seen as passively managing the US economy.  His predecessor, Janet Yellen was often accused of that and he would rather be seen as overzealous than inactive.  In the UK Andrew Bailey, who is the current Chair of the Bank of England, is much less decisive.  Mr Bailey’s role prior to joining the Bank was Chair of the FCA.   He presided over the scandals in relation to the advice of British Steel pensioners and the London & Capital Mini Bond fraud.   I will not waste time in this letter commenting on my view of Mr Bailey.  His predecessor, Mark Carney was in fact much more like Jerome Powell in terms of approach.  Effectively therefore we have seen the operational management of the two Central Banks reverse in recent times. 

For the last 15 years, interest rates, much like inflation, have been at almost zero.  The investment market and indeed those people growing up over that period have only ever been used to benign conditions.  Those of us old enough to remember the 1970s, 80s and 90s are known for muttering interest rates at their current levels are still extremely low.  The point however is not the level of interest rates but the speed at which they have increased. 

Last February the American general interest rate was 0.25%.  In eight months, it has risen to 3.25%, which is a twelvefold increase.  Mr Powell has been reported as saying he expected interest rates to continue to rise to a maximum of around 4.5%.  This is still quite a bit above where they are today.  The rate of increase, however, is dramatically slower and one could argue that if a curve was plotted showing the scale of interest rate rises, it would be much shallower now than it was in the summer.   

Indeed, Mr Powell has gone on to say that if inflation is brought under control as he expects, then interest rates will begin to fall in the spring of 2023.  America therefore, appears to be at the latter end of the interest rate cycle.  This is supported by the projections of a start in the downward trend of inflation over the next 6-12 months, something not commented upon because the recent political upheaval in the UK has for once had a global impact.  

Interest rates will always affect the value or attractiveness of a currency.  With interest rate rises in the USA being more aggressive than elsewhere, we have seen the Dollar strengthen throughout the year.  The recent issues in the UK have meant that Sterling depreciated rapidly due to unfunded tax returns creating an opportunity for the Currency traders such as George Soros to make $Billions in the confusion.  The only perceived way of protecting Sterling was to suggest interest rates would rise.  That supported Sterling but it fed through to lending markets and the turmoil in the mortgage markets we have seen in recent weeks.   

Fixed Interest Investments 

There is one area of investment, apart from cash, that is always deeply affected by interest rate movements.  That is the Fixed Interest Securities market made up from long-term borrowing by Governments and Businesses alike.   

Put simply, if a Fixed Interest investment offers a set amount of monetary return every year until it is redeemed, its attractiveness or otherwise of that will be related to prevailing interest rates.  We have had 25 years of declining interest rates and Fixed Interest Securities have been seen as increasingly attractive and prices have risen as a result. In some cases, they have actually reached the point where investors were willing to pay more than the total return payable over the entire lifetime of the Fixed Interest Security just to buy that investment, effectively guaranteeing losses to capital.  

The point about Fixed Interest Securities is they are meant to be low risk and many cautious investors find their portfolios stacked full of them.  Final Salary Pension schemes and the like will also be heavily invested in Fixed Interest Securities bathing in the unsustainable levels of profit they have seen over the last few years. 

This is vaguely ludicrous as there would have to be a time when interest rates would start to rise. Whenever this began to happen, the value of Fixed Interest Securities would reduce as they will become less attractive, something large insurance companies and Final Salary Scheme Trustees simply chose to ignore. 

When the Sterling crisis happened a few weeks ago, the capital value of these investments plummeted overnight.  With no-one willing to buy the investments that these funds wanted to sell (to preserve their gains) the market froze and panic ensued.  With the Bank of England stepping in to buy up these Fixed Interest Securities at a discounted price, the markets calmed, but not before substantial losses had been experienced.   

The consensus in the investment world was that the value of Fixed Interest Securities should gradually decline over a 10-year period as interest rates moved from almost zero to something more sustainable.  The effect of the Government mini-Budget announcement was that around five years of those expected losses happened within three days.  Whilst this was an extreme reaction, this illustrates why the fund managers we work with have limited their exposure to Fixed Interest Securities to the absolute minimum for some time now.   

There is still a considerable amount of pain to come in the Fixed Interest markets over the next few years where investors who have been used to earning 7-8% on a very low risk investment vehicle, will find themselves earning between 1-1½%.  With inflation targeted at 2% per annum over the longer term, this will mean that Fixed Interest investments will generally lose money in real terms for the rest of this decade.   

