Where will the class of 2023 invest?
It’s hard not to be infected by the brisk back-to-school mood that arrives with autumn. The French have a word for this time of new notebooks, sharpened pencils and squeaky school shoes: La Rentrée – by Luke Hickmore
That’s exactly what it feels like; a re-entering into work, study and school bringing a spirit of action and fresh initiatives. Politicians return to government, traders to their terminals, re-invigorated workers are back from the summer holidays eager to Get Stuff Done.
All this activity can cause a great deal of movement, and in some cases, even trouble. September to October can be an extremely positive time for financial markets, but these autumnal months have also witnessed some of the biggest crashes and corrections; from the bank crash of 1907, the 1929 Wall Street crash, Black Monday in 1987 (3 months after I started work), to the early foothills of the 2008 global financial crisis. These all hit at this time.
More recently, last year we witnessed a new Prime Minister, Liz Truss, sweep into office in September, determined to usher in a “new era for Britain” by cutting taxes and increasing spending, only to see the pound spiral, bonds plummet, an emergency intervention from the Bank of England and even a telling off from the IMF. Truss and her chancellor had barely unpacked at Number 10 and 11 before the removal trucks were back.
So, it is worth noting that too much optimism and exuberance at this time of year, and particularly this year, may be a bad thing. Why this year? Because the mood music is quietly optimistic and there’s a chance that investors could get carried away in the weeks ahead. We may be approaching the “new term” with potentially too much optimism based on indications that inflation has peaked, the rise of interest rates is likely to pause and there are hopes of an economic “soft landing” rather than a recessionary crash. But there are still many reasons for caution to be the watchword. Interest rates have risen too high too quickly, so the consumer and companies are suffering. There’s a good chance that post-summer, the consumer will rein-in, company earnings-per-share forecasts will be revised, and a hefty correction may follow.
What, then, is on the curriculum for investors of the class of 2023-24? First, many will have to learn, or re-learn, how important cash is within a portfolio. No longer sitting at the back of the class, cash is front and centre, eager to provide a cushion against volatility in other asset classes as we near peak interest rates. Alongside cash, the new curriculum will usher in short-dated bonds to provide a good level of yield, while offering the flexibility to take advantage of further volatility.
Next up is Corporate Bond 101; so, sit down, open your books and grab a calculator. As with all markets, timing is everything and buying quality corporate bonds as we near peak interest rates has been a successful strategy many times before. The returns come when yields drop due to falling inflation and bank rates, as bond prices rise when yields lower. So, the aim is to buy quality while yields are high and prices lower. BBB rated bonds generally see very low long term (over 10-year rolling periods) default rates and offer 1.5-2% more than government bonds. The supply of corporate bonds is likely to reduce as higher yields and interest rates make this form of raising capital more expensive for companies than other choices such as disposals or equity.
Down the noisy corridor and turn left into the next class; let’s call it Social Studies. Perhaps that’s a stretch, but I mean “the return” to the office. The much unloved Real Estate Investment Trust sector is starting to recover. For the past year, bonds from these groups have priced in the worst possible outcomes, but recent results suggest rents remaining firm and rising, good occupancy levels for offices, and some specialist operators in flexible spaces reporting very good and increasing demand for space for startups, music producers, and the arts.
Then, let’s do Maths. This may not be a favourite subject, but numbers will play a crucial role, particularly those relating to interest rates. Over the next year, it’s worth building up duration – and therefore benefitting from falling yields – in portfolios. Markets are currently predicting that rates will start to fall in 2025, though I see that starting to happen in the second half of 2024. In any event, as we reach the peak, then pause, and eventually see a fall in rates, the discerning investor might want to turn to bond markets when seeking long duration. However, it is also worth looking at property assets, and many technology companies for earnings that stretch into the future.
From Maths, it’s straight across the hall to Economics, where the class can learn that banks may not be the most obvious asset to own going into an economic slowdown, but thanks to the last banking crisis (the GFC), balance sheets have been substantially improved and buffered. Bank earnings have soared with higher interest rates, although costs are now starting to catch up and will eat into earnings over the coming quarters, so too will worsening non-performing loan records. Bank earnings are generally a problem for equity holders, not debt holders – with the odd exception. At this point in the cycle, bank bonds could be an attractive addition to a diversified portfolio of bonds, and any surplus cash can earn a decent rate of interest from those self-same banks as they issue new bonds this Autumn.
So, there we have the homework subjects for the new term: cash, corporate bonds, real estate investment trusts, the bond-market definition of duration, banks and tech too. But like all good scholars, it’s important to proceed steadily after doing your research. Hopefully, this can be an autumn term that results in a glowing report!
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