July 2022 Investment Bulletin
Economic Outlook
The economic outlook is as bleak as we have seen it since 2007. These are the worst returns provided by global equities during the ‘first half of a calendar year’ since the great recession, with many stock market values down by 20%.
Looking forward, the expectation is for further falls. However, do not fall into the ‘sell all now’ trap. Although it might save you some paper value now, you will inevitably miss the upswing whenever it occurs. This means you will end up having sold low and needing to buy high, which is an even worse position to be in
Inflation
Inflation is ramping up with the UK passing 9% and rising. The Bank Of England (BOE) has issued new monthly forecasts, all of which look worse. They are working to the assumption that inflation will peak at (perhaps) 11% before falling in 2023. However, inflation is expected to be highly volatile over the next 5 years. Looking beyond the BOE’s forecasts the best consensus we can provide is an average of around 4% to 6% p.a., but this is a moving needle. Moreover:
- Whilst the unions are not nearly as strong as they were in the 1970’s, wage inflation will fuel the inflationary spiral.
- The war in Ukraine is leading to food and energy shortages as the sanctions on Russia take effect.
- Covid lock downs in China have greatly affected the supply of components for manufacturing.
These are the main factors which many believe will keep inflation at higher levels for some years to come.
Monetary Tightening
Rising interest rates should begin to supress inflation as it draws money out of the economy. The problem is that, at the same time, governments are withdrawing monetary easing and there is no sign of any positive cash injection into the economy (for instance, on infrastructure projects). This means that the economy will have to cope with rising interest rates, rising food and energy bills and no stimulus from the government. This is highly likely to push the economy into recession.
Interest Rates
Even the European bank are proposing to raise interest rates in July. Current pricing of interest rate derivatives suggests that investors still anticipate UK rates to rise for the coming 12 months, with rates climbing to well above 3% by the middle of next year (from 1.25% now). Counterintuitively, they are actually pricing in more hikes now than they were before last week’s BOE announcement.
Commodity Prices
Are expected to remain high. Be it Ukraine’s wheat, Russian oil and gas, or Covid lockdowns in China, the supply chain has been disrupted leading to a shortage and hence much higher prices.
Correlation
Literature tells us to invest into a wide range of alternatives so that when one asset falls another will remain stable / rise to compensate. Our typical portfolio is highly uncorrelated, yet the market falls have been astonishingly correlated regardless of the asset class.
Even commodity stock (oil, gas etc) prices have fallen recently. This is due to fears that, at the current prices, the demand for these products will fall due to recession.
The War In Ukraine
The war itself has little impact on the global economy, the sanctions on Russia and the inability for Ukraine to get its grain out are the main drivers of global inflation.
Those who are more jaundiced about today’s politicians point out that Germany, France and UK (not to mention the USA) have elections coming up over the next 3 to 4 years so pressure to resolve the conflict (regardless of the outcome) will grow.
Demographics
Looking much longer term, China will lose 400 million from its labour force by 2050. The modern attitude is to produce, at most, an “heir and a spare”, which in itself is nowhere near enough to maintain the current global workforce.
If we are lucky, the technological revolution and development of artificial intelligence (AI) will compensate for this but this is by no means certain.
The Great Inflection
Whilst the short term prospect for the global economy and asset values looks bleak, I attended an interesting lecture from Graeme Leach who believes we are on the cusp of a huge surge in growth and living standards generated primarily by a leap in technology and the development of AI.
Asset Allocation
Bonds
The investment retreat I recently attended was the most anti-bond one I can remember. Since January 2022, indexed linked UK bonds have dropped over 50% in capital value. Traditional long dated bonds have also collapsed. Clearly this was an asset allocation we got right, given we either avoided or only included short-dated bonds.
Moving forward, we are now a firm ‘no fixed interest’ (even short-dated) until base rates return to more normal levels (3% to 5%). Should we reach those percentages, we will use bonds for what they should be – a good income source which is less volatile than equities. In the meantime, cash is king!
Small Cap
Has lost around 40% of value over last 12 months. Small Cap tend to be high growth companies and inflation is a killer of their valuations.
