The Big Picture: economic and political summary November
Economic and Political Roundup
Despite further geopolitical upheaval over the course of October, the US bond sell-off continued to dominate the market narrative with 10-year treasury yields briefly breaching 5% for the first time since the collapse of Lehman Brothers in 2007, which, for many marked the beginning of the global financial crisis. Part of the ‘problem’ was seen as the ongoing resilience of the US economy, with strong jobs, retail sales, and GDP data culminating in a hotter than expected inflation read. In addition to broader concerns around the long-term stability of government finances, these conditions led to a further entrenchment of the ‘higher for longer narrative’. US equites fell 1.9% for the month, although remained well ahead of developed market peers, who have continued to battle with slowing growth and stubborn inflation.
“Extreme fear can be just as costly as greed.” – Savita Subramanian, BofA
The UK led the way down, falling 3.7%, as gilt yields jumped higher, and economic indicators continued to deteriorate. With inflation stuck over 6%, the outlook in the short term looked relatively bleak. EMs also struggled with rising yields and increasing geopolitical concerns, while China continues to grapple with its broader economic slowdown.
All in all, October was a tough month for investors as both equities andfell, with commodities offering the only real buffer.
However, looking ahead indications are that November may offer some respite. Bond yields in the US fell significantly following a slew of positive data releases and a technical change to the treasury refunding programme, while the Bank of England decided against hiking further as the economy stutters, although inflation risks remain skewed to the upside. Global markets bounced almost 5% as financial conditions eased, although it remains to be seen whether this rally is sustainable.
Market sentiment remains cautious as recession risks continue to be modestly elevated. Our base case sees further moderation of inflation and economic growth, but also acknowledges the underlying resilience of the U.S. economy. This leads us to favour investments in bond markets with an attractive yield and relative value trades within markets rather than bold directional calls, although we believe that rates will move lower once it becomes clear that central banks will no longer need to continue increasing interest rates. Therefore, current yields support holding moderate levels of interest sensitivity in our fixed income allocation and we seepotential in the UK and Europe, where growth is slower, and in Australia where interest rates are lower. In equity markets, we have a bias towards the better earnings and cash flow outlook in the U.S. and Japan compared with Europe and the emerging markets.
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Managers, Ruffer – 3 October 2023
The recession, when it comes, will arrive with a sudden thud. Sentiment, valuation and market narratives are akin to an echo-bubble of 2021. The pessimism of 2022 has been forgotten and the markets are pricing a soft landing fuelled by AI-driven productivity improvements. The key dynamic is that monetary policy andwithdrawal work with Milton Friedman’s infamous long and variable lags, but their inevitable bite on economic activity and asset prices is coming. Perhaps, in our caution, we underestimated the willingness of the US consumer to keep spending in a strong labour market. The evolution of the UK mortgage market from predominantly variable, to predominantly fixed rate deals, has increased the time between a rate rise and the impact on consumer finances. Further, accumulated lockdown savings have offset the cash flow squeeze from inflation and interest rates. This buffer could either attenuate the pain or delay the reckoning; having been mostly spent it now seems likely it will be the latter.
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Investing in the UK equity market is not the same as investing in the UK economy.UK equities include a wide array of international firms, many of which are global leaders in their fields and derive the majority of their revenues from overseas. In fact, 77% of FTSE All Share revenues come from outside the UK. However, the negative narrative surrounding the UK economy has heavily impacted investor sentiment in the UK equity market, leading to an acceleration of outflows from the market into mainly global equities and other asset classes.
Since the Brexit vote in 2016, the UK has gained a reputation as a problematic economy among major economies, with political instability generating uncertainty about the nation’s future and a lack of confidence from both domestic and overseas investors. However, the economic performance of the UK has been better than feared. While Brexit has weakened supply potential, the UK economy has broadly kept pace with the trends seen across advanced economies over the past seven years. Recent revisions to UK economic data challenge the prevailing view that the UK lags behind all other major industrial economies (the G7) in its economic performance since the Covid pandemic. UK business investment has also been picking up more recently, having initially stalled after the UK’s vote to leave the EU and the aftermath of the pandemic. Recent data continues to exceed expectations, and UK corporates have strong balance sheets and liquidity to increase investment spending.
Sentiment towards UK equities has remained very negative, with persistent outflows weighing on market valuations. This has heavily impacted the absolute and relative valuations of listed UK companies, particularly those in the small and medium-sized (SMID) sectors. There has been a significant de-rating of medium and smaller-sized companies over the past two years, both in absolute terms and relative to the largest FTSE 100 companies, due to selling pressures from outflows. However, SMID companies have traditionally outgrown larger companies in the UK and have delivered attractive total returns that have kept pace with the best returns from global equity markets over the long term. The convergence of valuations between SMID and large-cap areas presents a mispriced opportunity.
