The Monthly Market Commentary (MMC), is an update on the world in which we invest.
This monthʼs theme is education. Songstress Lauryn Hill had a brilliant debut album, ‘The Miseducation of Lauryn Hillʼ and this memory prompts us to think about whether the investing public need education, re-education or indeed have been recipients of miseducation when it comes to the growth (and indeed inflation) outlook for the UK. Letʼs take a quick look back before we look ahead.
UK growth domestic product (GDP) growth was modest in 2019, and nil in the last quarter, so even heading into a year that heralded the first global pandemic since the 1968 ‘Hong Kong Fluʼ, growth prospects were lacking. The Bank of England predicted GDP growth of around 0.4% rising to 1% in 2021, with the possibility of what now looks like an incredibly healthy 2%+ in 2022. The inflation (CPI) target of 2% was well above the rate of inflation at the start of 2020, and expected to remain above it for at least that year. These were probably decent predictions based on what was known at the time. Here is the CPI projection chart from the Bankʼs Economic Report* of January 2020:
Once the pandemic had taken hold, all bets were off, and investors had to re-educate themselves. Fair enough… except the Bank, not an unreasonable source for oneʼs data on such matters, were well off the pace. In February 2022, they said “…projections are conditioned on a market-implied path for Bank Rate that rises to around 1½% by the middle of 2023”. This is the same chart from that report:
The interest rates were increased by 0.25% to 0.5% on a vote of 5-4, where the four wanted an 0.5% increase to 0.75% - they were right to want more sooner. Today, we have a base rate of 5.25%, ten times the rate less than 18 months ago, and more than three times what the Bank expected just 18 months ago. Inflation went beyond even the Bank's highest outlier (above) and stayed there for much longer than expected, hence interest rates, many argue belatedly, getting to where they are now.
So, what about the education of investors? “Rates will stay (historically) low, growth will be low but improving, inflation likely to remain well below even the target of 2%” – investors got that message, and even despite a pandemic, lockdowns et al, growth assets, smaller companies generally, real assets with a decent (inflation busting) income and stocks driven by near-free money all did well. Oil and gas remained ‘yesterdayʼs storyʼ.
Russiaʼs invasion of Ukraine impacted the latter, but in most other respects, the Bank got their numbers wrong despite having the data and the changes for investors were big – almost everything you wanted in one scenario, became too hot to handle in the other. Not exclusively, of course, but when rates started rising and inflation was not impacted (it rarely ever is quickly, usually taking a year or more, based on history) those aforementioned assets started to suffer/fall behind alternatives. ‘Trussonomicsʼ was a dagger, creating mayhem in financial markets here in Autumn 2022.
Today, we see a UK economy challenged, probably struggling to avoid recession by the end of 2023, growing very modestly if at all for a year or two, and certainly not back to long term trend GDP. Inflation is falling and will probably continue to fall until the year end. Normally, one might expect the Bank of England to reduce rates to boost the economy, but they simply dare not right now, as the spectre of inflation hangs over every economic decision. However, for investors, here is one piece of vital education (or a reminder for more ‘experiencedʼ readers.
It is always darkest before the dawn, and UK equity markets (driven of course by investors) are a very good leading indicator of bad economic news. Across the market, from large cap to small, there are significant pricing anomalies. Dawn will come, it always does. Investors may need a little more patience, but the re-education of investors, that the UK can make you money as an equity investor, might just be underway.
So, the Federal Reserve delivered what the market expected with another interest rate increase, but it really does feel as if we are close to the end of the tightening cycle. Inflation is falling back and there are now plenty of deflationary forces, not least those emanating from China, with which to contend.
Confusingly, we have a labour market which does not seem to want to slow down, and which remains something of a mystery even to seasoned commentators. Despite this, we still believe that we are likely to get a recession and probably at some point over the course of this year. Several key data points suggest a slowdown in the US economy with manufacturing and industrial production pointing to the fact that we may already have entered recessionary territory.
Remember that rate rises have their effects through long and variable lags and it is possible that corporates are sustaining themselves on the monies they raised at cheap rates previously. Certainly, it is difficult to reconcile interest payments being made with current interest rates, although the rise in bankruptcies might be playing a part. For those willing to look hard enough there are further signs of weakness with credit card delinquencies increasing and jobless claims rising across many states. We also have credit provision contracting so cracks in the job market might not be that far away.
As in many other spheres of life, the US is a leader when it comes to education, at least at university level. Along with our own Oxford, Cambridge and Imperial, her universities occupy the Top 10 positions for global universities. The rest of the countryʼs education system is perhaps not as well regarded.
