News & INSIGHT

Resilience in the face of adversity

The strong start to the year was tested in March with the failure of several regional banks in the US, followed closely by the bailout of Credit Suisse, the second largest Swiss bank. Unsurprisingly, these events led markets lower over the month as sentiment soured. However, it wasn’t long before they regained most of that lost ground during April, with shares once again showing resilience. Stress in the banking system appearing isolated and easing inflation calmed nerves sufficiently for the FTSE 100 to close just below its record high of just over 8000 and up 4.5% year to date.

After underperforming all assets last year, ‘growth’/tech stocks have rebounded strongly year to date driving most of the equity gains. ‘Growth’ stocks had reached valuations not seen for some time which enticed investors back in, lifting stocks and the tech-saturated US economy. Following the recent rise, it is hard to call ‘growth’ company valuations attractive when compared to history, bond yields or value stocks. The latter rebounded most in April, with many banks categorised as ‘value’ and recovering after an initial wobble.

Lower energy prices meant commodities were the worst performing sector over the quarter, but that continues to be good for European stocks which were most sensitive to the gas price shock. Gold has bucked the commodity trend as a ‘safe haven’ asset, rising in value on the back of a weaker dollar and expectation of lower rates in 2024. Elsewhere, real estate struggled thanks to higher borrowing costs, with commercial property feeling most of the pain. An overspill into residential prices in the US could be harmful, with it being over four times the size of the commercial sector. Major risks here should be contained with most homeowners in the US holding long-term fixed rate mortgages and therefore unaffected directly by higher lending costs.

Stronger economic data has helped resilience, but equally may contribute to stickier interest rates. Inflation is falling although the most recent US job creation report once again beat expectations in May (by over 30%) causing unemployment to unexpectedly fall further. At present, US bond markets are pricing (with almost certainty) that interest rates will be cut as early as the end of this year. We still think investors may be premature with this forecast and, in any case, expect central banks to act slowly on the way down, requiring concrete evidence lower prices can be sustained before dropping interest rates.

Don’t panic, any bank can fail

With enough loss of confidence this is true, but particularly so in a world of online bank-runs, rapidly rising interest rates and availability of higher returns with greater security outside of the banking system. That all being in the form of Government Bonds (UK gilts/US treasuries) and Money Market funds. The latter of these recently drawing inflows of £580bn in just ten weeks.

With the combination of uncertainty and availability of alternatives for savers, it is not hard to see how deposits can plummet overnight and continue to do so. Just last week, two more US banks – Pacific Western and Western Alliance – had their shares suspended. However, as we indicate,  there is no need to panic as we do not see a re-run of 2008. Banks today are in much better health than during the credit crisis and, where cracks appear in the small and medium-sized banks, larger institutions are likely beneficiaries of a deposit boost, thus strengthening their positions. Banking consolidation, certainly in the US, is not new, given they have many more banks than in the more concentrated European system. In the 80s there were around 14,000 US banks and today, around 4,000.

Markets have calmed for now, but we anticipate a few more small/medium US names running into trouble, hopefully without too much fuss. We trust authorities will act if needed to avert an all-out loss of confidence as we journey along with a fragile financial system that still can’t cope with the monetary medicine required.

Ain’t no mountain high enough

It’s not just banks struggling to balance the books. The US government is again in need of an urgent agreement to raise the debt ceiling after spending more than they earn from tax receipts year on year. The next couple of weeks will be critical and may add some volatility to markets, in the form of upward pressure to treasury yields and weakness in the dollar. Ultimately, we expect a last minute agreement to be reached as the alternative, to default, would be a catastrophe for the US. That said, a more divided Congress raises the probability of a potentially ‘messy’ array of short-term measures if the ceiling isn’t raised in time, which won’t help short-term economic progress.

We think the big banks will be just fine, but regardless, there are good reasons for investors with large cash deposits to re-think where they store their wealth. Higher returns, greater security, even improved tax efficiency, are a win-win combination achievable from UK Gilts and money market funds and something you will likely hear more about from us this year. These benefits alone are reason for individuals and companies to re-locate cash savings, with the recent bank failures merely a reminder to review things today.