Negative sentiment has resulted in aggregate valuations of UK equities at multi-year lows. Total shareholder yields are high in absolute terms, relative to other equity markets and other assets, including bonds and cash. Companies across the market, including those in your, are particularly active in buying back their own shares, as they see compelling returns from investing in their businesses at current prices. Small and medium-sized stocks are subject to ongoing bid activity from overseas and -backed entities. These low valuations are unlikely to persist indefinitely, and there is currently a broad set of investment opportunities within the UK equity market that may well be considered bargains in the future.
Fading political uncertainty, combined with a reassessment of economic performance on growth and inflation, could support a revision of the negative narrative on UK risk assets and be one of the catalysts to address the market’s persistent undervaluation. Investing in a market that remains significantly out of favour with investors provides a plethora of opportunities across the market spectrum, which should provide patient investors with highly attractive returns in the medium term.
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The UK has been highlighted by many as a particularly weak economy, with inflation more persistent than other developed nations, a poor recent record of growth, a succession of Prime Ministers, a weakening consumer environment, and a collapsing housing market. All of these factors have been compounded by the on-going disruption caused by Brexit. However, we would question this negative narrative. Starting with inflation (where recent published data has shown a moderation from the high levels previously experienced) we note that higher wage settlements are starting to feed through into the economy. The result is a potential increase in real wages towards the end of the year which (all else being equal) will be supportive for consumer spending. How about mortgage costs? No doubt mortgage costs at the population level are increasing, and will continue to do so, but the transmission mechanism is not as immediate as in previous interest rate cycles, with a higher proportion of mortgages on five-year fixed rate deals, giving time for wage growth to moderate the impact (or indeed for the rate cycle to start to turn). There is no doubt the housing market will continue to face headwinds as potential homeowners either struggle to find willing lenders or hold off purchases in the expectation of a better deal next year, but we believe that the housing market will eventually bounce back perhaps as a reaction to government policy. Finally, we note that unemployment, which tends to have a highto consumer confidence, has remained low.
However, the negative narrative has gained traction, bolstered by a political backdrop which gives a perception of a country in turmoil. It is interesting to note the recent changes to GDP statistics show that rather than lagging behind pre-COVID-19 GDP, the UK has in fact recovered all lost ground. But perception matters, and in the case of equity markets, perception manifests in flows, with the UK Small-cap market recording negative flows every month since September 2021. We note the recent statements from the Chancellor with regards to encouraging equity ownership in the UK, and from the London Stock Exchange with regards to reviewing and amending the Listing Rules in an attempt to encourage more companies to list in the UK. We also have to acknowledge the potential for the Labour party to win the next election, a party who are currently projecting a more market friendly set of policies, not least with regards to housing.
If equity investors are unwilling to take advantage of the valuation opportunities that currently exist, there are other forms of capital more than capable of doing so. After a lull around the time of the Truss budget, M&A activity has started to step up again in the UK. There have been a number of bids in the market from cash rich Private Equity firms. Given the huge sums these parties have to invest, and the attractive valuations of UK assets, we would expect this to continue.
Whilst the narrative so far has focused on the UK, we should not forget that the UK market is not the UK economy. UK listed growth companies have significant international exposure and global trends matter. From a global perspective we see a number of opportunities. The significant disruption to supply chains brought about by COVID-19 will see a prolonged period of capital investment. Investment will be made to near shore or “friend shore” essential components, supported by government initiatives such as the Inflation Reduction Act. The increasing cost of labour will lead to a long overdue investment in productivity as firms look to reduce labour content and automate where possible. This brings us on to those two magic letters, “AI” (Artificial Intelligence). AI has hit the headlines at a furious pace this year. Never have we seen a technology so widely adopted so quickly. AI will change business models and industries for years to come, there will be use cases that haven’t been thought of yet. But as with all new waves of technology, the reality is often more nuanced than the rhetoric would suggest, leading to opportunities to invest in businesses where the valuation suggests their business models will be obliterated.
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In the near-term, we expect that financial markets will continue to be heavily influenced by the inter-connected forces of inflation, monetary policy, and the impact of these upon economic growth expectations. These projections have all oscillated even more than usual in recent months, as economic forecasters have swung from expecting a UK recession this year, towards predicting a soft landing. Their assessment has shifted again more recently in light of the recent deterioration in leading economic indicators. Consensus forecasts now suggest that the UK will avoid slipping into recession in 2023, but most foresee a marked slowdown in economic activity over coming months, and only a shallow recovery in 2024.
While this may sound gloomy, there are some reasons for cautious optimism. Through a period of painful inflation and a genuine squeeze on consumer finances, consumption has remained more resilient than anticipated. The housing market is certainly a concern as higher mortgage rates gradually feed through to borrowers once their fixed rate deals expire, but aggregate debt levels are not excessively high, and the BoE has scope to reduce rates if it becomes clear that monetary tightening has been excessive. Furthermore, with inflation moderating, the average UK consumer is now experiencing real wage growth for the first time in nearly two years. If employment levels can be sustained, this should provide some support to the domestic economy. Furthermore, the uncertain outlook is evidently reflected in valuations, as the UK market is trading at a steep discount to both its own history and relative to other developed markets.