Against this backdrop we are finding it difficult to overcome our stance on US equities- namely that they are too expensive. Yes, Artificial Intelligence brings great opportunities, but the discount rate to be applied to the future earnings of large technology companies is now four times greater than it was a few years ago while they are now trading at much higher valuations. Other valuation metrics are also difficult to marry with the economic backdrop we see unfolding.
We have implemented our views on the US market with great conviction over the last few years and given the levels stocks are currently trading at, still believe that the underweight position accompanied by selective exposure through preferred themes is the right path to take. No changes this month.
It is difficult to argue with the proposition that Europe is facing significant headwinds. The latest Purchasing Managers Index (PMI) figures are concerning, and Germany looks as if it is in a real funk. None of this is helped of course by the continued travails of China which is putting a cloud over Europeʼs exporters. The latest inflation numbers are still providing sufficient raw material for the central bank to plough ahead with rate rises and this month brought the expected increase of another quarter percentage point. This is the ninth consecutive increase and takes rates to a level last seen in 2001. We might see a pause at the next meeting (though prices are still rising at an annual rate north of 5%) but sustaining rates at this level will have lagged effects on an already troubled economy.
European companies continue to trade at a historically extreme discount to US peers -with a forward earnings multiple of 13 compared to 19 of their peers. Typically, the discount has been around 20%. It is crucially not just a story of sectors and index composition – every sector is showing a large discount to its US equivalent. True there is less depth to the European investment market with more funds allocated to ‘non-equityʼ investments such as housing but there are a number of positive factors in the regionʼs favour.
Problems in sovereign credit appear to have receded for now, the banking sector looks to be in better shape and if investors do decide to diversify away from the US (surely those profit margins must at least partially revert soon?), then Europe could benefit from increased flows. But perhaps not quite yet. As with many regions, Europe has enjoyed a good run based on valuation multiple expansion rather than higher earnings and the next few quarters will probably be challenging.
Finland is often cited as having the best education system in the world. Its achievements are perhaps all the more remarkable given that students do not begin formal education until the age of seven!
Select opportunities will crop up in the region and we are maintaining allocations this month, but it does feel as if the short-term outlook is rather uninspiring.
Chinese economic data released in July continued to show the lacklustre recovery in Asia's biggest market, with the second- quarter Growth Domestic Product (GDP) growth rate figure of 0.8%, much lower than the 2.2% level for the first quarter. While at the start of the year there had been much made of Chinaʼs ‘re-openingʼ from the Covid-19 pandemic, the actual recovery has not lived up to those predictions, with falling exports, a waning property sector and weak consumer confidence weighing on performance.
At the end of July, a highly anticipated statement from the ruling 24-member Communist Party Politburo provided a lot of accommodative language around supporting the economy but very few specifics and certainly no massive stimulus plans as we have seen in the past. The focus appears to be on encouraging private enterprises to start investing, which should in turn lead to addressing many of Chinaʼs issues, although not much can be done in terms of a weaker global backdrop for its exporters.
Chinese consumer confidence has remained weak and there has not been a similar release of pent up demand as seen in the West. One reason for this is Covid-19 is not as far away in the rear-view mirror yet for China, with measures having ended in January of this year, rather than two years ago for the West. It is also worth noting that unlike the US, there were no stimulus cheques issued to Chinese consumers during the pandemic, so the Chinese consumer may be less willing or able to start spending again without improved economic sentiment.
In terms of the property sector, along with supportive words, China has been easing conditions with lower lending rates and extending credit support for developers,who have been struggling over recent years as the Government had clamped down on leverage levels and ending speculation in the housing market. The statement also indicated that regulatory crackdowns, particularly on the strategically important internet sector, have now come to an end.
There has also been a lot of focus on the urban youth unemployment rate, which was at 21.3% in June. While some commentators have been quick to speculate that this might cause social stability issues, it is important to note that migrant worker unemployment rates are less than 5%, suggesting it might be college graduates who are struggling to find suitable jobs inflating this figure. A slowdown in the technology sector and weak business confidence are likely causes of this.
Chinaʼs economy has struggled so far this year. High government debt levels will mean no mass stimulus is likely, but smaller policy changes could see green roots of recovery appear. For now, we have no direct China exposure, preferring other emerging markets or playing this indirectly via our Asian equity fund allocations.
On the surface, it may appear that the shift towards a more sustainable economy has run out of steam. Immediate energy security has (understandably) been the priority for global governments while news outlets report that legislative balls have been dropped across the globe in terms of enshrining environmental protections and incentives. Despite this noise, the allocation within portfolios to environment equities has generated positive returns this year but, like most assets, has been overshadowed by the handful of US listed technology and tech- adjacent, mega cap companies that have driven returns for most of the year to date.