Summary

With the economy still expected to slow this year and equities having done so well year to date, we wonder if the latest rally has more legs left. On the whole, the service sector has been the saviour keeping the economy afloat, with goods and manufacturing having a harder time. Until an agreement is reached to extend the US debt ceiling, the next couple of weeks are likely to see a restricted range either way. US yields may creep up until then, with pressure remaining on the dollar and regional banking system.

It is true companies in the UK are not overvalued by historical standards and certainly not when compared to the US, potentially leaving room for price growth. Energy prices will also ease cost pressures for firms this year, but wage bills will bite and in the UK, what is left (in profits) will be 6% lighter than last year thanks to the rise in corporation tax from 19 to 25%. With productivity readings down and savings rates also falling, a slowdown in new jobs and rise in unemployment seem inevitable and is what central banks will require before lowering interest rates. Against this backdrop, assets that traditionally provide shelter from economic weakness look more attractive than they have for over a decade. Taking less risk with investments is an easier choice than it has been for many years.

Clients who pay close attention to our Bulletins will note our cautious undertone persists in pursuit of an honest appraisal of the indicators we watch. However, this is not to be mis-interpreted. Our outlook for low-risk investments (namely bonds) is more positive than it has been for a long-time, so the ‘risk averse’ are well positioned for the future. Investors prioritising the preservation of capital are now being rewarded for their patience and remain well positioned to take advantage of any economic shocks.

The details, views and opinions expressed above are KMD’s, can change at any time and are not intended to be advice or a solicitation to make an investment. Professional advice should be sought before acting on any information contained in this document. The value of investments can fall as well as rise and your capital is not guaranteed. Past performance is not a reliable indicator of future performance.

2022 was a difficult year for most investments, but unusually, in a tough year for stock markets, it was Cautious investors who experienced the worst of the downturn. Rapidly rising inflation, caused by supply chain disruptions and low unemployment, left central bankers no choice but to react at similar pace with interest rate rises. This was bad news for bonds and fixed interest investments which are most sensitive to changes in interest rates.

There was some respite in the final quarter, with a feeling that recession was now priced into markets. Riskier assets/equities certainly bounced as inflation peaked, helped by falling oil & gas prices since the summer. A mild winter and expectations that interest rate rises would slow, or soon pause, also buoyed buyers. Small companies and European equities were big beneficiaries in the fourth quarter, the latter as a result of falling energy prices. China also rebounded strongly after a dismal 2022, with their zero-covid policy very much determining sentiment. Now one can only hope that they have moved beyond this stance.  Value stocks, particular in the energy sector, topped the performance tables over the year with the Russia/Ukraine conflict pushing prices higher.

Fundamentally Sound

For several years, Pinnacle Financial Services & Wealth Management has been positive on value stocks due to their fundamentals and inflation protection qualities. While technology stocks/growth equity won the race in 2020, the order has very much changed over the past two years where a ‘value’ tilt in our strategies helped contain losses in what was a very painful year for many. We have, for some time, been positioned for higher inflation and, while no diversified portfolio can completely protect against inflation shocks, we faired very well in ‘21 and ‘22. KMD’s strategies focussed on short maturity bonds, with lower interest rate risk which has also helped contain downside risks. Growth stocks bore the brunt of last year’s interest rate rises  and were down 29% compared with losses of just 6% from value stocks.

It is pleasing to see fundamentals finally working their way into share prices.

The future is not without its challenges, however ‘deep’ or ‘shallow’ the  recession we are facing. Supply chains are yet to right themselves entirely and deglobalisation is well underway, leading us to believe higher interest rates will be sticky. We think markets are a little optimistic by pricing in rate cuts just one year away, given inflation may  still be above trend ie above 2%. Prices will rise much more slowly this year, but one can’t help but think central banks are going to be much more cautious in lowering interest rates. This is relevant since all eyes remain on the Federal Reserve (and US rate policy) and it is rate expectations which will continue to dictate where equity markets go from here (as has been the case for some time).

Improving Value

On the positive side for 2023, equity valuations are more realistic than they were at the beginning of last year and energy input prices (oil & gas) are coming under control. A similar downside to that seen in 2022 is therefore less likely. In terms of home ownership, when compared to the past, today, not only is there a much higher proportion of homeowners with fixed rate mortgages (especially in the US)  who have not  yet been impacted by rising rates, but homeowners are also not as indebted as they were in the 2007/8 crisis.

