Monthly Market Commentary - September 2023

This monthʼs theme is turning points. From the end of the ice age, around 11,000 years ago but arguably still in place (a different publication, a different day for that story!), through to the Spinning Jenny, electricity, lightbulbs, the combustion engine and the world wide web, not ignoring turning points in the arts and in healthcare (mostly related to the aforementioned industrial/economic ones), we can see moments that matter for investors. Hindsight, of course, is a wonderful thing so, can we foretell a turning point, or at the very least spot when one has just happened rather than rely on a history thesis decades later?

It is September 2023, and uncertainty abounds … and yet, it feels as if we are nearing, if not at, a turning point. Admittedly, this is not Spinning Jenny territory, much less world wide web, but it might be of great interest to readers of this monthly missive. We are talking about … the resurgence of UK-listed equities. After several decades in the doldrums, relative to global siblings/peers, UK-listed equities could be in a sweet spot. Hereʼs why…

UK-listed equities are at a huge discount to global equity, both in terms of the main index/indices and, importantly, in many sectors. Share buy backs are increasing (owners/managers of listed entities see the value, shouldnʼt we heed their views?), and even the news from the weekend (that the revision of UK plc historic growth (GDP) is so high). Maybe the UK is not the poor man, the basket case of global growth, and if so … wonʼt investors start to recognise the value? Valuations are key … and they are undoubtedly priced in favour of investors right now.

US investors are, already (anecdotally) thinking about where they can invest if the US is no longer the best place for owning equities (we donʼt think it is), and apart from Japan, which has had a lot of coverage recently anyway, and which we do like, the UK looks very attractive now for foreign money. As ever, no two equities are the same, even if listed in the same geography. Nevertheless, the breadth of value we see across UK-listed entities is impressive, and the depth of discounts/valuation anomalies means (we feel) the risks are mitigated on day one.

Term or word(s) to watch: Winter. You might well think we have taken leave of our senses saying we expect people will be talking about winter in the coming months.

UK inflation is made up of a heady mix of three different types right now – demand pull (the increase in the supply of money and availability of credit, especially, since March 2020, has fuelled spending), cost push (most easily explained by ‘think oil priceʼ) and built in (also ‘expectationʼ and this drives wage rises, which form a loop back to demand pull). As we approach winter, with inflation fully expected to fall, will the consumer (and especially the homeowner) really feel the benefits of now fabled ‘lower energy costsʼ? Not if the weather is bad, they wonʼt … and anyway, a winter of discontent (written as  we  experience  a  proper  Indian Summer this week) is a distinct possibility.

So, expect lots of references to economic winter, winter fuel bills, etc. … and remember to look forward to all that spring 2024 will bring.

Investors still seem to be hoping for the best and largely rejecting the prospects for a meaningful downturn in the US. We continue to take a rather different view, so it is worth rehearsing some of the possible reasons to question the goldilocks type mentality surrounding the soft-landing narrative.

Perhaps the most important reason is the reminder that monetary policy works with significant lags. The economy might appear to be in good shape with the labour market carrying the flag, but it takes time for rates to work their way through the economy. The longer rates stay high (and it appears from both the Jackson Hole comments and previous remarks from Federal Reserve governors that rates are going to stay elevated for some time), then the greater the number of borrowers who are caught up in refinancing, which acts as an economic drag.

Much is made of the excess savings that consumers had built up over the Covid-19 lockdowns, but these are now practically gone, having reached $2.1 trillion in 2021. Was it not obvious that things would take longer to slow down in this cycle than in previous ones? By the end of this year, the savings will have been entirely depleted and we should have a clearer idea of the robustness of the US consumer. Credit card debt has already risen to over $1 trillion but spending has fallen away recently with more individuals cutting back in June. An idiosyncratic issue is the resumption of student loans payments. This will also act as a drag on consumption after a three-year moratorium on payments.

Much more significant of course is the state of the banks – some of which have recently been downgraded by the credit agencies. As rates stay higher for longer, we could see the resurfacing of problems in the sector similar to those we saw in March, which were essentially papered over with more liquidity entering the financial system. This, coupled with problems in commercial real estate, could see a material tightening of lending standards. It is this sort of reduction in credit that usually heralds a downturn in the economy.