Looking at the longer-term prospects for the space, there are indications of significant structural growth across key areas of decarbonisation. Renewable-energy demand remains high; year-on-year growth in global solar-module shipments has increased to 55% this year, up from 50% last year and 33% in 2021, as post-Covid supply chain bottlenecks have eased. Within the electric- vehicle sector, year-on-year global sales growth of 56% was reported in the latest data release in May 2023.
You may remember hearing about a piece of US legislation called the Inflation Reduction Act (IRA) that boasted supportive measures for investment in decarbonisation. The act is due to turn one year old in August and, much like the typical unruly toddler, we can only see glimpses of what it could achieve over time. Since the IRA is almost entirely comprised of tax credits, it is not possible to say how much government spending it will ultimately beget, it depends how many projects are built.
Nearer term, it is likely that the space will be tossed about by macroeconomic winds and will underperform broad equities if the momentum behind US mega cap companies and enthusiasm for Artificial Intelligence related-companies continues. While we expect that AI will be part of our future, it will likely be just one key component of our lives. Given that, according to the International Energy Agency, renewable capacity will meet 35% of global power generation by 2025, as investors we are keen to participate in that growth.
We maintain a small, strategic allocation to this space within portfolios.
In June we witnessed bond yields moving notably higher as investors exhibited concern over persistent core inflation (which strips out food and energy prices), and the extent to which interest rates would need to rise in order to tackle this. July initially continued along the same path, bond yields steadily climbing and conversely, bond prices steadily falling, as markets awaited the most recent inflation data releases.
Thankfully, when those inflation readings for June arrived, they provided relief for bond yields. In the US and the UK, both consumer price inflation and core inflation fell, coming in below market forecasts. This resulted in a move lower in short-term yields, those most sensitive to near-term rate expectations. These quickly repriced a lower terminal interest rate for the UK; where previously UK interest rates were expected to peak at 6% in 2024, that peak is now forecast to be 5.8%.
While it seems likely interest rates will remain at a higher level than we have become used to over the past decade, falling inflation will provide reassurance to the Bank of England that though the UK does remain an outlier in terms of inflation readings, they are trending in the right direction. Indeed, there will be renewed hope the cost of debt falls - the UK Debt Management Office (DMO) sold £4 billion of a 2025 maturing gilt this month with a yield of just under 5.668%, the highest yield seen on a gilt since 2007. A far cry from the circa 1% yields on offer less than two years ago.
Longer term yields, for example those around the ten-year mark, were broadly flat over the month. They had moved higher before retreating but are seemingly coming to terms with higher-for-longer rates and economies that are proving resilient to higher borrowing costs. Labour markets are showing no signs of weakness and many economies are seeing growth targets revised upwards. The US Federal Reserve this month withdrew their forecast for a US recession – the fabled ‘soft-landingʼ where central banks subdue inflation by slowing economic growth, through monetary policy decisions such as interest rate rises, without sliding into a recession appears more probable.
While this is proving a better environment for stocks than bonds, in a year in which many expected bonds to outperform, there are still plenty of reasons to hold fixed income assets. Not least attractive yields across the entire spectrum including high quality, often low-risk, government and corporate bonds. Further, an environment of growth, regardless of whether it is stable or accelerating, is positive for many corporate bond issuers and here we could see further spread compression. Spread represents the premium a corporate bond issuer pays over a government bond to compensate for the increased risk of lending to that issuer. This year we have seen those spreads move lower, and similar to movements in bond yields, a lower spread conversely sends bond prices higher. So, all in, the outlook for bonds remains favourable, though it is likely inflation readings will have more to say.
Our fixed income allocations comprise healthy exposures to a mix of high-quality US Treasury bonds, investment grade (the strongest) corporate bond issuers and to take advantage of a waning US dollar, exposure to emerging market debt. With inflation showing clearer signs of subsiding, we have started to become more comfortable in adding duration (broadly, interest rate sensitivity) where appropriate, in order to capitalise on better capital return as yields decline. The value of bonds, from both an income and capital return perspective, has not been this appealing for some time.
An Education Bond is an interesting product that can be found in a handful of countries, most notably, Australia. The product offers all the features and benefits of a traditional Investment Bond with the added bonus of special education tax benefits and estate planning features.
After declining year-to-date, as a Chinese economic slowdown heavily impacted demand forecasts, the price of oil climbed notably through July. Taking brent crude oil, and measured in US dollars, the price per barrel rose over 13% for the month to $85 per barrel. While there are several reasons for this, including a more optimistic outlook for the global economy as the threat of a deep US recession subsides, much of the rise comes as a result of cuts in oil supply among the OPEC+ (Organisation of Petroleum Exporting Countries plus allies) group.