Markets tend to price risk very well, but we could see a couple of positive ‘surprises‘. Firstly, de-escalation between China and the US in relation to Taiwan and agreement to cease their trade war would certainly boost markets. Similarly, if continued unnecessary loss of life fuelled a Russian revolt and Putin were to be overthrown, we could see an end to the conflict and re-opening of food and energy supply lines. Either outcome would provide a boost to stock markets.  However, for now, they are just potential ‘surprises’ and unfortunately, both carry even greater risks if they escalate instead, so positioning for either outcome with high conviction is unwise.

We have been cautious for some time and while, importantly, stock markets are now better value, so too are defensive assets, cash and fixed interest. Therefore, we see limited logic in now taking considerably more risk than we have done over the past decade. For the first time in a long while we are becoming excited about the prospects for Cautious investors and fixed interest.

Another tough year ahead

On the side of caution, housing market weakness has already begun with further falls in prices and construction activity likely, although price drops should be contained only by limited stock. Continued strike action in the UK remains disruptive to productivity and if the government concedes, could spark inflationary pressures through higher wages thus forcing interest rates higher. Even without wage increases, UK government debt issuance is set to soar over the next decade, with Citigroup forecasting this at c.£240bn a year compared to just a third of that (c.£80bn) over the past decade. With interest rates also over three times higher than they were, that is a 10-fold increase in new debt servicing costs! No wonder then that governments are not entertaining union demands.

High corporate debt levels, rising wages and extended profit margins lead us to believe earnings forecasts, that make up today’s more attractive valuations, may have undue optimism built-in. Equally, bond markets appear to be calling central bankers’ bluff in that interest rates will fall sooner (by the end of the year) than central banks are indicating. Markets often know best, but this time round we are with the central banks ie anticipating they will want to see inflation fall to target and remain there before considering a reduction in rates.

The worst of the inflation and market correction is probably behind us, but another economically challenging year lies ahead. In our view, the current economic balance is not conducive to high levels of conviction across most assets and regions. There are some areas where profit taking could be wise. For example, in energy stocks with additions to oversold sectors such as REITs or even bonds. US and Growth stocks could enjoy a little rebound, but our medium to long-term view remains that value stocks and emerging markets are likely to offer better value amongst risk assets with the potential for smaller companies to be added at opportune times.

Finally, cautious investors who suffered most in 2022 will be pleased to hear we are quite optimistic  about the outlook for those who are more risk averse (particularly in risk adjusted terms). The ‘return gap’ between high-risk and low-risk portfolios is likely to be much smaller in future and high-risk investors should carefully consider if additional risks will be commensurate with diminishing excess returns.

The details, views and opinions expressed above are KMD’s, can change at any time and are not intended to be advice or a solicitation to make an investment. Professional advice should be sought before acting on any information contained in this document. The value of investments can fall as well as rise and your capital is not guaranteed. Past performance is not a reliable indicator of future performance.

Behind the curve

The world economy has recovered strongly since the pandemic hit in 2020, but 2022 has proved to be a challenging year for the majority of assets.

The labour market has been tight, with the US unemployment rate at a near multi-decade low and wage growth a multi-decade high. These conditions have been compounded by supply chain disruptions leading to the economy experiencing inflationary expansion.

In our view, central banks should have had one foot firmly on the interest rate brake and governments been less loose with fiscal policy, but populist politics tends to be less accepting of prudent economics.

As we entered 2022, central banks were behind the curve just as price rises were exacerbated by the Russia/Ukraine conflict pressuring the cost of energy, food and transportation.  Now playing catch-up, with some large and prompt increases to interest rates, around 24 countries have already raised rates once this year. The US has led the way, with some of the larger moves increasing rates by 0.75% in both June and July. Further global rises are on the cards for 2023, although likely to be at a slower pace.

Nowhere to run, nowhere to hide

In this environment, typically ‘defensive’ assets (bonds) have fallen year to date to reflect higher market yields, but so to have equities, especially ‘pricier’ rate sensitive shares (e.g. tech/growth stocks).

In the first half, it is only really property and commodities that have held up, with energy and utility companies being the brightest spots amongst equity sectors, helping the UK to fare better than others. On the other hand, being home to many of the major tech firms, the US market retreated more with some of that weakness offset only by a stronger dollar for UK investors.