FAANG Equites
Are down 50% from their high point last year. Inflation discounts the previous valuations very significantly. If you think Apple will be around in 50 years time then that’s the time period you have to discount the value to account for higher inflation.
Europe
The southern European malaise of over-borrowing has not gone away. Italy, Spain and Greece cannot sustain their debt if the interest rates rise and their spreads increase. Whilst Mario Draghi maintains his absolute support they may survive….
Cash
If you have a need for cash in the next 3 years, we would advise ringfencing it now. Whilst we may hold more cash as a short term defensive ploy, the effect of inflation long term is to reduce the value of your savings by the rate of inflation less your after tax return.
| Basic | Higher | ||
| Interest Return | 2.00% | 2.00% | |
| Less Tax | ( .40%) | ( .80%) | |
| Net Return | 1.60% | 1.20% | |
| Inflation say | 5.00% | 5.00% | |
| Net return | ( 3.40%) | ( 3.80%) | |
UK
Initially the UK market fared well in global terms, sadly we have few tech or growth stock but our FTSE 100 is packed with miners, oil producers and banks. All went well until June when the market took fright regarding the outlook for commodity suppliers.
In the short term, the UK may hold up well, longer term we look like a stagnant economy.
The USA
Whilst the stock market has taken a beating, the FED’s approach to interest rates should retain the strength of the Dollar which may be a saviour of international stock value. Having said this, the FED has been the most aggressive towards interest rate rises and the fear is that they may push the US into recession next year
Emerging Markets
Should recover when China turns the corner, however, during turbulent times bigger markets trend to be less volatile.
Property
Residential
Residential property prices are significantly above their historic trend and are due a correction. Over the last 20 years the ratio of earnings to house prices has risen as follows:
|
2002 |
2022 | |
| London | 6.70 | 13.70 |
| South East | 6.00 | 10.70 |
| UK Average | 4.90 | 9.00 |
With 74% of all borrowers on fixed interest deals, as these come to an end the higher underlying interest rates will force significant falls in capital values. In the 1970’s, lenders frequently had clients calling in to hand back the keys to the property which had negative equity. A 70% loan-to-value does now look vulnerable in the next couple of years.
Commercial
Janus Henderson have now concluded their sale to a private equity company. This highlights the issues of instant-access collectives holding illiquid bricks and mortar commercial property.
Overall property does well in inflationary times and will remain in our factor choices. Clearly, there are some question marks over office accommodation, however we believe the scaremongering is overstated. Most progressive firms are now requesting staff work from the office a minimum of two or three days a week. This means that, by hot desking, the requirement for office space is reduced, but certainly not eradicated.
Value Stock
We believe Value will be king over the next months, so have significantly increased our exposure to same. A Value stock is one where the company’s assets and revenue create a value which is equal to or in excess of the market price of the shares. Tech stock, on the other hand, is usually valued based on future potential returns, not today’s actual returns.
Defence Sector
We have had several request to include the Defence sector in our Long Term Growth section of funds. If you would like to add this sector to your portfolio please let us know.
Clean Energy
Actually all types of energy should do well until the global shortage is resolved.
Infrastructure
Should do well but we are not seeing the government investment as yet which would give the stimulus to equity values.
Automation
Over 5+ years has to be a must, but it has been hammered by the inflationary backdrop.
What Should You Do Now?
Do You Need Cash In The Next 3 Years?
If so consider encashing investments and ring fencing the cash now.
Do You Need Income From Your Portfolio?
Then we have already put aside (typically) 2 years income in cash on your behalf.
Thinking Of Investing?
Now is a great time to invest and it will probably get better should prices fall further. Do, however, phase onto the market to reduce volatility.
Maintaining Your Savings
Unfortunately, ‘now’ is the difficult set of circumstances our client reviews have consistently warned against. We have adapted our recommendations in an effort to optimise your returns in falling markets. Whilst the work we do improves your position, it cannot prevent fundamental shifts in perception and valuations. We hope that you take our advice and ‘sit tight’ until markets improve. If you have any worries at all, then please do get in touch.