The market’s historically low valuations, combined with the solid fundamentals of many UK companies, leave us excited by the investment opportunities in our market.
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The trajectory of inflation and interest rates are clearly key for the outlook. While we had expected a mild recession in the UK in the second half of 2023, the economy looks likely to avoid this – but UK growth prospects are pedestrian at best. Following the encouraging inflation figures over the summer we believe inflation has peaked
in the UK, and we foresee a significant further decline from the current levels over the course of 2023, which will hopefully bring the UK more in line with other developed markets. Interest rates at 5.25% have risen significantly and we believe are close to peak levels. Consumer confidence has staged a significant recovery from its abject lows – largely we believe due to continuing very low unemployment rates and the wage increases that have been seen this year – although the recent spike in mortgage rates caused a setback in what had been an upward trend.
Clearly the stockmarket is currently extremely focused on theeconomic outlook. In this regard, the very recent historic revisions to GDP by the ONS are a notable positive, demonstrating that the growth of the UK economy post the pandemic has not been out of line with that of Europe. However, as always our focus is on the companies themselves. Overall the message we are hearing from them is a positive one. The majority of smaller companies are successfully navigating their way through the headwinds of cost inflation, labour inflation, labour shortages and higher interest costs.
History tells us that stockmarkets rally when investors believe that interest rates are close to peak levels – and this has especially been the case for the UK smaller companies sector. When this occurs, we believe the upside from current lowly valuation levels could be substantial. In addition, investors will be aware there is a significant focus by the Government on the future of the UK equity market, and a strong desire to improve its allure. Although not an instant fix, the change to pension investing proposed by the Mansion House reforms this summer, with DC pension providers being strongly encouraged to invest at least 5% of their funds in unlisted assets, should also be beneficial for small cap companies. This is because stocks on the AIM market are included in the definition of ‘unlisted’.
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The current level of economic growth in the UK is lacklustre, and we are just beginning to feel the lagged effects of the steep increase in the Bank of England base rate, so the prognosis for the coming year appears gloomy. However, we are not currently in recession and the most recent data suggests that wages are growing again in real terms for the first time in a couple of years. We are also in the fortunate position of having full employment and healthy consumer balance sheets (in aggregate) which should feed through to confidence over time.
We are hopeful that inflation should continue to decline over coming months. The supply chain tightness that drove the initial wave of inflation following the pandemic has largely normalised, and energy prices have now significantly fallen year on year. Conversations with companies suggest that it is now much easier to find staff than it was a year ago and this is beginning to feed through to wage settlements. So hopefully the worst of the cost of living crisis is now behind us, and we are near the peak of the current interest rate cycle.
The value within the UK smaller companies market is very apparent to us. Whether we compare current valuations to history, or to other international markets, the sector looks anomalously cheap. Over time this should attract increased interest from the investment community, but in the meantime we have seen a surge in takeover activity from both corporate and private equity buyers looking to exploit the “knock-down” prices of UK equities. Whilst the economic backdrop is underwhelming we continue to see opportunities to buy undervalued shares in companies with excellent long term growth potential. So, after a difficult couple of years, we are optimistic of better returns over the coming year.
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The economic challenges to global growth continue to build, following rapid and sustained interest rate increases from central banks across the world, coupled with a Chinese economy facing significant headwinds. Despite some signs of easing, inflationary pressures remain significant in most economies and supply constraints are placing upward pressure on many commodity prices. In the UK, inflation remains too high and growth too low, albeit there are indications that a trough has been reached and perhaps somewhat ahead of other major economies. For equity markets, there remain reasons to be cautious and the next 18 months are likely to be a tough period for corporate earnings development.
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Recent data points provide a less than clear picture around current conditions and future direction. However, in most developed economies growth appears to be more robust than might be expected in light of the meaningful monetary policy tightening over the past 12 months. On the other hand, the momentum of China’s reopening has faded and more stimulus is likely to feature. Underlying price pressures have been sticky reflecting excess demand across various sectors and economies prompting central banks to remain hawkish. We believe that the current tightening cycle will ultimately restrict economic growth with the resulting downturn in demand helping to engineer a relatively rapid fall in inflationary pressures allowing significant interest rate cuts over the next 18 months. The valuations of UK-listed companies remain attractive on a relative and absolute basis. Apart from the global financial crisis, the UK’s market multiple is nearing its lowest point for 30 years. It is cheap in absolute terms, relative to history and also relative to global equities. Investors are benefiting from global income at a knockdown price. Moreover, theyield of the UK market remains at an appealing to other regional equity markets.
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