In June, OPEC+, which includes the likes of Russia and Mexico, in addition to the worldʼs largest supplier, Saudia Arabia, agreed a broad cut in supply through until the end of 2024. Saudi Arabia (which in 2022 accounted for over 20% of global daily supply) commenced a further voluntary cut, which has now been extended through until the end of September this year. All told, the cuts (if fully implemented) could account for around four million barrels per day less production compared to the same month last year.
While there are many large producers outside this group, including the US, the move to cut supply to stabilise the post- pandemic oil price has so far proved successful. Increased demand is triggering inventory falls just as the scale of the Saudi- led cuts impacts supply. This move higher in the oil price has benefitted many of the large energy names that have to-date missed out on much of this yearʼs stock market rally. The MSCI World Energy sector delivered a return of 5.2% in sterling terms over the month.
There was a further boost to some UK energy names as the Government announced it would continue to license hundreds of North Sea oil and gas developments in order to bolster energy security. As part of an apparent row-back on many green measures, Prime Minister Rishi Sunak stated the move to net-zero needed to be ‘pragmaticʼ. North Sea producers including Ithaca and Harbour Energy have seen their share prices rally over 10% through July.
We maintain exposure to energy for certain investors, noting its inherent volatility. While there is cyclicality, namely economic sensitivity, in oil and gas prices, we are still seeing economic growth which is underpinning pricing. Further, many of the large producers in the sector will remain at the forefront of the green transition as fossil fuels are needed to support the switch to more sustainable forms of energy. Finally, energy security will continue to prove vital and there is a clear price advantage for those who can deliver.
As we know, our supply of metals –including those essential for the energy transition - remains dependent on mining. Despite its indispensable nature, recent studies show that few young people consider it an interesting career option. A survey by the Mining Industry Human Resources Council of Canada found that 70% of 15–30-year-olds will probably or definitely not consider a career in mining, which was the highest negative proportion for any industry. A separate PricewaterhouseCoopersʼ survey found that two-thirds of mining CEOs believe skill shortages will have a large or very large impact on profitability over the next decade. The industry may have to take to TikTok or swing a positive mention in ‘Barbie 2ʼ to enhance its appeal.
For an archipelago in the Atlantic Ocean, the UK has achieved some great things despite its small size. This has unfortunately come at a cost as Great Britain has become one of the most nature depleted countries in the world and has lost more wildlife than any other G7 country. As investors, we might well ask, why does this matter? Estimates suggest roughly half of global GDP is either moderately or highly dependent on nature. So, then, why do we not hear more about it? The role nature plays within our global economic system is often taken for granted and involves complex topics that need granular, location-based data for appropriate study, such as biodiversity.
If you think global policy makers have been slow to act on climate change, you would not want to investigate the response to biodiversity risks and nature more broadly. Although dilatory, it is an area of increasing interest for governments, legislators, and investors. Montrealʼs COP15 in December 2022 delivered agreement of the Global Biodiversity Framework, an overarching mission to halt and reverse biodiversity loss by 2030 with 23 underlying targets to work towards that goal. As always, we have been keen to understand the potential impacts and opportunities for investors.
As part of a response to this goal, the UK environmental audit committee has launched an inquiry into the role private finance can play in investing in nature. The committee is part of a larger campaign to help the UK embrace the economics of biodiversity. The aim of the inquiry is to understand how private investment can help achieve the Governmentʼs nature commitments and how the UK might develop markets in natural capital assets while avoiding the ‘greenwashingʼ of investments (something the UK Green Taxonomy should help with so, the sooner that is enshrined by law, the better). Investors will have a role to play and there are likely to be some interesting opportunities in the development and enhancement of the nationʼs natural capital from air to water, soil to forests.
The Mattioli Woods Responsible Equity Fund invests in a broad range of companies that are aiming to protect, restore and promote sustainable use of ecosystems, and halt biodiversity loss both on land and at sea.
The Monthly Market Commentary (MMC) is written and researched by Simon Gibson, Richard Smith, Scott Bradshaw, Mark Moore and Lauren Wilson for clients and professional connections of Mattioli Woods plc and is for information purposes only. It is not intended to be an invitation to buy, or to act upon the comments made, and all investment decisions should be taken with advice, given appropriate knowledge of the investorʼs circumstances. The value of investments and the income from them can fall as well as rise and investors may not get back the full amount invested. Past performance is not a guide to the future. Mattioli Woods plc is authorised and regulated by the Financial Conduct Authority.
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