2022 continues to deliver challenges and the UK became the talking point across financial markets for a short time in late September/early October. The “mini budget” debacle is likely to go down as a footnote in the history of financial markets but the effects on cautiously invested portfolios, the wider economy and, arguably, consumer confidence has been profound.
Bond investors have not experienced such a period in UK Government Bond (Gilt) markets EVER and the longer-term effect on the economy remains to be seen. The political instability has not helped although markets seem to have been placated somewhat by Jeremy Hunt being appointed as Chancellor and, latterly, Rishi Sunak as Prime Minister.
Yields on Gilts have fallen substantially from their peak as investors perceive Sunak and Hunt as being fiscally prudent. Because falling yields mean increased capital values, Gilts and Index Linked Gilts have recouped some of their recent declines:
Nonetheless, it is fair to say that the volatility in the UK Gilt markets is unprecedented (2022’s word of the year) and deeply uncomfortable for cautious investors used to a more stable return profile.
Opportunities in Bonds
In the years preceding September 2022, many strategists warned of potentially lacklustre returns from bonds as yields were at rock bottom, cash in the financial system was plentiful and interest rates remained near zero in the developed world. This is no longer the case and strategists have become much more positive about bonds.
As bond yields increased and prices fell, this created opportunities for investors. Many segments of the corporate bond markets (where one lends to a company, rather than a government) now look the most attractive they have done for over a decade.
As an example, some corporate bond funds now offer a gross redemption yield (what you would receive if the fund manager simply did nothing until all the bonds matured) of over 7%. The dividend yield on the FTSE All Share is 4.39% at the time of writing. Now, that doesn’t mean that investors will receive 7% per annum because the holdings are still subject to market forces. However, it serves to demonstrate that one can now achieve attractive returns from the relative safety of bonds, when compared to equities.
Bear market rally or equity market bottom?
Looking to equities now, developed markets have enjoyed strong returns through October. The jury is still out as to whether this marks the low point in equity markets. The dark spot, however, has been recent earnings announcements from US mega-cap technology companies, such as Amazon, Microsoft and Meta. Whilst many reported decent earnings for the third quarter, management guided for much more challenging times ahead, resulting in large falls in share prices for some.
This would seem to indicate that the difficult economic outlook is starting to impact companies and we continue to believe that analysts’ earning estimates for 2023 are too high. Most indicators point to a recession in Europe, the UK and US and yet analysts are still forecasting for US companies to grow their earnings by around 6.6% on average.
As we have warned before, if a recession does transpire, then earnings should logically fall as economic activity slows. In fact, historically, earnings typically fall 15% to 20% in a recession. Therefore, there is a risk that the recent strength in equity markets is merely another bear market rally and that there is further room for markets to fall from here.
However, market downturns do not last forever. We can’t say with any certainty when the current downturn will end, or indeed if it has already ended. But we can say with absolute certainty that it will end at some point.
Interest rates and fiscal policy
As I write this article, we are waiting on interest rate decisions from the US Federal Reserve (Fed) and Bank of England (BOE). By the time you read this, both will have raised interest rates, which the market expects to be by 0.75% each.
A rate rise of 0.75% from the BOE would be one of historic proportions although it is a far cry from the 1% to 1.50% priced by market in the immediate aftermath of the “mini budget”. Now that the majority of the inflationary policies announced by Kwasi Kwarteng have been scrapped, the BOE doesn’t need to raise interest rates quite as aggressively as it would have done if the policies had remained in place.
However, the UK Government still has a yawning chasm in its balance sheet, by some estimates to the tune of £50 billion, that needs to be addressed to keep the bond markets at bay. The, much awaited, policy statement is now slated for the 17th November and indications are that the Treasury will look to raise money through a combination of increased taxes and reduced public spending. This is not great news for the UK consumer already grappling with high inflation and the prospect of increased mortgage payments.
Where do we go from here?
Unfortunately, 2023 will not feel good. Wages are likely to get squeezed by higher taxes, high inflation and higher mortgage costs. UK house prices are forecast to fall and this will mean further deterioration in confidence.
However, markets tend to bottom around the middle of a recession and, if our guestimates for the economic outlook turn out to be correct, the next market upswing could be here before too long. Until then, we will continue to stick with our tried and tested processes.
This all sounds bad. Should you be invested?
The short answer is yes. But I would say that, wouldn’t I?
For those invested, cashing out now would only crystallise losses. One would then be faced with the question of when to invest again. By how much would markets need to rise before you are confident enough to go back into markets? 5%? 10? And there lies the rub.
For those holding off making a new investment, the question to ask yourself is this; if you were comfortable investing at the beginning of the year, why wouldn’t you now, when you can buy the same portfolio circa 7% to 12% cheaper?
Until next time, stay well.