Our full Investment Committee meets quarterly to review our recommended portfolios and consider changes in the light of current economic conditions. Here is an extract from our January 2024 Investment Team Commentary from Investment Team Manager, John Genovese.
UK inflation is currently running at 4%, having fallen from a peak of 11.1% at the back end of 2022. As predicted, the biggest drop came in October 2023, from 6.7% to 4.6% year-on-year, as a result of base effects triggering a +2% drop out of the year-on-year numbers. The figure for January 2024 may tick up, as the 2023 comparator is -0.6% and the 5% rise in the quarterly energy price cap will feed into January’s numbers. However, looking further into 2024, there are more 2023 comparison readings dropping out. These are +1.1% for February 2024, +0.8% for March 2024, +1.2% for April 2024 and +0.7% for May 2024. These numbers would suggest that inflation in the UK could conceivably fall back towards the Bank of England’s 2% target by the time the April number is released in May.
There are of course other factors to consider which will impact the numbers, such as food prices, the price of materials and energy, services inflation and wages, not to mention the longer-term potential drivers of inflation, such as reshoring and decarbonisation.
Food prices have been on the way down for some time now, the UN Food and Agriculture World Food price index has only risen month-on-month twice since March 2022. There has been a lag in this trend hitting prices in the supermarkets, due to hedging, but prices on the shelves are now falling amidst a supermarket price war.
The price of building materials is also falling, although some more energy intensive products have been more resilient. Weaker demand and lower energy prices should eventually feed into lower prices across the board.
Services inflation has proved somewhat sticky, despite aggressive rate hikes, with the higher cost of debt and significant increases in wages being passed on to consumers by way of higher prices. However, with economic growth flatlining, wage settlements in 2024 might be expected to moderate, and if lower inflation overall allows the Bank of England to reduce interest rates, borrowing costs may come down before the bulk of companies need to refinance their debt.
Other factors, such as shrinking workforces, reshoring, decarbonisation, increased geopolitical tensions and trade wars, also present upside risks to inflation, but are difficult to quantify in advance.
Overall, whilst there are risks to the upside, we should perhaps now be considering the risk to global growth posed by deflation. China is now exporting deflation and some countries are now seeing consumer prices fall as a result. Ageing populations means lower consumer spending and the potential for AI to boost output may also impact the longer-term balance of supply vs demand. In the shorter term, the key will be central bank policy, will they keep rates too high for too long while the global economy stagnates? If history is anything to go by, this seems unlikely, especially in a year of elections, although of course, they are not politically motivated (?), but data dependent. Either way, based on current data and trends, interest rates look to have peaked and the trajectory from here is lower.
On economic growth, having been the standout in the recent period, the US economy is forecast to slow in 2024 to 1.5%, as the lagged impact of eleven rate hikes takes effect. Again, the ultimate outcome, be it soft/hard/no landing, will be heavily influenced by central bank policy on interest rates, and like the UK, this coincides with an election year.
Growth in Europe is forecast to improve to 1.3% in 2024 and the figure for the UK was recently upgraded from 0.7% to 0.9%. China is forecast to grow at 4.2%, well below the 6-7% being achieved pre-Covid. India’s strong performance looks set to continue, with growth forecast at 6.3% for 2024.
All told global growth is set for the weakest half-decade performance in 30 years, according to the World Bank’s latest Global Economic Prospects report. However, slower growth is to be expected in the face of such aggressive rate hiking cycles, it is the necessary evil required in order to tame inflation. The impact of rate hikes has been accentuated by the fact that we have enjoyed 13+ years of free money, and that was long enough for people to forget what it was like to have to consider the cost of capital.
Looking ahead, there may actually be reasons to be more optimistic about the UK economy, at least from the perspective of the consumer, whose spending ultimately drives growth in our largely service-driven economy. Mortgage rates have fallen from a peak of around 6% down to below 4% in some cases, while savings rates have increased to around 5-6%. When you consider UK households in aggregate, the recent reduction in borrowing costs combined with better rates on savings results in a net benefit to consumer savings over the net cost of higher mortgage rates of around £10 billion a year. This is in addition to the £10 billion a year better off consumers were in aggregate prior to recent moves in savings and mortgage rates. Despite the uneven distribution of this excess cash, when you combine this £20 billion a year with £280bn (10.7% of GDP) of excess savings (savings above the pre-pandemic trend) built up since the start of 2020, it represents a significant amount of potential spending power as confidence builds.
Furthermore, the Autumn statement announced a 2% cut in employee National Insurance contributions, a 9.8% rise in the National Living Wage and an 8.5% increase to be applied to State Pensions. It’s also worth remembering that wage growth has been strong during this inflation spike, which has dampened or even completely offset the net impact on real incomes.