Aside from questions over the current demise of the dollar, there is no doubt that the US abandoning the gold standard in 1971  was  a  major  turning  point  in economic history. With no limit on how much money could be printed, the scene was set for a world of fiat currency and the seeds sown for extraordinary monetary policy like quantitative easing.

It just feels too early to declare that we are out of the woods. The labour market has fooled many into thinking the economy can withstand higher rates and that inflation will fall away without a recession ensuing. Again, this is a lagging indicator and usually shows cracks after other economic data. We have seen this sort of thing before, not least in 2007 when the economy was roaring on all cylinders before ‘challengesʼ surfaced.

Our US allocations remain unchanged for now – we are certainly not chasing the stocks that have led the market this year and a targeted approach still looks attractive to us.

The economic data from Europe is decidedly weak, with the latest purchasing manager surveys pointing to a deteriorating backdrop. Manufacturing was already in a depressed place, but overall business activity is now at its lowest level since November 2020 and if the Covid pandemic months are excluded, the numbers are the lowest since April 2013. So, crucially the weakness lies both in services and manufacturing. All of this qualifies as being recessionary in nature and the fact some of the most rapidly deteriorating data appears to be in the German service sector (usually so robust) is concerning. This comes at a time when the European Central Bank (ECB) is still not able to definitively state that rate rises have come to an end and a re-acceleration of inflation in some countries, (for example Spain and some German states), means a sort of stagflation-lite scenario might not be that far away. The possibility of a pickup in energy prices is another factor that could continue to cause price pressures despite weak aggregate demand. Investors may yet again find themselves hoping for a mild winter as the year progresses.

Against such a weak backdrop, one would normally expect to see defensives outpacing cyclical stocks, but this has not been happening. Cyclicals – the more economically sensitive stocks such as airlines, banks and autos – have behaved as if economic momentum is accelerating rather than weakening, which suggests (as we have claimed for some time) there is still too much economic optimism baked into equity valuations in the region. It is of course possible investors are anticipating that sentiment and manufacturing will improve from these low levels and so address the disconnect that way, but a fall in cyclicals from these levels and a rotation into more defensive names seems more likely to us. The rapid downturn in the fortune of the Chinese economy is of course a further reason why some sectors of the European economy will find the going tough for the rest of the year.

If one is looking for a major turning point in European history, the Black Death of 1347 would certainly fit the bill. The devastation of the European population had implications for demographics, society, politics and economics for the centuries that followed.

Earnings have been more resilient than many expected, and a lot of risks have been swerved for now, but we continue to expect headwinds for Europe. Allocations remain unchanged.

August saw the world watch, as India became the fourth country to land a craft on the moon. Asiaʼs most populous country, having overtaken China in April, remains on course to overtake both Japan and Germany to become the worldʼs third largest economy by 2027 and have the third biggest stock market at the end of the decade according to estimates from Goldman Sachs. So how have we arrived at this turning point?

India has benefited from increased comfort in remote working and outsourcing, as well as societal reforms over recent decades, with access to electricity vastly expanded as well as laying the foundations for a digital economy through the national identification programme. The latter has helped improve access to bank accounts and the financial system as well as helping crack down on the black-market economy. Improved access to credit – Indian consumers are among the least indebted in the world – as well as further infrastructure spending are likely to be key drivers for the decade ahead and India is likely to be viewed similarly to how China is today in terms of not just being an important emerging market but an important global growth engine.

On 3 November 1957, long before humans left Earth for the first time, Laika the dog was launched into space aboard Sputnik 2. Laika, the first animal in space, was a stray from the streets of Moscow. She sacrificed her life for this mission and without her, human space travel would not be as far advanced as it is today. Thank you, Laika, a very good girl!

In the present day, India is also less integrated with China than other Asian markets, giving it some resilience to the tribulations of China with its own more insular sources of growth. While this piece has been largely upbeat about India – particularly as a long-term theme – the stock market does look expensive to us at present, particularly relative to other global markets. India would also not be immune to prolonged global recession, commodity price issues and domestic political changes.