In terms of where we think general interest rates will be, the trend is certainly upward at the moment but with expectations that they will decline in 2023 and 2024.  Exactly where they end up will depend on a number of factors, none the least political developments which are happening non-stop.  The market consensus however is that by the end of 2024 interest rates will be down to around the 2% mark with long term rates slightly lower than that.  This is why short-term mortgages have increased so much whilst longer-term rates, such as those fixed at the five-year point or longer have stayed relatively stable during the maelstrom. 

Currencies 

I have already commented on how currencies are affected by interest rate expectations. Currencies are important to the global economy as the cost of trading increases when imbalanced currency markets occur.  If one currency such as the Dollar is strong as it is now, US exporters will struggle to sell their goods at a profit.  Equally investments into America are more costly.  Currently, tourists and investment in the UK if converted from US Dollars are extremely cheap but there are other parts of the UK economy that do not benefit from low currency levels, especially where raw materials are concerned as they are usually denominated in US Dollars.  

Central Banks around the world want stable currencies and there is a hope that the Dollar will weaken over the next year or two.  Certainly, as interest rates in the US drop then the Dollar will become less attractive relative to currencies such as Sterling, the Yen and the Euro.  It is hoped over the next year to 18 months that the currency markets will stabilize closer to $1.30 to £1.  

In the meantime, investments held in US Dollars and converted back to Sterling are doing well.  Many of our mangers are now hedging the currency risk within their portfolios to preserve profits that they have made as the markets have dropped whilst currency moved in their favor.  None of the managers we work with profess to want to manage currency as a normal portfolio activity.  They are more interested in the quality of the businesses in which they are investing but the opportunities afforded to them by the current mismatch in exchange rates is something they could not miss exploiting.    

 Investment Portfolio Thoughts 

Pulling all of this together, the last 12 months have been dramatic to say the least.  We are not in times that would be deemed unprecedented simply because interest rates and inflation are higher than they have been for a while, but we have been here before.  Experienced fund managers are negotiating through this difficult period and whilst a number of them are frustrated with the ridiculously low values of some of the companies they have invested in, the general consensus is that things should begin to get better in the reasonably near future.   

Clearly the one thing no one can predict is the effect of political maneuverings in the UK.  It is interesting to note that at the point of Liz Truss’s resignation speech, both Sterling and the market rose suddenly; something highlighted by the BBC and attributed solely to her resignation. It was only afterwards it became apparent that the market increases were due to the fact that American markets had opened strongly on the back of a realization that interest rates were likely to be less aggressively increased in the future than they have been earlier this year, rather than the UK Politicial developments having any influence over the values of Global Businesses.  

If we are looking at investment opportunities, there are clearly large numbers of them in the active investment world right now.  It is often said that the best time to invest is when it feels uncomfortable but that is when most investors stay on the sidelines.  The managers we work with are used to this paradox and use a wide range of assessment tools as well as experience to make investments decisions on a daily basis.  Not all are successful of course. Stock Markets are only every “perfect” in retrospect so being invested is generally far better than not and this is something that experienced managers really understand. 

Summary 

The Chinese greeting ‘may you live in interesting times’ is often quoted by well-wishers.  I would quite like it to be adjusted to add ‘as long as there are quieter times as well.’  We certainly deserve a period of calm stability after the last few years.   

Whilst much of this letter is looking forward with a degree of positivity, this is because markets are designed to look at what is going on in the future rather than what has gone on in the past.  Day-to-day emergencies will affect markets but the general consensus is that investments returns should improve over the next year or two.  Unfortunately, returns are never simple and in a straight line.   

We expect volatility to continue and investment returns to remain sluggish for the remainder of this year and potentially the early part of next year.  As soon as a firm trend in economic policy changes in the USA and possibly here, then investment values will rise, potentially very quickly. 

The first years of this decade have been challenging to say the least.  Whilst client portfolios have fallen in value for some of those periods, they have also risen.  The blend of the strategies we use including ideas such as structured products have avoided the worst of the downturns and left portfolios in a stronger position to benefit as markets recover.   I will leave you with a comment from Warren Buffet, the legendary Sage of Omaha.   He made this as part of his address to Shareholders.   

‘As long as the tender shoots remain unfrozen by another unexpected winter storm, I expect to see those tender shoots recovering and growing rapidly during 2023.  Now is the time that any self-respecting fund manager takes the opportunity to benefit from market dislocation to tend to their garden with an increased level of due diligence.  The level of summer flowerings that I believe are on the horizon, will be determined by the active gardening undertaken now.’ 

Every one of our managers would see themselves as enthusiastic and active gardeners. As their capital is invested alongside ours, let’s hope they deliver spectacular summer blooms for us all. 

Yours sincerely 

D. K. BALDWIN APFS FLIA (dip) 

Managing Director 

Mob: 07919 328 651 

Email: david.baldwin@christiandouglass.com