US stocks officially entered a bear market (defined as a 20% decline) as investor sentiment and consumer confidence fell, a slowing economy and mild recession at the forefront of investors’ minds. Q2 has been particularly tough as financial markets do not like rising interest rates. Higher mortgage/borrowing costs and more attractive cash returns simply don’t incentivise investment, but the UK has been a structural sufferer on this front since leaving the EU.

With two negative quarters of GDP already this year, you would be forgiven for thinking the US is already in recession, but with the Mid-term elections fast approaching, the White House would be quick to remind you that that doesn’t ‘technically’ mean the economy is in recession! If that convinces you, one still cannot deny the late cycle dynamics of price pressure, global monetary tightening and tight labour markets. In short, these factors all stress company profits and we don’t think this has been fully felt by firms as disposable consumer income is likely to feel a greater squeeze into 2023 and Covid-induced savings are spent.

A ‘recessionary’ bear market is typically accompanied by declining company profits, but in the first half of the year profits have been rising, just at slower rates. What we are hearing from company CEOs is more forward guidance of the challenges ahead and that corporate profit margins have already peaked.

China and the Eurozone

If the US is not in recession, then the Eurozone appears to be teetering close to the edge, continuing to suffer the fate of reliance on reduced Russian gas supplies. Political instability with a snap election in Italy, the Eurozone’s third largest economy, at a time when the European Central Bank is bringing the region out of negative interest rates, is adding to near-term trepidation.

China, the world’s second largest economy has been slowing for some time and Hong Kong slipped into recession in Q2. The economic toll of following a zero Covid strategy resulting in rolling lockdowns is certainly being felt. A weakening housing sector in China also remains a dark patch with shares dropping further, especially through July.

Not all doom and gloom

Despite all the doom and gloom this year, the major assets of bonds and equities turned positive in July and August to bring some summer respite for investors. Trends also turned again, the largest gainers being those that fell the most year to date, with tech stocks rallying.

Although noting the weakness in Chinese markets, economically there are some green shoots. China is further through into its slowdown phase and some data has surprised. Exports significantly beat expectations, credit growth is improving and importantly, while still suffering with rising input prices, Chinese consumer price rises are more stable. This is allowing monetary policy to loosen, in direct contrast with policy in the West. At attractive valuations and prices lower than the worst seen during the pandemic, in our view, the outlook for Chinese stocks is improving if they can battle through recent property market weakness and balance their political tensions with the US.

The recent positive performance has been driven mainly by expectations that interest rate rises would not be as fast or high due to slowing economic activity and limited corporate earning weakness. Markets are never linear and are now far from their highs. A rally in a ‘bear’ market is normal just as corrections are in rising ‘bull’ markets. Whether this is just a bear market rally remains to be seen – the economy is very late stage and has understandably lost momentum. Policy makers remain in tightening mode, the impact of which has not been fully felt by consumers, neither has the full winter cost of higher energy prices which are bound to weaken demand without further government support.

Stickier than anticipated inflation could yet cause further problems and populist politics of lower taxes and handouts add to price pressure. Either way, we typically discount much of the benefit you might think a new leader may or may not bring whether in No 10 or elsewhere. There are greater forces at play.

Against this backdrop, we feel investor optimism for profit growth is still too high. Expectations that this would be in double digits in 2022 at a time when conditions are challenging, significantly exceed the low single digit long-term earnings growth rates seen since 1950.

The details, views and opinions expressed above are KMD’s, can change at any time and are not intended to be advice or a solicitation to make an investment. Professional advice should be sought before acting on any information contained in this document. The value of investments can fall as well as rise and your capital is not guaranteed. Past performance is not a reliable indicator of future performance.

In the year to date, the most significant reference point for financial markets has been the Russian invasion of Ukraine.

Russia has a strategically important role as a leading global commodity supplier. In 2021, it was the world’s third largest supplier of oil and also produced 40% of the natural gas consumed by the EU. This reliance poses a significant problem, particularly for Europe. In the short-term, the choice appears to be between a country continuing to buy Russian products (where this is still legally permissible) and therefore helping to fund Putin’s war, or to potentially induce energy shortages, eyewatering price increases and ultimately recession for its own people and economy where it is not.