We continue to like India with a long- term view in mind but currently see better opportunities in less expensive markets at present. We took profits from our direct India allocations earlier in the year, leaving only a direct allocation in our Adventurous portfolio, although still retain indirect exposure through broad Asia Pacific and global emerging markets allocations.

We have become used to the US Treasury bond yield curve, which shows yields on bonds of different maturities being inverted when viewed on the basis of the two-year versus 10-year bond yield (the former being higher than the latter), since July 2022. We also know that an inverted curve has historically been a reliable sign of a pending recession.

However, during August, this dynamic interestingly changed. Longer maturity bond yields moved notably higher, resulting in a steepening of the bond yield curve, as markets considered the prospect of ‘higher-for-longerʼ interest rates. A steeper yield curve typically suggests markets are expecting a growing economy and a continuation of higher inflation. While this move higher in yields reversed marginally over the final week of the month, it highlighted concern surrounding resilient economic data.

More specifically, this recent steepening resulted in 10-year (and longer) yields climbing higher while shorter bond yields remained relatively flat. Technically, this dynamic is referred to as a ‘bear steepenerʼ, where long-term yields rise by a greater amount than any rise in short-term yields over the same period. A ‘bear steepenerʼ happens quite infrequently and is considered to suggest accelerating growth or concerns around inflation. Of course, this is all at odds with the expected outcome of higher interest rate policy, which should curtail growth and combat inflation.

The opposite dynamic, a ‘bull steepenerʼ, would see shorter-term yields falling more than longer-term; here yields are falling, so bond prices are rising, hence the ‘bullʼ.

Broadly, the flat response of short-term yields points to a scenario in which US interest rates are not expected to rise much beyond current levels. Indeed, market pricing of the next Federal Reserve rate setting meeting in September gives an almost 90% probability of there being no further rate hikes. Unsurprising, as inflation is falling. The contrast is the outlook for longer-term rates where economic data is proving much more resilient than would have been expected at this stage of the cycle.

There is also concern around the amount of debt in the system and future issuance – we touched on this from a UK perspective last month – and a similar situation is underway in the US, where Treasury Department debt issuance for the third quarter has been revised upwards by $274bn to a substantial $1tn. With a great deal of the longer maturity debt (10-year plus) being front- loaded, investors have made it clear they want to be sufficiently paid for soaking up the extra funding requirements. An indicator came via the early August auction of 30-bonds where even with a yield of 4.189%, the highest on offer since 2011, demand was soft – though make of that what you will during the traditional summer lull.

As noted, this dynamic did start to unwind towards the end of the month, as US labour market data showed a larger than expected drop in the rate of new job openings. Similarly, a climb in the US unemployment rate to 3.8% from the multi-decade lows of 3.5% suggests higher rates are impacting growth. Subsequently, yields fell back across the curve; however, it demonstrates a continuation of the contrasting narrative between recession (or some form of economic slowdown) and a reacceleration of growth.

Our fixed income allocations comprise healthy exposures to a mix of high- quality US Treasury bonds, where we are actively managing interest rate sensitivity, investment grade (the strongest) corporate bond issuers, and to take advantage of a waning US dollar, exposure to emerging market debt. While there will undoubtedly be short-term data driven fluctuations in the growth and inflation outlook, the value of bonds, from both an income and capital return perspective, has not been this appealing for some time.

The energy transition may seem an obvious topic for an edition focusing on ‘turning pointsʼ; however, it is hard to pinpoint one or a few pivotal moments as we remain amid the shift from reliance on fossil fuels to renewable energy. The transition is a multi- decade process; perhaps in a century, historians will be able to shoehorn this complex process into a neat, linear narrative but as we live through it, it can feel volatile and uncertain.

We cannot gloss over the challenges companies in the environment sector currently face; rising inflation and interest rates have dramatically changed the operating conditions. For fledgling companies in the space, it has become harder to raise capital, with initial public offerings (IPOs) slowing and discounts widening. Several companies now deal with the frustration of having exciting and impactful solutions that will now take longer to be deployed … but most of these will still, eventually, be deployed.