So, if the direction of travel is lower inflation and lower growth, which ultimately leads central banks to start cutting interest rates, what might this mean for financial markets and ultimately client portfolios?
Equity indices have historically risen once interest rates start falling. This dynamic was evidenced in the period from late October 2023 to the end of the year, following the sharp drop in UK inflation which altered the market’s expectations around the timing of interest rate cuts.
Our medium risk portfolio was up around +12% over this period, with four individual portfolio funds rising by more than +20% (Gravis UK Listed Property +25%, GCP Asset Backed +24%, GCP Infrastructure +23%, Aberforth UK Smaller Companies +22%).
Five funds rose between 15% and 20% (Chelverton European Select +19%, Empiric Student Property +18%, AVI Global Trust +18%, Triple Point Social Housing +18%, CFP SDL Free Spirit +15%).
A further eight funds rose by between 10% and 15% (Amati UK Listed Smaller Companies +15%, Impact Healthcare +14%, Chelverton UK Equity Growth, +14%, Slater Growth +13%, Gresham House UK Micro Cap +12%, New River REIT +11%, TwentyFour Income Fund +11%, De Lisle America +10%).
This helps to demonstrate that the same forces which resulted in weak performance in 2022 and most of 2023 work both ways and have the potential to drive strong outperformance when the cycle turns. The funds listed above which performed so strongly during the end of year rally, represent underlying assets/strategies which are characterised by the market as being more sensitive to changes in interest rates and/or are early cycle sectors which tend to outperform during the recovery phase. With respect to funds structured as investment companies, with discounts to net asset value at historically wide levels across the board, there is the added bonus of renewed buying pressure driving up share prices and narrowing discounts. In aggregate, with yields high, discounts wide and valuations low across our portfolio holdings, we see the latent potential for future outperformance across our portfolios as being broadly in line with the most attractive levels we have seen in our 30+ years of managing client portfolios.
In the short term, it is worth remembering that interest rate cuts typically come as a response to more difficult economic conditions. This means that many companies may be faced with a more challenging trading environment as the rate cutting cycle begins. It is for this reason we have populated portfolios with a number of funds with managers who have a preference for higher quality companies. These are typically companies with no or low levels of net debt, strong balance sheets, good generation of free cash flow, a product or service less linked to broader economic activity, market leaders in their field etc. Such companies can do very well during periods like this, as they can ride out the storm and pick up chunks of market share as their competitors go to the wall.
US equities have been the headline grabbers for much of the last decade. The ‘Magnificent 7’ namely Apple, Amazon, Alphabet (i.e. Google), Nvidia, Meta, Microsoft and Tesla now represent around 30% of the S&P by market cap. If we look at the S&P equally weighted by company, then it has risen 6.4% in 2023, but the actual performance is 20%, illustrating the influence of these seven companies. US equity markets have risen to a historic high of 42.5% of global equity listed markets. It wouldn’t take much diversification overseas to move to the UK equity market to lift valuations. Also of note, is that when concentration has been this high in the past, it has preceded a period of underperformance for the S&P vs its equally weighted counterpart index.
A major headwind for UK equities in recent years has come from continued outflows, owing to a number of factors, including Brexit, unintended consequences of regulations, lower liquidity and generally poor sentiment. There are signs that net flows could soon turn positive, the smart money is already taking out undervalued listed companies by way of M&A, with around two UK quoted companies being acquired every week. At some point investors will recognise the value currently on offer across the UK market, and it won’t take a lot of inflows to drive prices higher from here, given the starting point in terms of valuations and underlying liquidity. Also of encouragement is the UK government’s apparent commitment to addressing the regulatory issues which have increased net outflows in UK Equities, and in particular, UK listed investment companies. Regulatory reform has the potential to bring a swathe of institutional buyers back into the market.
Liquidity, or lack thereof, helped to drive prices lower during the recent sell-offs. However, it works both ways, and a pronounced shift in sentiment which results in sustained buying pressure has the potential to drive an epic rally. The last five times since 1988 UK Small Caps rallied off a bottom, the average gain to the next peak was +142%. It certainly pays to be patient.
As legendary baseball player (and philosopher) Yogi Berra states: "It is difficult to make predictions, especially about the future." However we’ve mentioned a number of factors that, taken in concert, point to a potential significant uplift in market values to come. It may not happen for a while yet, and undoubtedly we will see more market volatility along the way. But for long-term, patient investors the current conditions remain highly attractive and our portfolios are very well positioned to profit from any upturn.