Going forward, countries are likely to think far more clearly about the wisdom of placing control of a wide range of matters in the hands of neighbours, thereby further enhancing the deglobalisation motion.

Russia and Ukraine also collectively export a quarter of the world’s wheat and a sizeable proportion of other grains. Both nations will likely face a reduced willingness, or ability, to supply food products to the rest of the world over the next year and beyond, thereby threatening global food supply chains. In the event that richer nations might hoard limited supplies for their own consumption in a temporarily shrinking market, poorer countries without sufficient domestic production may run the risk of facing food shortages, with likely devastating human consequences.

As events unfolded, this inevitably brought sudden shock to commodity supply chains, resulting in soaring commodity prices across the board in a short space of time. The diversified Bloomberg Commodity Index is up 32% YTD in USD terms. Although this can be a boon to those selling, it can represent financial hardship to those buying. Such changes have been sudden, thus explaining the violent reaction of financial markets.

Naturally, spiking prices in all directions inevitably leads to an inflationary destination. Prior to the invasion, financial markets were debating whether the inflationary pick-up during 2021 was ‘transitory’ and about to fizzle out (with 2021 inflation largely the story of Covid supply shocks in 2020 – in many respects, a similar parallel). Suddenly, elevated inflation is now likely to be with us for at least another year. The jury is out on whether higher levels of inflation than seen in recent years might be here to stay more permanently.

Bond markets were especially hard hit by this possible reality, on some counts registering their worst quarter for several decades. The FTSE All Gilts index (representing UK Government Bonds) is down just under 10% YTD at the time of writing – hardly a safe haven, losing more than almost all major stock indices. Longer-dated issues are down further still as market interest rates surged in anticipation of central banks needing to hike rates in order to get inflation back under control.

This comes at a time when global stocks have also lost money in the calendar year (with MSCI World down 3% in GBP terms, Emerging, European and Japanese markets falling between 6% and 9% and the higher beta US Tech-heavy Nasdaq index down 10%, all in GBP terms, at the time of writing). Russian equities lost almost all their value, as markets priced in a possibility of total loss.

Seeing both Bonds and Equities falling together is a big wake up call for the traditional 60 (Stocks)/40 (Bonds) portfolio. This has worked well over the past few decades (with past winners, such as Tech and other extreme Growth vehicles trading at lofty valuations, also falling the hardest in the stock market) but now appears to be changing. This is explained for the most part by the poor value on offer for both asset classes at headline level (not least as rising interest rates are mathematically able to threaten both sides of the ledger – something we have been warning about for some time).

This dynamic has been less of a threat for most Pinnacle Financial Services & Wealth Management strategies, with consistently lower sensitivity to interest rate rises through holding lower duration Bonds or All Weather funds as an alternative (which to generalise have held up better than most Bond types).

Amongst equity markets, the FTSE 100 index (with its large Energy and Commodity exposure) and MSCI World Value indices have bucked the trend, registering light gains so far of 3% and 5% respectively YTD in GBP terms.

Furthermore, exposure to Real Assets (Commodities including Gold, Infrastructure, Real Estate) have been inflation beneficiaries and could continue to be so from here. This performance grouping illustrates in no uncertain terms why the principle of diversification matters.

A further economic consequence of inflation is that higher prices hurt the consumer or the firm, acting as a brake on economic growth, thereby raising the risks of global or regional economic slowdowns or even recession. Some regions, such as Europe, could be especially squeezed, far more than say the USA. For this reason, some sharp divergences have been observed between various regions and asset types.

It may well be that the trends so far seen in 2022 will serve as something of a dress rehearsal for what might be expected over the next decade, albeit likely with several twists and turns along the way. The Pinnacle Financial Services & Wealth Management strategies have generally been well positioned for this set-up with some portfolios holding up far better than peers who were more aggressive in their focus on short-term rewards (and past big winners). Therefore, although the tone may sound negative, we remain confident in our ability to deliver diverse strategies for a range of market conditions, but particularly a continuation of the present trend which does not appear to be over.

The details, views and opinions expressed above are KMD’s, can change at any time and are not intended to be advice or a solicitation to make an investment. Professional advice should be sought before acting on any information contained in this document. The value of investments can fall as well as rise and your capital is not guaranteed. Past performance is not a reliable indicator of future performance.