Savvy investors now have a greater focus on revenue growth, balance sheet strength and a path to profitability. This has forced companies to adapt to the current new environment by cutting costs, focusing on the most critical development programmes, and attracting larger partners. The companies that survive this period are likely to emerge in much better shape and more attractive to long-term investors. Over the past five years, it is fair to say that a number of sustainable solutions companies came to market with valuations that were too high but, with the change in the investment landscape, this has reversed and a number of well-managed companies now look relatively cheap.

Good companies in the space have an incredible opportunity to grow and generate returns for investors. While offshore wind technology has been maturing in recent years, its deployment is poised to accelerate in the near term. Various estimates suggest that global offshore wind capacity could grow at c.21% compound annual growth rate (CAGR) between 2022 to 2030. The International Energy Agencyʼs (IEA) net-zero by 2050 roadmap forecasts annual offshore wind capacity installation to increase 16-20x from 2020 levels. Since 2002, the IEA has consistently been under-forecasting the pace of solar power adoption. In 2023, solar power capacity additions beat its predictions once again, coming in 24% higher than the agency forecast just six months ago and double what it expected in 2020. What these figures show us is that the sheer scale of the physical infrastructure that must be demolished, overhauled, or replaced is almost beyond comprehension.

In 1962, Rachel Carsonʼs ‘Silent Springʼ was released. The book warns of devastation that pesticides, particularly DDT, are wreaking on birds and other creatures. Unsurprisingly, Carson faced criticism from the chemical industry, but the book became a bestseller and has had an immense impact worldwide, even getting a nod from Joni Mitchell in her well known song, ‘Big Yellow Taxi,ʼ from her iconic 1969 album ‘Ladies of the Canyonʼ.

In our view, the market continues to underestimate the growth potential of decarbonisation companies in general. As such, we maintain an actively managed position in companies delivering sustainable solutions and facilitating the energy transition. This allows us to invest, via industry specialists, in the cream of the crop.

This summer, Taylor Swift rocked the globe with her record breaking ‘Erasʼ world tour but, as autumn approaches, it might be time to prepare for the far less jubilant ‘Erisʼ tour. Eris is the name given to a new Covid-19 variant that was recently classified by the World Health Organisation (WHO) on 9 August. The strain, also known as EG.5.1, is a descendant of Omicron and is now the second most prevalent variant in the UK and the most common variant in the US, according to the Centers for Disease Control and Prevention (CDC).

Over recent months, we have seen a spike in Covid-19 cases, estimated numbers jumped by almost 200,000 in July, from 606,656 predicted cases on 4 July to 785,980 on 27 July, according to The Zoe Health Study, which estimates figures for UK Covid infections. While the majority of the population have been exposed to some variant of the virus and as such, we are in a better position than we were three years ago, the uptick in cases and spread of a new variant remains a concern as the Western hemisphere approaches ‘flu seasonʼ.

Vaccines, in some form, have been around a lot longer than you may have thought but it is a challenge to pinpoint when they became an accepted practice, largely because the journey to discovery was long and complicated. Beginning with an attempt by Edward Jenner in 1796 to use inoculations to tame the infamous smallpox virus, the usefulness and popularity of vaccines grew very quickly. Throughout the 1800s and early 1900s, various vaccinations were created to combat some of the worldʼs deadliest diseases and over the course of 200 years, one of the deadliest diseases known to man – the smallpox – was wiped off the face of the earth. Since then, virtually all vaccines have worked using the same concept. That was until a new technology, called mRNA, came along, and created game-changing possibilities for the future of healthcare; as you may know, two separate mRNA vaccines Covid-19 were developed and approved for use in just a matter of months.

The goal has always been for Covid-19 to become a manageable, largely seasonal virus, that the global population is able to handle effectively. Healthcare companies have played, and will continue to play, a huge role in the management of seasonal outbreaks. Over August, Covid-19 vaccine stocks rose ahead of the rollout of updated shots in the next few months. Healthcare companies, Novavax, Moderna, BioNTech and Pfizer are slated to roll out new vaccines designed to target the omicron subvariant XBB.1.5, which are expected to provide protection against newer variants of the virus, including Eris.

Healthcare company fundamentals remain robust, balance sheets across the sector are healthy, which is fuelling M&A activity, and utilisation rates are much improved over 2023. Clinical data and new drug approvals are also trending in the right direction. As a result, we remain highly constructive on the sector.